Adjusting Position Size Based on Currency Volatility

If you've traded currencies before, you understand that not every pair behaves the same. Some pairs move slowly, as if it's taking an eternity to move a few pips. Others swing like clockwork within a matter of minutes. 

The difference is volatility, and if you ignore volatility, a trade that you thought you had planned could really expose you to much greater risk than you intended. Learning to size your position based on volatility, is one of the most effective ways to protect your capital and stay consistent. 

Lore about Volatility

Volatility, in its simplest form, is a measure of how much movement occurs between highs and lows in the movement of a currency pair for a period of time. For example, usually EUR/USD is steadier than GBP/JPY because GBP/JPY often has its fair share of sharp movements. If you took the same size position on those two pairs and did not account for volatility, you could be safe on the EUR/USD but still dangerously exposed on GBP/JPY. 

Think of it in terms of driving. You can drive safely and at a steady speed of 70 miles per hour while on the highway. In contrast, if you are on a twisty mountain road, you must reduce your speed accordingly. In effect, trading volatile pairs without altering position-size is the same as driving too fast around the various corners of the mountain road; sooner or later, you are going to run into trouble. 

The ATR

One approach traders use to determine volatility is called the Average True Range (ATR), which measures (or averages) the movement of pair over a set number of candles. If EUR/USD has an ATR of 50 pips, and GBP/JPY has a 120 pip ATR, we can see GBP/JPY by default tends to move much greater than two times than the EUR/USD.This difference should only affect how big your position is.

How to change position size

The formula for risk is the same:

Position Size = (Account Size × Risk %) ÷ Stop Loss Distance

But here is the kicker, your stop loss distance should be related to volatility. On a calm pair, you may have a stop that is 30 pips away. On a wild pair, you may have to use an 80 or even 100 pip stop. If you just increase the stop without decreasing your size, you are taking a serious risk than you planned for.

Quick Example

Lets say you have a $10,000 account and you are comfortable risking 1% per trade ($100).

Notice how on the more volatile pair, the position size has to be smaller in order to keep your risk equal. Same $100 risk but very different position sizes.

Two Advantages

Consistency on the risk – Your dollar loss is fixed regardless of how wild the pair is.

Flexibility in your strategy – You can trade both calm and volatile markets without the fear of blowing up from one misplaced trade.

What about correlations?

Another wrinkle is correlation. If you are trading EUR/USD and GBP/USD simultaneously, you are effectively doubling your exposure to the USD. If both pairs were to move against you, it would be all that much worse if that market was quite volatile. If that happens, a good way to manage risk is to decrease position size to have a more controlled risk across all correlated pairs.

A trader story

I once had a friend tell me how he blew half his account in a week trading GBP/JPY. His entries were not terrible but his sizing was the issue. He treated it like EUR/USD and placed the same lot size with a very tight stop loss. The swings on the pair hit his stop multiple times, and before long, he would have the wind taken out of his sails and start to chase money. Had he adjusted his position size for volatility, he would not have been chasing losses and could have remained in the market.

Creating the habit

Changing position size is not something that is too tough to do but it does require discipline. Before you enter every trade, always ask yourself, "How much volatility is there on this pair right now?". Then check an ATR or the recent daily ranges. Let volatility dictate stop loss size, and let the stop loss dictate your position size. Once you make this a habit, you will find your risk to stay steady, despite any volatility in the markets.

Final thoughts

Not every currency pair can be treated equally. When you adapt your position size to reflect volatility, you get a controlled risk from a calm euro pair to a wild yen pair under the same paradigm. That is the difference between most professionals and retail traders and how they last longer in the game.

If you'd like to learn more in applied ways on balancing risk and adjusting for market conditions, check out the Learn section on Wikilix. It is overflowing with links, strategies, and guidelines on helping you trade smarter.