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Position sizing is crucial to ensuring your long term success as a trader. The first rule of trading is to preserve your capital. If you lose all your equity in your first few trades then you cannot continue and that may be the end of your trading journey.
We all start out thinking that our strategy is infallible but be assured it is not. Anyone that promises a 100% win ratio is being less than truthful. Your position sizing strategy must allow for a series of losses that will reduce your trading capital.
Lets give 2 examples to clarify the risks.
Trader A – High Risk
Trader A has an account with £10000 and they decide to risk 15% on each trade. They start their journey by opening 3 trades. Unfortunately, an unexpected news event occurs and all 3 trades close at their stop loss, meaning a loss of 45%. The traders account now stands at £5500. To get back to their original £10000 they now need to make an 82% return, so they decide to increase their risk to 25%. Their strategy surely cannot be wrong 4 or 5 times in a row. You guessed right, another unexpected event occurs and these 2 trades also close at a loss. The traders account now stands at £2750. They now need a huge 264% return just to get back to their original £10000. Trader A gives up and withdraws his £2750 after just 5 trades.
Trader B – Lower Risk
Trader B has an account with £10000 and they decide to risk 2% on each trade. They start their journey by opening 3 trades. Unfortunately, an unexpected news event occurs and all 3 trades close at their stop loss, meaning a loss of 6%. The traders account now stands at £9400. To get back to their original £10000 they now need to make an 6.4% return but they decide to keep their risk at 2%. Their strategy surely cannot be wrong 4 or 5 times in a row. You guessed right, another unexpected event occurs and these 2 trades also close at a loss. The traders account now stands at £9024. They now need a 10.8% return just to get back to their original £10000. Trader B carries on.
Trader B is disappointed with his losses but they are not terminal, unlike Trader A who has given up.
There are many position sizing strategies you can use and you can be as creative as you like. Although simpler is often better and definitely more transparent. If you are in doubt whether you have chosen a good strategy then reread the above examples and decide which category yours falls into.
The following sections cover a number of position sizing strategies that are common to all types of trading.
Fixed Dollar Amount
This strategy is the simplest of all but that does not make it a bad one. As the name suggests each trade has a fixed dollar risk.
Trader A has an account of £10000 and they decide to have a fixed dollar risk of £200 per trade. Whether a trade wins or loses their next trade will also have a fixed dollar risk of £200.
If you decide to adopt this strategy then you will need to set a reasonable value depending on your trading strategy. You will also need to determine a period of time when you review your fixed dollar risk and decide whether it should increase or decrease. This could be daily, weekly, monthly, quarterly. Again this will depend on your trading strategy as well as the frequency of trades.
Fixed Risk Per Trade
This strategy is similar to the fixed dollar amount above but it attempts to automate the review process. This is achieved by using a % risk instead of an absolute risk.
Trader A has an account of £10000 and they decide to have a fixed risk per trade of 2%, which equates to £200 (just like the fixed dollar strategy). Assuming a 1-1 reward to risk ratio, if the trade wins, then their next trade would risk £204 (2% of £10200). If the trade loses, then their next trade would risk £196 (2% of £9800).
When using this strategy you should review your fixed risk % to determine if it is suitable for your trading strategy. If your strategy incurs a high number of losing trades then your risk % should be lower.
This approach has many variations but they all have the same aim. They all adjust the position size a trader takes depending on the volatility of an asset.
To do this a trader must first determine whether the current volatility is higher or lower than the historical average. The duration you choose for these 2 values is determined by your trading strategy. If you are a day trader then historical volatility could be calculated for the past 5 days, where as a position trader may use 25 days. Similarly the current volatility would also differ for each strategy.
The 2 common methods of calculating volatility are:
- Standard Deviation
- Average True Range (ATR)
Lets use an example to illustrate:
Trader A has an account of £10000 and they have a base risk of 2%. Their strategy means they could hold positions for weeks. They therefore calculate the historical volatility of the asset they want to buy over a 25 day period. This returns an ATR of 15. They then calculate the current volatility of the asset over a shorter 3 day period. This returns an ATR of 20.
Trader A now knows that the current volatility is higher than normal but needs a method to adjust his position size accordingly. This is achieved by dividing the 2 ATR values to form a ratio. The resulting volatility ratio is (15 / 20) = 0.75
This volatility ratio is used to alter their base risk of 2%. Their position sizing strategy means they can only trade 75% of the base amount, resulting in 1.5%.
This seems logical during times of high volatility when you may want to reduce your exposure.
The opposite example also stands. If current volatility is lower than normal then the resulting ratio would be greater than 1. This would allow for an increased position size.
The volatility based strategy has many variables, including historical volatility (duration), current volatility (duration), base risk (% or $). Additionally, you would need to specify a maximum risk % so that you can’t trade above a limit. You could also specify a minimum risk %, or maybe decide to ignore a trade when volatility is too high/low.
The basic concept of averaging down is to add to your position when the trade goes against you. This principle works when trading in either direction.
Many traders frown upon the averaging down strategy as they say you are adding to a losing position. If the averaging down approach is abused and you keep adding to a losing position without a stop loss, or a maximum risk %, then I would agree with their complaint.
For the approach to have any value a trader must retain an overall stop loss. They must also stay within a specified risk % for the whole position.
Lets use an example to illustrate:
Trader A buys 100 shares of XYZ stock at £2.50.
The price falls to £2.45, so they increase their position and buy another 100 shares of XYZ stock
The price falls to £2.40 and they buy 100 more shares of XYZ stock.
In total Trader A now owns 300 shares of XYZ stock at an average price of £2.45.
To break even the trader needs the price to reach £2.45, instead of the original £2.50.
The advantage of this strategy is that it allows you to split your trade into blocks and is useful if you think the price may go against you a little before it moves to your final target.
Who amongst us has ever placed a trade with perfect timing? It happens very rarely. This approach takes advantage of that fact if used wisely.
When you have decided upon your position sizing strategy it should be clearly documented within your trading journal. The strategy you choose will directly affect how you manage your entries and exits.
All position sizing strategies need a degree of tolerance as you will rarely be able to place an individual trade with an exact amount of risk. Once you have placed multiple trades the average will naturally be drawn towards your target risk.
Trading AtoZ uses Fixed Risk Per Trade in conjunction with Averaging Down as the basis for its position sizing strategy. You need to identify which approach best suits your trading strategy and style.
These position sizing strategies will be expanded upon when we discuss money management and how that can affect your trading performance. Money management is the final piece of the trading puzzle and where you can fine tune your trading strategy to make it purr.