Position sizing involves making an objective decision about what positions to take when trading, and it makes up an important part of just about any sound money management strategy. As a result, it would be a good idea for forex traders to incorporate some form or position sizing methodology into their trade plans.
Furthermore, many successful traders routinely assess the risk reward ratio of a particular trade they are considering entering as part of their decision making process. Some of them even incorporate criteria based on risk reward ratios into their trading plan.
An additional application of risk reward ratios among forex traders is in performing position sizing. Such a technique usually increases the size of a position depending upon how successful the trade is anticipated to be.
How to Determine the Risk Reward Ratio on a Forex Trade
Different forex traders might use different methods for assessing the risk reward ratio for a particular trading opportunity that presents itself.
Nevertheless, the basic idea involves quantifying the anticipated amount of risk or loss that the trade might result in and then comparing this to the trade's quantified potential returns.
When trading forex, the potential risk on a position would typically be assessed by computing the difference between the anticipated entry point and the proposed stop loss level that would be entered for the transaction, if entered into.
On the other hand, the reward on a proposed trade could be initially assessed by calculating the difference between the anticipated entry rate and the intended take profit level.
Of course, once a trade is entered, any changes to the stop loss or take profit levels, perhaps using the technique of trailing stops will change the risk reward ratio of the position.
Using the Risk Reward Ratio
Traders often use risk reward ratio criteria to help them place stop loss orders and also when assessing how large a position to take. In addition to assessing the risk reward ratio the trader is willing to assume before any trade, they may also take into account important technical analysis factors like the presence of nearby support and resistance levels.
Most successful traders refuse to take on a position unless they can expect to at least make twice the original investment. This would be a minimum risk/reward ratio of 1:2, where they risk one unit to make two.
They can also take on larger trades when a higher probability of success is anticipated, perhaps using the risk reward ratio as a criterion for doing so.
Sizing Positions Based on the Risk/Reward Ratio Alone
Although simpler ways exist to size positions, using a risk reward based position sizing method means that a trader will take larger positions when the trading opportunity seems more likely to be profitable. As long as the risk taken on each still falls with acceptable risk taking parameters, then this can be a successful enhancement to a trading plan.
Perhaps the easiest way to size positions based on the risk reward ratio would be to first compute the ratio, and then take positions only if it is better than say 1:2, for example. Then, a trader could take a position in direct proportion to how profitable the trade might be.
For example, a trader observing a 1:2 risk reward ratio for a potential trade could take a two lot position. Similarly, they might take a three lot position if the ratio was 1:3, or a four lot position for a ratio of 1:4, and so on.
Including Probability Weighting
An added degree of complexity would involve first assessing how profitable a trade might be relative to its risk, as determined by the risk reward ratio. The trader might then assess how likely making such a profit might be in order to determine what size of a trading position it is appropriate for them to take.
This would help the trader take larger positions when they were more certain about the outcome for a particular trade. In essence, using this technique would allow a trader to take bigger positions when a trading opportunity presents itself with a high probability of profit and a high potential return.
Alternatively, smaller positions would be taken for lower probability trades with lower returns.