Understanding position sizes in stocks and Forex

If you have ever traded either stocks or Forex you might be confused when you go from one market to the other. This is because both markets were structured in fundamentally different ways and it can be challenging to get used to the way in which position sizes are calculated in one side versus how they are calculated in the other. Today I want to share a post with you about these differences so that if you’re changing markets – or if you’re new to both – you won’t be surprised by the differences in how position sizes and gain/losses are calculated depending on what you’re trading. We’ll also go into why position sizes are calculated differently in the first place and why this implies a fundamental problem when dealing with specialized software that tackles one or the other market.

Selection_999(315)

There are some important differences between the stock and Forex market that arise because of the fundamentally different focus both markets have. The stock market rose as a way to gain ownership of a part of a particular company and therefore the stock market is centered around the value of these “shares”. Since the important thing in stocks is to understand how the value of your portion of the company has changed this is the exact value that is tracked and the value that is used to carry out transactions. In stocks you don’t buy “one dollar worth of a company’s stock” you need to buy at least one share from that company.

The Forex market was structured in a different way because the nature of the transactions is different. In FX the aim is to facilitate the exchange of currencies so the most natural thing is to allow for transaction sizes that involve different amounts of currency. To facilitate these exchanges the standard lot sizes were created – analogous to the contract sizes that were created in the futures market –  so you can always trade one standard lot, usually 100,000 USD, independently of the value of the underlying asset. It does not matter if the EUR/USD is currently 0.9 or 1.4, you can always open up a transaction for 1.0 lots using the same amount of US currency — what changes is the amounts of EUR you end up receiving. Currently you can trade fractional lots but the same principle holds, a fixed amount of term currency always buys the same amount of lots.

Selection_999(316)

This causes the difference that is most confusing. In stocks the amount you trade depends on the value of the underlying asset, in Forex it does not. In Forex you can buy 2 lots of a pair using the same amount of term currency no matter what the value of the pair is while in stocks the amount of company shares you can buy depends on the value of those shares at any given moment in time. In both markets the gain/loss can be expressed in the same manner: final position value – initial position value. But the calculation of these position values is different depending on which market you’re trading. In Forex the gain/loss from a long position is in the end calculated as : (number of lots) x (final price – initial price) x (term to deposit currency exchange rate) while in stocks the gain/loss is expressed as: (number of shares)*(final share price – initial share price).

However the amount of money that we would need to put on the line is calculated differently. Say we want to calculate the amount of money in the FX and stock markets we need to trade to take a Y deposit currency loss when an instrument moves Z price units against us. In FX this would be: (Y/((Z) x (TDER)))x(TDL/ 1 lot). Where TDER is the term to deposit exchange rate and DPL is the amount of deposit currency per standard lot. In stocks this is instead expressed as: (Y/Z)x(current price per share). When we look at a simple case in FX – such as buying EUR/USD on a USD account – the above equation ends up being (Y/Z)x(100,000 USD), depending only on the amount we want to risk Y and the amount we want the market to move for us to take that loss Z. It never depends on the value of the instrument while in stocks we always need to look at the current price per share to figure out how much money we need to trade.

Selection_999(317)

The above is very important as it is an often critical factor that makes software designed for stock simulations incompatible with FX simulations and vice versa, rarely do software libraries account for these differences. This is a significant reason why you will commonly face problems using libraries designed for one market on the other, although the back-testing principles are the same this difference in how position sizes are calculated means that there needs to be an explicit “switch” to toggle between FX and stock position sizing calculations if there is to be support for both markets. If you would like to learn more about FX trading and how you too can design and trade your own systems  please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach towards automated trading.strategies.

Print Friendly
You can leave a response, or trackback from your own site.

Leave a Reply

Subscribe to RSS Feed Follow me on Twitter!
Show Buttons
Hide Buttons