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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 Tips

Some of the worst market analysis ever!

I came across an article the other day which got my blood boiling a bit. It basically talks about trading the “spread” between the S&P 500 and EUR/JPY forex cross rate. The author was quite happy with himself for calling the spread being exceedingly wide and recommending a spread narrowing trade. He went so far as to say “Selling ES and going long EURJPY is now pretty much risk free.” I don’t know what anyone else’s definition of “risk free” is, but this trade certainly isn’t mine.

I don’t have any problem with the general idea underlying the trade that stocks and the EUR/JPY rate tend to trade in tandem. It’s been the case for quite a while now that when the market’s are feeling good and buying stocks EUR/JPY (and really all the JPY pairs) will rally, but when the markets are nervous and shifting into a risk aversion mode both the exchange rate and the stock market falls.

My issue with this analysis is this. The author is using a dual-axis plot of the S&P and EUR/JPY (meaning two price plots with different y-axis) to determine the “spread”. When there’s a gap between the lines there’s a spread. When there isn’t, the spread is zero. That would all be just fine if the S&P 500 and EUR/JPY were even close in price, which they aren’t.  At this writing the mini S&P contract is at about 1066 while EUR/JPY is right around 110. Notice how they are not anywhere close to zero?

This has got to be some of the worst analysis I’ve ever seen. Please, please, please don’t every employ this methodology – if you can even call it that.

And calling or implying this trade is some kind of arbitrage is even worse. There is absolutely no mathematical or other direct linkage between the S&P and EUR/JPY. That means no arbitrage, just a coincident relationship. It just so happens that in this market cycle they are trading based on the same main drivers. That could change at any time. That means you most definitely have risk.

Again, I’m not necessarily arguing against the idea of the trade (stocks and cross get back in line). I’m just saying the analysis used to get there is severely flawed and dangerous.

Categories
Reader Questions Answered

Minimum Amount Required for Option Trading

How much capital is required to trade is a question which crosses just about every trader’s mind somewhere along the way. It certainly comes up in questions on trading forum sites frequently. I actually got a fairly specific version of the minimum funding questions yesterday by and emailer.

How much is needed to start trading options? What things should I be considering before going ahead?

There are a few general things which come in to play here:

  • How many positions will you have open at a time?
  • What is the price level of the underlying market?
  • Are you trading in, out, or at the money options?
  • Are you doing outright long/short positions, or spreads?

Obviously, the fewer positions you have open the less capital you need. Likewise, if you’re trading options on lower priced underlying markets the price of the options will tend to be lower. For example, an option on a $100 stock is going to be markedly more expensive than one on a $10 stock.

Similarly, there’s a difference in cost, and thus capital needs, depending on whethere you are trading options that are in-the-money (ITM), out-of-the money (OTM), or at-the-money (ATM). ITM options will be the most expensive and OTMs will be the cheapest, and the further away from ATM you get the greater the price differentials.

Finally, if you are doing outright long or short positions your capital needs will probably be greater than if you are spread trading. This isn’t a guaranteed thing, though, as in some cases spread trades can require just as much capital as going straight long or short. It depends on the strategy in question.

Consider the strategy as well
Beyond those basics, there is the need to look as your method of trading and what it means to things like exposure and potential drawdowns. More frequent trading probably, but not necessarily, means a higher capital requirement. That likely depends mostly on how many overlapping positions you’d have, but also takes into consideration transaction costs. They can really chew up an overly small account.

What kind of losses you may take on individual trades makes a difference as well. If you are figuring that you will lose all or most of the money you put into a trade (or potentially more if you’re shorting) then you’ll need more capital than if you normally would only take fractional losses on the options when trades go against you.

You also need to consider your risk of ruin, in a manner of speaking. Basically, that’s a look at the potential drawdowns you could suffer. You have to make sure you’ll never lose enough to keep you from being able to trade any more. That means having enough staring capital to make sure any drawdown that may come about will not cause too much trouble.

Bottom Line
If you’re just getting started in options, stick to one position at a time and one contract in size, and focus on lower priced underlying stocks you could probably begin with $1000 and be assured of at least a few trades to get your feet wet. Once you’re beyond that stage and are set to really make a go at trading options with a decent chance of success you’ll probably want to be working with something

Categories
Trader Resources

Volatility, Stops, and Other Topics

Here are a few interesting posts from my blogging peers that you may find interesting.

Vix and More wrote Thinking About Volatility. It’s part of one of a set of posts and does a very good job of laying out the different ways to think about market volatility.

Along those same lines, Brett Steenbarger recently posted Think Like the Herd, But Don’t Follow the Herd. In it he discusses the combined states of volatility and trend, and how volatile non-trending markets like the current stock market can cause traders fits.

Trader Mike posted Tight Stops and Risk/Reward Ratios. In it he answers a reader question about where he places his stops, the impact of volatility, and the implications for the risk/reward positioning of his trades. Stops are a subject I have posted about here on many occasions, such as Close stops do not lower your risk, Where do I put my stops to avoid being taken out?, and Respecting Your Stops is Easier With Better Stops.

Building confidence was the subject of my recent Afraid to Trade? Build Your Trading Confidence post. The parallet subject of dealing with your fears is the focus of Conquer the Fears Lurking in the Dark Corners of Your Mind recently posted at Zen Habits.

Categories
Deep Posts Reader Questions Answered

Once you’ve suffered a huge trading drawdown, how do you recover?

I imagine this question is one that more than a few traders are struggling with at the moment.

Dear John,

Here’s a question. Once you’ve suffered a huge drawdown, what’s the best way to recover? I suffered the losses from making very stupid mistakes, but I’m not sure how to recover from here. Can you offer any help?

Thanks,

Glenn C.

Believe it or not, Glenn’s question has a silver lining to it. Of course it’s always rough to suffer a big drawdown. It can be a very destablizing event, above and beyond the obvious financial impact. In this case, though, Glenn’s losses came from what he as described as boneheaded moves on his part. That’s a good thing because it immediately implies something which is correctable. It’s much worse when you feel like you’ve been doing everything right and take a big hit.

That said, rattled confidence doesn’t generally come back quickly, as the current market environment is telling us quite clearly. It takes time to build back up as the result of some success. Generally, the best path back from the abyss is to perhaps shift back to demo trading for a while and to definitely cut way back when going back into live trading. Progressively build yourself back up to normal risk levels over time as your confidence returns.

Categories
Trading News

Another Rogue Trader

If you were completely out of touch Thursday you might have missed the adventures of our latest rogue trader. And this one’s a biggy. He puts Nick Leeson to shame. How about $7bln+ in losses for his employer, French bank Societe Generale. Inexplicably, he’s vanished. Imagine that!

Let’s just say someone didn’t practice very good money management. 🙂

By the way, a lot of folks are blaming this guy for the market insanity this week. He apparently had gotten very, very long (read tens of billions worth) in European stock index futures, especially the DAX. The unwinding of that position, which Soc Gen only found out about on Friday, was a major contributor to the global sell-off.

Rogue Trader - Nick LeesonIn case you never heard the Nick Leeson story (he’s the guy who sank Barrings Bank about a decade ago) you should definitely read his book – Rogue Trader. If you can get beyond the questionable ethics of helping a guy who caused the loss of over $1 billion and the death of Britain’s oldest bank make a few bucks based on his experience doing so, then it’s a interest read. The film version starring Ewan McGregor is ok, but lacks the real depth of the story as Leeson tells it in the book.

Another good read if you’re into the kind of “inside Wall Street” type of book is Black and White on Wall Street. This one is an autobiography written by Joseph Jett, a former Kidder Peabody fixed income trader who was accused of improper trading or accounting or something (it’s a bit unclear) which resulted in substantial losses. Unlike the Leeson book in which he admits to his wrong-doing, this one is an attempt by Jett to tell his side of the story and clear his name. There are some complex financials issues discussed in places, but they don’t really hinder things when you read it.