How much to risk on each contract - Basic setups Part 4

Let's return to our earlier trade where we are now ready to allocate $2000 toward a long gold trade. How many contracts can we buy for $2000? To calculate this we need to determine the amount we risk losing per contract, and then divide that into our $2000. The amount we risk per contract is the amount we would lose by opening one contract at OP and getting stopped out at SL.

A simple stock market example: MSFT

In order to see more clearly the direction these calculations are going, let's consider a typical example you might be more familiar with from the world of stocks. The usual contract size for stocks is 100, so at today's price of around $76 per share for Microsoft (MSFT), a full lot of 100 shares would cost $7,600.

If we only had $10,000 to invest in this trade then we could only buy one 'contract' of 100 shares. Two contracts would cost more than $10K (I am ignoring odd lots for this example). The only difference in futures and forex markets is that the contract size varies between different instruments. Also, to keep things simple I ignore margin rules here.

Example of a simple trade in the stock market: MSFT
                    OP = 76            (Open Price)
                    CS = 100           (Contract Size)
  Cost of 1 'contract' = OP x CS
                       = 76 x 100
                       = $7,600
      Amount to invest = $10,000
 Number of 'contracts' = Funds / contract cost
                       = 10,000 / 7,600
                       = 1.3
Contracts rounded down = 1             (Ignore odd lots)

Every financial contract traded on an exchange will specify the contract size. You must be familiar with the contract sizes of the instruments you trade. The following table lists just a few of the contract sizes for common instruments:

As you can see from this small selection of futures and forex instruments, there are wide variations in contract sizes.

Note that the forex contracts listed above are traded in the very liquid 24 hour interbank market. There are similar contracts with different symbols and sizes traded on the CME. For example the Australian dollar futures contract is traded on the CME under the base symbol AD.

What is important from the table above for our example trade in gold is that one contract of gold specifies 100 ounces with one ounce costing about 1260.75 at the open. So the price quote from an exchange that you see reported in the media is for one unit, but you will need to calculate the value or risk of a whole contract. For example, when the gold price moves up or down $1, an open contract has changed in value by $100 ($1 x 100 ounces).

Dollar risk of one contract

To calculate the dollar risk of one contract, simply subtract the SL from the OP and multiply that answer by the contract size, because that's how many units we will need for one contract. If you are shorting, the SL will be higher than the OP and you will need to subtract the OP from the SL. In other words, calculate the absolute difference between the open and stop loss prices. For our example above:

Risk per Gold Contract for the Sample Trade
    OP = 1260.75                   Open Price
    SL = 1251.40                   Stop Loss
    CS = 100                       Contract Size
    CR = (OP - SL) x CS            Contract Risk (absolute value)
       = (1260.75 - 1251.40) x 100
    CR = $935

Earlier we calculated the amount we could invest in the trade without risking more than 2% of our available risk capital. Given $100K to invest, we have $2,000 available for this trade. Finally we can readily calculate the number of contracts to buy:

    Number of contracts = ($ at risk) / (risk per contract)
                        = 2000 / 935
                        = 2 contracts
       Cost of position = $1870    from: 2 contracts x $935

We cannot buy a partial contract so we need to round the final result down to a whole number. Rounding up will cost more than the $2K we are prepared to risk. It is important to stay close to the $2,000 and two contracts only risks $1870. That's not bad but if we lose this trade and the next one rounded down to only 1 contract then it becomes that much harder to regain a profitable position: we need to consistently win more than double the amount we lose. Consider buying more mini contracts, where available, if they help you stay closer to the $2,000 risk limit.

While the numbers above apply to trading gold, the calculations are almost identical for most futures and forex instruments. You will need to insert the proper contract size and adjust for the quote currency if it is not your local currency. For example, the USDJPY contract opens a position in 100,000 USD and is priced in Yen. I will discuss these differences in a separate story on forex trading.

We now have all the elements in place to make the trade: the open, stop loss, target price and the number of contracts. All of these elements ensure the trade never risks more than 2% of our risk funds. To place the trade you will need to be familiar with the software your broker provides. Trading software from MetaTrader, which is widely used, accepts all the key variables in one panel.

Software from Interactive Brokers on the other hand provides greater flexibility for those who want it, breaking the trade up into the three constituent orders:

• a limit or market order for x number of contracts, representing the main trade
• a stop order at your SL, bracketed as a ONO (One Cancels the Other) with:
• a limit order at your TP.

If either the limit or the stop gets triggered, the order executes and immediately cancels the other pending close order. With this method, you can have trailing stops, partial enters, partial exits, and almost any other combination you prefer. For example, you can have the stop trigger but only to then place the close order with a limit attached to help you get a better price. Of course, it may then fail to protect you if the limit is outside the market. The software your broker provides is a major tool and you must become familiar with how to enter and exit trades smoothly and proficiently before you risk any of your capital in a live trade. Practice in a demo account until you are 100% comfortable.

In the final story in this series, I discuss some important considerations about margin calculation. I will also make a few points about managing the above gold trade.

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