How To Calculate Risk In Forex? A Guide To Managing Risk And Position Size

Managing risk is about limiting your losses to protect your capital. This concept isn’t exclusive to the currency market—it’s also relevant in poker, blackjack, sports betting, and many other areas.

If you had a trading account with $10,000, would you risk $5,000 on each of your trades? The answer is obviously no. Just 2 bad trades would be enough to burn your account.

Let’s take an example: Daniel and Thierry are two Forex traders at Saxo Bank, Daniel being aggressive (he risks 25% of his capital per trade) and Thierry being rather conservative (he risks 1% of his capital per trade).

With the same trading strategy in their hands, winning on 50% of trades, we could have:

→ For Daniel: 25% -25% – 25% – 25% = BANKRUPTCY

→ For Thierry: -1% -1% -1% -1% +2% +2% +2% = +2%

Do you see the difference? The % of capital used on each trade is therefore fundamental. To last on the Forex market, the secret lies in… the size of your positions.

Understanding Risk in Forex Trading

Since Forex is a fairly unique financial market, let’s start by clearly identifying the risk associated with a Forex trade.

When you decide to buy 1 lot of the GBP/USD pair, one of the most traded major pairs, whose quote is 1.3945, a margin of $4640 will be necessary, if you trade with a leverage of 1:30 as with most Forex brokers on the market.

You place a stop loss at 1.3900 based on the indications of the technical analysis. If the price falls by 45 pips, your position will be automatically closed.

Knowing that the pip value is $10, such a scenario would cost you $450 (45 pips x $10). Then your margin of $4640 would be released .

Hence the important distinction to understand when it comes to risk in Forex trading:

• Your position risk is $450 , this is the amount you risk losing
• Your position margin is $4640 , this is the amount that will be released if your trade is closed because the price has “hit” your stop-loss.

Having made these clarifications on the notion of risk in Forex trading, you have been able to see that your risk depends on three factors:

• The Stop-Loss
• Pip Value
• The maximum % of capital risked on each position

Combined, these 3 factors bring us to a formula that will allow you to adjust your position size relative to your personal risk limits.

How to calculate your Forex risk?

The following formula allows you to calculate the correct position size to open, respecting the maximum risk that you have set for yourself in relation to your capital.

The formula:

Position size = (Maximum risk ÷ Stop-loss level in pips) * (Currency pair quote / Quote increment).

This formula is rather complex. To go faster, Forex brokers provide you with trading tools to calculate your position size on their trading platform. You just need to fill in the parameters of the formula:

• The currency pair
• Current rating
• Stop-loss spacing in pips
• The desired risk taking (in % or in $ depending on the tool)

Example:

You have a trading account with FXCM broker of €10,000.

You want to risk 1% of your capital, or €100, per position.

Trading the EUR/USD pair which is quoted at 1.2510 – 1.2511, you decide to place your stop-loss at 1.2480 based on your technical analysis. This represents 31 pips (0.0031 = 1.2511 – 1.2480).

The value of each pip on your trade should be: €100 ÷ 31 pips = €3.22.

What batch size does this correspond to? Let’s use our formula:

Position size = €3.22 x (1.2511 ÷ 0.0001) = €40,285 invested or 0.40 lots .

The value of a pip varies depending on the base currency (here EUR: euro) and the quote currency (here USD: US dollar) on the pair. Trading currency pairs of the xxx/USD type allows you to earn money up to $10 per pip (0.0001 in currency price movement) if you trade a position of 1 lot … And proportionally, $1 per pip if you trade 0.1 lot, $0.10 per pip if you trade 0.01 lot.  

Final Thoughts on Managing Risk in Forex Trading

To trade Forex and more generally to trade other stock market assets via CFDs (shares, stock indices, Bitcoin crypto, etc.), it is imperative to properly adjust the size of your positions in order to properly manage your risk-taking.

In concrete terms, money management comes down to its most basic form of risking the same amount (or the same % of your available capital) on each of your trades. In this way, it will be very difficult for you to fall into a scenario in which your account is threatened with bankruptcy .

Choosing a good position size is based, as you may have read, on several parameters:

1. Currency pairs traded : each pair in the foreign exchange market associates a base currency with a quote currency. The quote currency has an impact on the pip value, the latter is not the same on a currency pair of type xxx/JPY (yen), xxx/CHF (Swiss franc), xxx/AUD (Australian dollar), xxx/USD (US dollars), xxx/GBP (sterling pound) …
2. The desired risk : 1%, 2% of the capital? It’s up to you to determine how much you want to commit to a trade. For a beginner trader, the ideal is to trade on Forex with 1% of your capital on each position
3. The distance/level of your stop-loss : the further your protective stop is from the entry point, the smaller your position size should be. This helps reduce your risk. 

This last point is the most flexible, since each trader has their own style.

Indeed, the swing trader or the foreign exchange investor will seek to capture large movements on the currency market, and profits ranging from 500 to 1000 pips, which will lead him to set a wide stop to prevent the price from hitting his stop-loss and prematurely closing a potentially winning trade. 

Conversely, the scalper will speculate and take positions in a few minutes on small volatility movements of the main pairs or targeted secondary/exotic pairs, of the order of 10 to 50 pips, with a close stop.