Keeping track of your exposure during trading is a fundamental aspect of risk and money management. If you find yourself getting stopped out a lot, or that your account balance isn’t holding up as you expected, it might be because you aren’t handling your exposure as best you could.
Previously we talked about how you can use the exposure tab on MT4 to keep track of how exposed you are to the markets while trading. Today, we’re going to try to anticipate the problem so you can calculate your exposure ahead of time, and include it in your trading strategy.
Sources of exposure
When trading a currency pair, you essentially have four exposure points that lead to three market outcomes: each currency in the pair can go up or down, the pair can go up or down or it can stay flat. Although the practical impact on your trade is the same whether it’s one currency getting stronger, or the other getting weaker, it does make a difference in terms of your exposure analysis, especially if you are trading multiple pairs simultaneously.
For example, buying the EURUSD. The euro could get stronger, and it would be a positive trade. Or the dollar could get weaker, and that would also be a positive trade. But the euro getting stronger will be because of different economic and/or technical circumstances than why the dollar would get weaker.
In this case, you are open to exposure from weakness in the Euro, or strength in the dollar. Or a combination of both. So, it’s not just that you are exposed to the pair going the wrong direction, but the individual moves of each currency.
If you are getting into the trade on the basis of technicals, it’s easy to forget that each currency can move independently.
In the case of concurrent trading, your exposure can be:
– In line: Where you take positions that lead you to be exposed multiple times to a currency moving in a certain direction. For example, you sell the AUDCAD and the AUDUSD, meaning that you have two trades open where you could lose if the AUD gets stronger. You are exposed once to CAD weakness, once to USD weakness and twice to AUD strength.
– In opposition: Where you take positions that cancel out your exposure to a certain currency. For example, you sell USDCAD and AUDUSD; if the US dollar gets stronger, you win out on the first trade, but lose on the second. If it gets weaker, then you lose out on the first and win on the second. You are exposed once to CAD strength and once to AUD weakness, with USD moves cancelling each other out. In terms of exposure, this is similar to taking out an AUDCAD trade.
How does this factor into your calculations?
Once you’ve identified your units of exposure, including those which cancel each other out, you can then evaluate your exposure risk considering your strategy performance.
Remember that that each time you take a trade, that is one unit of risk; and you’ve divided your account into a certain number of risk units to account for the unpredictability of the market. Usually you want a minimum of 30 risk units available (in other words each trade exposes 3,3% of your account), meaning that you can make 30 losing trades before your account is exhausted.
All things being equal, for each pair you take a position in, there’s a 50% potential that the trade will work out, and a 50% exposure that it will not. If you open a second position at the same time, involving the same currency, then your exposure doubles while your potential stays the same.
For example, you sell the EURUSD. There is a 50% potential that either the dollar weakens or the euro strengthens. There is a 50% exposure to the market, which is divided between a 25% exposure that the euro gets weaker, and a 25% exposure that the dollar strengthens.
If you buy the USDJPY, now your exposure is divided between 25% yen and 25% dollar, which, added to the 25% dollar exposure you had previously, means 50% of your risk is tied up in the dollar. In order to profit, you need both currencies to go in your favor, but to lose you just need one to go against you.
Calculating strategic exposure risk
Remembering that past performance does not guarantee future results, if you have a strategy that is expected to work 60% of the time, it means each trade implies a 40% risk the trade won’t work, which is divided between the exposure of each currency.
In the previous example, that means when you sell the EURUSD there is a 60% chance the trade will work out, and your exposure is divided between 20% risk from the euro, and 20% risk from the dollar (all things being equal). When you buy the USDJPY, your exposure doubles (200% of your risk unit), but the risk to the euro remains at 20%. You then add another 20% from the yen, but the 20% from the dollar in the first trade is added to the 20% of the dollar in the second, so now you have a 40% risk of exposure.
Thus we deduce the formula:
(Strategy risk)/2 x number of trades in particular currency = risk of exposure.
This allows us to calculate how much strategic risk we take for each currency.