Position Sizing
Position sizing is deciding HOW MANY contracts to trade when a trading system gets a signal. Position sizing is potent, and many traders do not understand it. Its purpose is to manage risk, enhance returns and improve stability through market normalization (equalize). Position sizing can sometimes be more impactful than where a trader buys or sells! Most trading systems and testing platforms either ignore position sizing or use it illogically.
A massive problem with many trading systems is that they risk too much of the trader’s equity per trade. Most professionals agree that traders should never risk more than 1% to 3% of their capital per trade. These rules also apply to the risk for each sector. For example, if a trader is risking 2% of their money in highly correlated markets like 2yr bonds, 5yr bonds, 10yr bonds and 30yr bonds, this method is mostly like risking 8% in the same market. Overtrading this way can produce impressive looking results with returns of 100% or more, but this method is usually a case of using too much leverage.
When running a “Worse Case Analysis” at those high-risk levels, it becomes clear that the risk of ruin climbs dangerously high. A series of losing trades or starting on a wrong day could cause an investor to lose all their capital (or have an enormous drawdown).
Trading System & Position Sizing Basics
The main idea is that when putting on a trade, traders should know what percentage of their equity they will lose if they are wrong. The amount should be a tiny percentage of their available trading capital. To do this requires that they know their risk when entering a trade. Some moving average systems do not understand how much risk they are taking. The reason for this failure is that the trading system is not sure how far the market needs to move to trigger an exit. We think it is dangerous to trade this way and do not recommend it.
Another problem is the lack of market normalization (such as one contract based result). For example, we do not think it is logical to trade one contract of natural gas with typical daily volatility of around $2,000 for each Eurodollar contract with the average daily volatility of about $150. Doing this would mean that natural gas is a more portfolio weighted market than the Eurodollar. If Eurodollars trend, we want to give them just as much weight as natural gas (or any other market). In the previous example, traders could remove the Eurodollar from the equation and get almost the same performance. The results are unintentionally biased (curve fit) to natural gas. A typical $150 winner in the Eurodollar is not going to offset an average $2000 loser in natural gas.
We recommend trading a basket of commodities for diversification; however, if traders do not weight each market the same and most of the profits and losses are arising from few markets in the portfolio, then they are not diversified. The problem is that in the future; traders are going to depend on those few markets to perform. It is better if any market has the potential to deliver equally instead of depending on specific markets in that portfolio.
The reason that most trading systems ignore position sizing, or use it illogically is that the design of most software packages is to work with one contract based testing. Of the many backtesting products, available for sale, we are aware of only two software packages that can sufficiently do position sizing and money management testing. Many products claim to do it, but we have found that almost every one of these products do not do position sizing & money management correctly (there are many reasons for this, contact us for details). We use Bob Spears’ advanced testing software Mechanica (which sells for $25,000 a copy) for most position sizing based research and testing.
Other problems include vendors that only report the smaller drawdown numbers like “closed trade” drawdowns or “average annual” drawdowns. problem areas with position sizing include methods such as “Optimal F” or “Fixed Ratio.” We feel these are just dangerous forms of hindsight biased curve fitting.
Another common fallacy says that traders should find their “best single contract based trading system FIRST and THEN apply position sizing to it”. It is not the correct approach; position sizing can change the risk-to-reward profiles of one contract based trading system. A trading system that looked terrific, with a smooth equity curve on one contract basis, can seem far less attractive when all markets get equally weighted for stability.
Our Trading System & Position Sizing*
For all the reason cited above, we develop trading systems with proper position sizing logic. We think this raises the soundness and significance of the testing results. Our method also assists to avoid the inadvertent hindsight curve fitting that can occur with other types of position sizing/money management based testing software.
*Account Risk, Trade Risk, Risk Level
By: Dean Hoffman
FUTURES TRADING IS NOT SUITABLE FOR EVERYONE AND PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF SUBSTANTIAL LOSS IN FUTURES TRADING OR WITH ANY TRADING SYSTEM OR PROGRAM. CAREFUL EVALUATION OF YOUR PERSONAL FINANCIAL SITUATION MUST BE DONE PRIOR TO DECIDING TO TRADE IN THE FUTURES MARKETS OR ANY GIVEN TRADING SYSTEM OR METHODOLOGY.
By: Dean Hoffman
FUTURES TRADING IS NOT SUITABLE FOR EVERYONE AND PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF SUBSTANTIAL LOSS IN FUTURES TRADING OR WITH ANY TRADING SYSTEM OR PROGRAM. CAREFUL EVALUATION OF YOUR PERSONAL FINANCIAL SITUATION MUST BE DONE PRIOR TO DECIDING TO TRADE IN THE FUTURES MARKETS OR ANY GIVEN TRADING SYSTEM OR METHODOLOGY.
