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From a purely academic point of view, the profits generated by a Forex trading system or any strategy would be risk-adjusted. However, when most retail Forex traders think about money management, they solely focus on the upside potential and disregard the downside risks. As a result, even with a very low rate of risk-free return under the low-interest-rate environment in major developed economies, the Sharpe ratio of some of the best Forex strategies turns out to be pretty depressed.

For retail traders, Forex money management is a tricky topic to discuss because there are so many different ways to deal with it. However, most traders, after spending some time in the business – wasting countless hours and a considerable amount of capital trying out Martingale, Kelly criterion, and everything under the sun - tend to gravitate towards risking a fixed percentage of their invested capital per trade. Better known as the percentage risk model.

The problem with this approach is, even though a trader wants to allocate a fixed amount, a certain percentage of the account balance per trade, most retail traders forget to incorporate pip value in the calculation.

The Pip Value is Important When Applying the Fixed Percentage Risk Model

Pip values of different currency pairs are always changing, every second. As a result, a trader risking two percent of a $5,000 account might end up risking $100 on the EUR/USD trade, but an hour later, risking $75 on an AUD/CAD trade.

The inconsistency in the perceived risk-taking has a direct consequence on the overall efficiency of the trading strategy. Since most trading systems are evaluated based on how it would have performed in the past – by backtesting, risking variable amounts, while thinking a fixed percentage is being risked every time, can dilute or increase the risk and associated expected return of the system.

For example, let’s assume that a Forex trader has $100,000 equity in the account. Based on historical performance, and win rate of the strategy, the trader used Kelly criterion formula and has figured out that risking five percent of the equity per trade would generate the optimum result for the system.

Hence, the trader would like to risk ($100,000 x 5%) $5,000 per on each trade. Now, assume that to maximize the utility of the system, the trader uses a diversification strategy and opens multiple simultaneous positions with various Major and Minor currency pairs.
With 100:1 leverage, each position would worth $500,000 or five standard lots. Let’s assume the trader would like to open three positions with the EUR/USD, AUD/CAD, and the GBP/JPY - risking $5,000 on each trade.

For this example, we will use the ForexChurch Pip Calculator (https://www.forexchurch.com/pip-calculator). As of November 25, 2019, the pip value of five Standard lots for the EUR/USD, AUD/CAD, and GBP/JPY was $50.00, $37.612, and $45.977, respectively.

If the trading system requires risking a fixed amount of pips, let’s say 100 pips on each trade, then not calculating the pip value before placing the order would unevenly distribute the risk across the three trades.

Because, for each trade, the system’s optimum risk per trade is $5,000, which means ($5000 ÷ 100) $50 per pip. Therefore, the risk for the EUR/USD would be ($50 x 100 pips) $5,000 as intended. However, risking 100 pips for AUD/CAD would risk only ($37.612 x 100 pips) $3761.2. And, for GBP/JPY, the total risk would be ($45.977 x 100 pips) $4,597.70.

Consequently, instead of risking $15,000 on the three trades as the system’s optimum risk amount, the trader would risk only ($5,000 + $3761.2 + $4,597.70) $13,358.9, which is 10.94 percent less than perceived optimum risk.

Since most strategies have a higher expected return than the risk to keep the reward to risk ratio above 1, let’s assume the reward to risk ratio of the system was only 2:1. Under this circumstance, risking 10.94% less would mean the system will end up generating (10.94 x 2) 21.88 percent less return just because the trader didn’t consider the difference in pip value!

While this is a hypothetical scenario, over a series of hundreds of trades, the trading system will certainly generate sub-optimum results.

How to Incorporate an Online Pip Value Calculator into Your Trading Process

Now that you know how important it is to calculate pip value for each and every day you place in the interbank market, let’s discuss how you can make life easier by creating a step-by-step order placement process.

There are hundreds of Pip calculators on the Internet, but we found ForexChurch to be one of the most advanced. In fact, the website claims that the calculator refreshes currency rates every time a new quote is requested, in real-time. And, traders do not even need to refresh the page to avail the latest rate. Hence, we highly recommend using this online Pip calculator.

Now that you have an automated way of finding your pip value, creating the step by step guide would become a straightforward process.

Step #1: Know Exactly How Much You Want to Risk Per Trade

Whether you used Kelly criterion to figure out your risk percentage or simply want to risk an arbitrarily determined fixed percentage of your equity, you need to convert this percentage into an actual dollar amount.

So, if you have an equity of $5000 and want to risk 2%, your risk per trade in dollar value would be ($5000 x 2%) = $100.

Step #2: Calculate the Pip Value of Standard or Mini or Micro Lot

This is the easy part. Simply open the ForexChurch Pip calculator and input 10,000 in the Trade Size box. Make sure you do not put any higher or lower trade size as it will help you get the exact multiplier value for the next step.

Step 3: Calculate Your Position Size

Once you have your risk amount and real-time pips value of 10,000 units, figuring out the optimum position size would be just one calculation away.

It does not matter if you want to risk a fixed amount of pips or your system requires you to risk a dynamic number of pips per trade, as long as you know how many pips you need to risk on a given trade, the formula will be either of the following two:

If the pip value is less than 1 (i.e. 0.752), and you want to risk 40 pips, divide your nominal position size by the pip value:

$100 ÷ 40 pips = 2.5 lots ÷ 0.752 = 3.3245 lots

However, if the pip value is more than 1 (i.e. 1.003), and you want to risk 40 pips, multiply your nominal position size by the pip value:

$100 ÷ 40 pips = 2.5 lots x 1.003 = 2.5075 lots

This way, regardless of how many pips you want to risk and what is the pip value of the currency pair you are trading, your risk will be always $100 per trade, as intended.

Takeaway

Risking a fixed percentage of your equity is perhaps the best way to manage your risk while trading Forex or any other assets. It keeps your risk consistent in terms of dollar amount regardless of how many pips you want to risk per trade.

Since the market is dynamic, risking a fixed amount of pips on a single trade is always a bad idea. You might find a BUY trade setup, where risking 100 pips would mean putting the stop loss just a few pips above a major support level. Again, a bad idea. But, with the percentage risk model, you can stretch your stop loss size to 110 pips and still risk the same amount of capital.

The Achilles' heel of percentage risk model strategy is the inconsistent pip value of different currency pairs. The lack of understanding regarding pip value often jeopardizes the long-term viability of otherwise proven trading systems. However, you can easily mitigate the situation by calculating pip value in real-time to find out the optimum lot size or position size for each of your trades.
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