Fri 22 Jan 2010
We regularly size our forex positions based on the amount of risk we are willing to assume. To detail a feel for the steps that are gone through for each trade, we're going to go through all the steps based on a hypothetical scenario. Our situation is a young, go-get-er that is managing a ¥1M account. Because this guy understands that he's young and can take on more risk (not to mention it makes our math easier), he is willing to lose 10% of his account on any one trade (which is not recommended, you should know your own risk levels).
The trader has been looking at the USD/CAD pair, over several timeframes.
The trader feels that the recent short term rally is pushing into over-extended territory, and believes that the long term trend will once again assert itself and push the price back down to support around 1.025. Examining moving averages, trendlines and other forecasting tools, the trader settles on a short entry price of 1.062. If the price moves against him and pushes above 1.075 then the trader knows the gig is up, the long term trend has been broken and he should be out of the trade. The total loss the trader is willing to take is: 1.0750 - 1.0620 = 130 pips.
The USD/CAD pair has all of it's profit and loss calculated in Canadian dollars. So if the trader is going to risk 10% of his portfolio of ¥1M, first determine what ¥100k would be in Canadian dollars. CAD/JPY is about 85.25, so the maximum ¥100k loss would work out to be $1,173.02 Canadian. Now, what position size would result in 130 pips, being equal to the maximum drawdown of $1,173.02ish Canadian?
The position size would be: 1,173.02 / (1.0750 - 1.0620) = 90,232.31 CAD. Now, all transactions on the USD/CAD pair are done in the base currency, which in this case is USD. So converting the 90,232.31 into its US equivalent of 85,431.04. This means that if out Japanese investor wants to cap his risk at ¥100,000, then a short position of 85,000 USD/CAD entered at 1.062 and stopped out at 1.075 would put a ceiling on the losses with the price targets from the chart.
This simple example is missing a couple of larger points, like the exchange rate between JPY and CAD messing with the total profit and loss, as well as interest charged/rewarded for the currency position. This example also doesn't take into account any margin requirements, transaction fees, spread on the bid/ask or other risk factors.
Why would this Japanese trader enter this trade, if they were only planning on losing 10% of their account? Looking at recent bottoms in the chart, the trader has determined that a price target of 1.03 is where they would close the short position, which would equate to 320 pips of profit and more than double the 10% of their account that was at risk. Of course, the price can move in any direction, and every trader should do their own research.