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The Basics

The Primary Trade Size Forumla

Position sizing is something that comes up ALL THE TIME in the discussions among new and developing traders. Everything starts with the size of the risk we’re looking to take and works up from there.

Here is the basic formula:

Position Size = Amount at risk /(Number of Points or Pips being risked x Value of  Each Point or Pip)

Amount at risk comes from looking at the fraction of your account that you want to be exposed to loss on the given trade. So if you have a $5000 account and want to risk 2% then that would be $100.

The number of points or pips being risked is basically how far away from your entry point your initial stop will be. If you’re getting long at 100 and your stop is at 95, then the point risk is 5.

The value of each point or pip will depend on the market you’re trading.

Thinking in stock market terms where the value of a point is $1.00 per share (adjust for your own currency), the formula would be as follows:

Shares = $ to be risked / (Points risked)

So if you want to risk $1000 and your point risk is 10 you would trade 100 shares: $1000/(10 x $1)

If you’re trading a fixed size contract market such as futures or forex (lots), then it would look like this:

Contracts (Lots) = $ to be risk / (points risked x point value)

In the case of e-mini S&P 500 futures, the point value is $50, so if we want to risk $1000 and have a 10 point stop, we would trade 2 contracts: $1000/(10 x $50)

If we are trading micro lots of EUR/USD where the pip value is $0.10 and we are risking $1000 with a 125 point stop, we’d trade 80 contracts: $1000/(125 x $0.10)

Notice that nowhere in here did I bring up the question of appropriate leverage. It only matters if you don’t have enough available to you to put on the trade you’re looking to do.

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Trading News

Expanding Margin Rates in Silver

The CME Group yesterday announced that it would be bumping the margin on the silver futures contract from $5000 to $6500 effective today. That’s a 30% bump, which no doubt has impacted some traders. In making this move, the exchange increased the margin from about 3.6% (at current prices as I write this) to about 4.7% (a silver contract being 5000 troy ounces). The chart below explains the move.

Silver prices have jumped about 50% since the end of August. Back then, the $5000 margin was about 5.4%. Volatility was also significantly lower. Now we’re looking at a much higher price and significantly higher volatility. The futures exchanges will make adjustments to margins based on both factors as they see fit. It’s interesting in this case, though, that they haven’t bumped it up to the approximate level it was before.

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Trading News

New CFTC Rules for Retail Forex Trading

Can I say I told you so? 🙂

The CFTC has finally come through with its new rules on retail foreign exchange, which come into effect on October 18th, 2010 (Q&A about the new rules can be found here). Despite fears to the contrary, the CFTC will not be cutting permissible leverage in retail forex trading down to 10:1. The people have been heard! There was so much contrary opinion against that move from traders and brokers that the regulators were forced to rethink the plan.

That said, the CFTC will, however, be restricting leverage to no more than 50:1 (2% margin requirement) on the major currencies (5% on regional currencies). This is basically taking the NFA restriction put in place last year for 100:1 max leverage and tightening it up. I’m sure that’s going to have some folks up in arms, but the reality is that most of your better traders never go much beyond 10:1 actual leverage. Further, one of the biggest forex brokers out there, Oanda, has never permitted more than 50:1 leverage.

I know this won’t have any impact on my trading, nor encourage me to move my account outside the US. What about you?

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Reader Questions Answered

Working Out Position Size in Forex Trading

I got this (slightly edited) private message inquiry from a Trade2Win member yesterday. It gives me a chance to reiterate something which has new forex traders minds spinning regularly for nothing.

… wondered if you could assist me in working out my position sizing for different currency pairs? Be great if you could as im a bit stumped…

Say i have an account of £10,000

I want to risk 1% which = £100

I’d like to buy usd/chf @ 10500, with a stop of 20 pips @ 10480.

How do i go about working this out if i have leverage of 100:1?

Dealing with USD/CHF pip values isn’t quite as clean and easy as dealing with those of EUR/USD where they are fixed (in dollar terms), but it certainly can be done. The math isn’t all that hard.

To get the pip value for a pair where the USD is the base currency (quoted first) you are effictively determining what a pip represents in % terms relative to the market price. In this case we’re looking at USD/CHF with a starting value of 1.05, thus

Pip % value = .0001/1.05 = 0.00952%

So if we’re trading a full standard lot ($100,000) then the pip value will be $9.52, which is $100,000 x 0.0000952.

Now the question is how to determine position size based on a 20 pip stop loss for a given risk exposure. The first step there is to figure out the 20 pip % value. That’s 0.0020/1.05, or 0.19048%. From there you have to do some algebra to figure out the size of the position based on how much you are risking. You’re using this base formula.

R = PPV x S

Where R is risk amount in $, PPV is the pip % value for the number of pips you’re risking, and S is the position size in $. Flipping that around to solve for S you get:

S = R/PPV

Using our example, we have a £100 risk. If the GBP/USD exchange rate is 1.50, that’s a $150 value for R. Plugging in that into the formula above and we get:

S = $150/0.19048 = $78,750

Rounding down that gives us either 78 micro lots or 7 mini lots.

We can put all of the above into one formula.

S = R/(Pf/Pr)

Where Pf is the pip fraction (decimal difference between entry and exit) and Pr is the current market rate for the pair in question. Using our example numbers we have:

S = £100/(.0020/1.0500)

Using the GBP/USD value of 1.5 that becomes

S = $150/(.0020/1.0500) = $78,750

Now here’s where the 100: 1 leverage question comes in. Ready? It’s very simple. You just have to ask this question:

Based on my permissible leverage, can I take a position this size?

In this example where a £10,000 account is being used, so long as a major chunk of those funds aren’t already being used for margin on other positions, the answer is yes.

To put it another way, the leverage question plays absolutely no part in determining the size of the position you take when you are working out that size from how much risk you want to take other than to set the upper end limit of how big that could be.

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Trading News

More New Margin Requirements

I posted before about the NFA’s new rules on maximum forex trading leverage permissible for traders with US brokerage accounts (see New NFA Retail Forex Leverage Restrictions). Those went into effect on Monday. Tuesday new leverage rules kicked in for the trading in leveraged ETFs. Darwin’s Finance has a good write-up on the subject.

I find it somewhat interesting that margins on short ETFs is higher than on long ones. Granted, equities do tend to move more rapidly to the downside, but a double long ETF is going to move just as quickly as a double short when the market is falling (considering day time frame moves here, which is what the leveraged ETFs are intended to track). It’s basic math, so I see no real justification for the higher margin between the two.

The other interesting part of this is that even with the new margin requirements you can still trade at effectively 4:1 leverage. That’s a fair amount of leverage when you consider how much volatility there can be in the markets underlying these ETFs. Many experienced forex traders don’t go much beyond 10:1 leverage when they trade, and that’s in a lower volatility market (see Looking at Volatility Across Markets)

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Trading News

New NFA Forex Leverage Limits In Effect Today

I wrote a while back (New NFA Retail Forex Leverage Restrictions) about new rules coming into effect from the NFA which limit the amount of leverage US member forex brokers are permitted to allow their customers. Those new rules start today. If you have a US brokerage account you have probably already received notice about the rules if your broker previous offered more than 100:1 leverage, which is the new cap.

Also, the margin must be calculated from the notional value of the position. I believe this has forced a change among some brokers who previously set their margin based on the size of a position rather than its value. For example, they would require $1000 margin on a 100,000 EUR/USD trade. Under the new rule they would have to require 1% of the value of the position be posted as margin. If EUR/USD is trading at 1.50, then a standard lot position would be worth $150,00, meaning a $1500 margin requirement.

Categories
Trading News

New NFA Retail Forex Leverage Restrictions

The National Futures Association (NFA) is not well liked by many retail forex traders because of restrictions they put in place earlier this year.  You may recall my posts NFA rule which effectively bans the practice of “hedging”, NFA Justifications and Reasoning for Killing Forex Hedging, and New NFA Rule Impacts More Than Just Forex Hedging and all the discussions that went on around them (literally hundreds of comments). They forced some changes to the way brokers handle positions and transactions, and the way some traders did their thing (or forced them to switch their account to non-US regulatory coverage).

Well, in case you haven’t heard yet, the NFA is back at it.

Effective November 30 they will be requiring US-based retail forex brokers to cap available leverage at 100:1. To quote the notice to members:

“…beginning on November 30, 2009, all FDMs must collect a customer security deposit of at least 1% for the currencies listed in Section 12 and at least 4% for all other currencies.”

The Section 12 currencies are the majors and some of the big European regional ones: British pound (GBP), the Swiss franc (CHF), the Canadian dollar (CAD), the Japanese yen (JPY), the Euro (EUR), the Australian dollar (AUD), the New Zealand dollar (NZD), the Swedish krona (SEK), the Norwegian krone (NOK), and the Danish krone (DKK). The US dollar (USD) is not specifically listed, but obviously it’s included.

As I understand it, any pair which includes at least one of the above currencies is covered by the 1% margin rule (100:1 leverage). In other words, the Mexican peso (MXN) isn’t on the list, but USD/MXN would fall under the 1% margin rule because the USD is part of the pair. All other currency pairs fall under the 4% (25:1) rule.

Value vs. Size
Note that according to the proposed rule change that was sent by the NFA to the CFTC for approval (the latter regulates the former) the margin must be calculated from the notional value of the position. I believe this is going to force a change among some brokers who have set their margin based on the size of a position rather than its value. For example, they would require $1000 margin on a 100,000 EUR/USD trade. Under the new rule they would have to require 1% of the value of the position. If EUR/USD is trading at 1.50, then a standard lot position would be worth $150,00, meaning a $1500 margin requirement.

It’s Actually More Leverage
This rule is actually an expansion of permissible leverage over what the NFA had proposed back in 2003. At that point they wanted 2% for the Section 12 currencies. That would have only permitted 50:1 leverage, which is closer to what the futures market margin rates are at (though still well short). The members put up a fuss at that point, however, and got them to put a hold on implementation of the rule.

Higher Leverage Means More NFA Action Against Brokers
The rules change proposal noted above also indicates that brokers permitting higher than 100:1 leverage were more apt to be the subject of NFA and/or CFTC enforcement action. At the same time, the two NFA member brokers capping leverage at 50:1 were never the subject of such action. Oanda is one of those brokers. I don’t know the other.

The NFA has indicated that it is concerned about an increased account burn-up rate at higher leverage points. While leverage is only a tool, it’s clearly that it is a dangerous tool in the hands of many new traders, even more so when you consider that those brokers offering the higher leverage seem more apt to engage in shenanigans.

Actually, the NFA proposal letter notes that one broker who offers 700:1 leverage (yikes!) actually claimed that it allows customers to employ tighter stops. I know this may sound like a contradiction, but I’ve long held that tight stops are a trap (see Close stops do not lower your risk). This 700:1 broker should be shut down if it honestly believes that higher leverage is required for tight stops. What are they smoking over there? I’d love to hear the logic. It would no doubt be quite humorous.

My Reaction
I’m perfectly fine with this rule. In fact, it really has no impact on my own trading. I have long traded through Oanda with their 50:1 maximum permissible leverage and never found myself constrained. A great many experienced forex traders will likely have the same response as they tend not to trade at much more than 10:1 or 20:1 actual leverage.

Also, I think the 100:1 leverage keeps the spot forex market in a good competitive position vis-a-vis the currency futures market.