With fixed ratio position sizing a trader will increase or decrease his or her position size at specific intervals. The key parameter in the following equation is delta. Delta is the dollar amount of profit per contract necessary to increase the number of contacts by one. For example if the trader chooses a delta of $5,000 and the trader begins by trading one contact the account balance would have to grow by $5,000 before adding another contract. To add another contract the account balance would have to grow by $5,000 per contract. In this example it would take another $10,000 account balance growth to go from two to three contracts.
Contract Account Balance
1 $20,000
2 $25,000
3 $35,000
4 $50,000
The fixed ratio position sizing formula is: Trade Units = 0.5 + (2 * Profit/Delta + 0.25)^(0.5)
Having a lower delta value is more aggressive than having a higher delta value because it the position size will increase more rapidly. Unlike fixed fractional position sizing, trade risk is not part of the fixed ration formula. Fixed ratio is only concerned with accumulating profits and the delta value. Fixed ratio position sizing ramps up the position more rapidly then as profits accumulate slows down to a capital preservation mode. See the equity growth chart below based on a beginning balance of $20,000 and random trade data.
Position sizing and money management are some of the most important, yet most overlooked tools that can have extreme effects on trading. These concepts can determine whether or not a trader will be profitable in the long run. One of the, if not the biggest mistake new traders make is over leveraging their trading account. Without proper position sizing and money management a new trader may have a much larger chance of blowing up their account.
In the most basic sense fixed fractional position sizing means taking on a trading position based on the percentage risk per trade. Many traders use anywhere from 1% - 5% when using this principle. Risk in this sense is defined as either the dollar amount the trade would lose per contract if the position is stopped out (i.e. trader uses a stop loss order to protect a position and the order is executed) or the largest historical loss if the trader does not use protective stop order (not recommended).
For example, a trader with an account size of $20,000 risking 2% (a common percentage) will only risk a total of $4000 per trade. In forex trading, if the trader enters a trade and places a 40 pip stop, assuming $10 per pip, the trader would trade a position size of 100,000. The formula used for this calculation is:
Trade Units = % Risk * Capital / (StopLoss Points * TickValue)
Trade units = .02 * 20,000 / (40 * 10)
1 units = 100,000
See the equity growth chart below comparing the effect of using fixed fractional position sizing versus trading one standard lot. The comparison uses a starting balance of $20,000 and is generated with random trading data.
As a trader’s equity balance increases or decreases his or her risk level remains the same, i.e. 2% but the size of the trading position will increase or decrease along the equity balance.
Market makers brokers discourage scalping strategies and are known to add restrictions that potentially make order execution more difficult. It is possible for market makers to delay transactions or manipulate currency prices to run their customers' stops or not let customers' trades reach profit objectives.
A forex ECN is typically more volatile, which may be better for scalping. The liquidity providers do not have a vested interest in any particular trade as most times a trader will enter a trade with one liquidity provider and later exit the trade with another. An ECN will also provide anonymity for the trader. The bridge between the liquidity providers and the traders will not allow pending orders to be seen by the liquidity providers.
Forex ECN brokers allow and encourage scalping strategies because it is in their best interest to. Scalping strategies typically trade frequently and will potentially generate the forex ECN broker substantial commission and as we know a forex ECN broker only makes its money on commissions.
This is important to know as it can have an effect on your trading account. A market maker forex broker makes its money in one of two ways. The first way is quite common in that the broker will take the other side of your trade. So, if you buy Eur/Usd, the broker is selling it to you. You will profit if the Eur/Usd rate goes up but the broker will profit if the Eur/Usd rate goes down. In this case the market maker broker makes money when the trader loses money. Another way the market maker broker makes money is when the broker hedges the trader’s account when the trader becomes profitable. An example is if the trader goes long the Eur/Usd, the market maker broker will attempt to buy the Eur/Usd at a lower price. This means they are buying the cross a little better than the trader instead of passing the best rate on to the trader. A forex ECN broker makes it money by the commission it charges its traders. Since the forex ECN broker is not negatively affected by the profitability of its traders it is able to pass on the best prices available through its forex ECN and charge a fixed commission per trade which most of the time can result in a tighter effective spread (spread plus commission) than the market maker broker.