A little bit of practice

Now, let’s combine all the concepts you saw in the previous posts, so that you understand how to organise your trading. Doing this will keep your aims always clear in your mind, minimising the feelings and emotions that often lead to mistakes.

Asset Allocation

A premise: if you trade with the intention of making a monthly income, then you need adequate capital. You cannot expect to earn $3,000 or $5,000 a month with a trading account of $5,000 or $10,000.

Yes, it is true that some markets, such as forex, allow you to trade with very high leverage. However, to get an income of that size, you also have to raise your risk levels considerably, and sooner or later, this will inevitably lead you to lose a good portion (if not all) of your initial capital. I am now going to give you a couple of examples, using a trading account of $50,000.

First, you need to decide how to divide your capital into asset classes. The table below shows an example of this, both in percentages and in dollars.

Alongside deciding which part of your capital you want to allocate to each asset, you can also choose, within each asset, the allocation by type of trade. For example, in forex, you may decide to allocate 20% of your capital to day trades, and 80% to medium and long-term trades. Once you have done this, if you decide to withdraw your earnings every month, nothing changes. If, on the other hand, you decide to leave them in your account, you will have to rebalance your asset classes.

Part of Capital for a Single Trade

Now that you have allocated your capital into asset classes, the next step is to decide the most you would be willing to invest in a trade for each asset. It is essential that you choose, before opening a trade, the part of the capital you are willing to use, and therefore risk, for that trade. It has to be an amount that will not create even the slightest problem, for you or for your trading account. If a trade requires more capital (margin) than you planned, you will not take that trade.

The table below shows an example of how much money you could allocate to each trade.

Percentage of Maximum Loss for Each Trade

Next, you have to decide the maximum loss you are willing to accept if the price hits the stop-loss. A loss that would not cause any problems for you. Decide this for each asset class, as you can see in the example in the table below.

Important. The percentage must be calculated on the equity, that is, on the entire capital you have in your trading account, not on the part allocated to the asset classes.

Stop-Loss and Position Size

At this point, you only have to decide where to place the stop-loss and, based on the maximum loss percentage, determine the position size to open. With options and spread trading, it is very easy to calculate how many contracts you can buy or sell.

With stocks, CFDs, ETFs and forex, it is slightly more complex. There are different ways to calculate position size, depending on the type of market. Below, I will show you the formula you need for stocks, CFDs and ETFs, and then the one for forex.

Stocks, CFDs, ETFs

Regardless of whether you trade stocks, CFDs or ETFs, the calculation is simple and always the same. Here is the formula:

Number of shares (LONG) = Max loss / (entry price − stop-loss)

Number of shares (SHORT) = Max loss / (stop-loss − entry price)

So, for example, if you open a long position on a stock with an entry price of $43.00, a stop-loss at $38.00 and a maximum loss of $800, the number of shares to buy is:

Number of shares (LONG) = Max loss / (entry price − stop-loss)

So:

Number of shares = $800 / ($43.00 − $38.00) = 160

Based on your maximum loss and stop-loss, the number of shares you have to buy is 160. If the price reaches the stop-loss, you will lose exactly $800.

If, instead, you established the maximum loss not with a fixed amount of dollars (or any other currency), but with a percentage, the formula changes as follows:

Nr. of shares (LONG) = (capital × % of max loss) / (entry price − stop-loss)

Nr. of shares (SHORT) = (capital × % of max loss) / (stop-loss − entry price)

Where capital is the amount of money in your trading account and % of max loss is the maximum percentage of the money (in your account) that you are willing to lose in the trade.

If, for example, you have a trading account of $60,000 and you decide to open a short trade on Apple with an entry price of $230.00, a stop-loss at $240.00 and a maximum loss of 1.5% of the money in your account, the number of shares to sell is:

Nr. of shares (SHORT) = (capital × % of max loss) / (stop-loss − entry price)

So:

Number of shares = ($60,000 × 1.5%) / ($240.00 − $230.00) = 90

Based on your percentage of maximum loss and stop-loss, the number of shares you have to sell is 90. In this way, if the price hits the stop-loss, your loss will be exactly the amount you established, that is, $900 (which corresponds to 1.5% of $60,000).

Now, let’s look at the formula for calculating the position size in forex.

Forex

Now, I am going to show you how to open a proper forex position based on your risk appetite. In this way, even if a currency pair reaches the stop-loss, this will not create any problems for your account, or cause you any additional stress.

Having completed your analysis, you decide to go short on GBP/JPY with an entry price at 133.000, a stop-loss at 134.500 and a target at 130.000. Your maximum bearable loss is $600. How much should you invest in this trade? You calculate the position size you should open with the formula:

Position Size = [(1,000 × max loss) / pips of stop] / value of 1 pip

In this formula, max loss is your maximum bearable loss ($600); pips of stop is the distance in pips from the entry price to the stop-loss (150 in this example); value of 1 pip is the value, in dollars, of one pip for a position of 1,000 units of the first currency of the pair (here, GBP), which is 0.09 in this example.

Returning to the example, the position size to open is as follows:

Position Size = [(1,000 × max loss) / pips of stop] / value of 1 pip

So:

Position Size = [(1,000 × $600) / 150] / 0.09 = 44,444 units of GBP

Slightly rounded down, the position size to open is 44,400 units of GBP. I rounded down the result, but you can decide to round the amount as you prefer. Thus, this is a trade that would lose you about $600 if the currency pair hit the stop-loss, just as we had planned.

Even here, if you establish the maximum loss not with a fixed amount in dollars (or in another currency) but with a percentage, the formula changes as follows:

Position Size = [(1,000 × (capital × % of max loss)) / pips of stop] / value of 1 pip

Where, as you have already seen, capital is the amount of money in your trading account, and % of max loss is the maximum percentage of money in your account you are willing to lose if the trade goes badly.

If, for example, you have an account of $50,000 and you decide to open a long position on EUR/CHF with an entry price at 1.0950, a stop-loss at 1.0780 and a maximum loss of 1% of your account, the position size you should open is:

Position Size = [(1,000 × (capital × % of max loss)) / pips of stop] / value of 1 pip

So:

Position Size = [(1,000 × ($50,000 × 1%)) / 170] / 0.10 = 29,411 units of EUR

Rounded down, the position size to open is 29,400 units of EUR. This is a trade that would lose you about $500, or 1% of your account, if EUR/CHF hit the stop-loss.

At this point, you must be wondering: how do I calculate the pip value of a currency pair? No problem: there are several free tools on the internet, one of them is Myfxbook (https://www.myfxbook.com/en/forex-calculators/pip-calculator). Once you enter the parameters (USD, or another currency, Lots = 0.01 and Pips = 1), it will automatically calculate the pip value for all the currency pairs.