So far in the lessons leading up to this one we have covered some of the different methods traders use to pick their entry points, as well as some of the different methods which traders use to set their exit points. In this lesson we are going to look at the factor which ties all of the above together and allows a trader the greatest control over their returns: Position Sizing.
While position sizing is one of the Key components of successful trading, like many of the other things we have covered, it is often overlooked as an unimportant aspect of trading. What successful traders know however is that once the psychology of trading is mastered and a trader has developed a sound strategy for picking their entry and exit points, it is the method they use to determine the size of the positions they trade that is the final factor which will lead to their success or failure.
To help illustrate this lets say that three traders are each given $10,000 and the same EUR/USD Mini Forex strategy to trade which has a win rate of 60% (makes a profit on 6 out of 10 trades) and makes an average profit on winning trades over the long term of 100 Points. On the losing side, this same system has a lose rate of 40% (takes a loss on 4 out of 10 trades) and takes an average loss on those trades of 90 points.
So here we have a trading strategy that has more winning trades on average than it does losing trades, as well as a strategy that when it does lose it loses less than what it does when it wins. I think most traders including myself would take that system any day of the week.
So we give these traders each this system and tell them to come back to us after 10 trades and show their results. As the system is the same for all traders, when they bring us back the trading results of their systems the entry points and exit points for each trade is going to be the same, leaving them only the position size as the factor that they can tweak.
As they are trading mini EUR/USD forex contracts the value of a 1 point move is $1 per contract traded. With this in mind after 10 trades the system produces the following results:
So Trader 1 recently read an interview of a successful trader who said that one of the major reasons why forex trading has such a bad name is that people over leverage themselves. In this interview the trader recommended not leveraging more than 20 to 1. So with this in mind the trader decides that since this is a winning system he is going to take it to the max that this trader recommended and trade 5 mini forex contracts (50,000) on each trade since he is starting with $10,000.
With this in mind his results are the following:
Trader 2 decides that since the strategy is one of the best he has seen he is going to be more aggressive than trader 1 and trade 10 contracts (100,000) on each trade. This produces the following results.
As you can see here by doubling the number of contracts that he traded on each trade trader 2 doubled the returns of trader 1.
Trader 3 decides that since the system is a guaranteed winner he is going to leverage up as much as he can and swing for the fences on every trade thinking that this will produce the maximum gain at the end of the 10 Trades. This produces the following results.
As you can see here because he had such a large trade on and the first trade was a loser, he now had very little money left after the first trade and therefore could not trade as many contracts. Continuing with the strategy though the trader kept swinging for the fences on every trade until he was basically at the point where he did not have enough money in his account to initiate a new position for the 9th and 10th trades.
As I hope the above examples of three traders given the same strategy can produce drastically different results based on the position size they take with each trade, and thus shows the importance that position sizing plays in any successful strategy. In the next lesson we’ll look at some of the different strategies many traders use to determine their position size.