The Critical Role Of Position Sizing In Trading
The Critical Role Of Position Sizing In Trading
Position sizing is the act of determining HOW MANY contracts to trade when a trading system gets a signal. It is one of the most powerful concepts available to traders and yet often the least accepted. Position sizing should manage risk, boost returns, and improve robustness thru market normalization. Position sizing can end up being far more serious than where a trader buys or sells! Nevertheless most trading systems and testing platforms either ignore position sizing or use it illogically.A big problem with many trading systems is that they risk way too much of a trader's equity on each trade. Most pros agree that a trader should never risk more than 1% to 3% of his equity on any given trade. This same idea is applicable to the total risk for each sector. For instance, if a trader is risking two percent of his equity on each trade in some highly correlated markets like 2 year bonds, 5 year bonds, 10 year bonds, and 30 year bonds, this is basically the same as risking 8% in the same trade. Though over trading in this way can produce phenomenal looking results with returns of one hundred pc or more, this is generally just a case of using too much leverage, taking too large a share of risk on each trade ( or sector ), and / or "cherry picking" the best starting date ( for example, right before a sequence of winning trades ).When running an evaluation of the worst-case scenario at those high-risk levels, it becomes clear that the danger of ruin climbs dangerously high. A series of losing trades, or just starting on the incorrect day, could cause a speculator to lose everything ( or at the least have an enormous drawdown ).The final analysis is that when putting on a trade, a trader should know what proportion of his equity he will lose if he is wrong. This should only be a little part of his available trading capital. This also implies that he should know the risk he's taking on when entering a trade. Some trading systems, moving average systems, for example, don't even know how much risk they are taking. This is as the trading system does not know how far the market needs to go to trigger an exit. We think it is perilous to trade this way and don't suggest it.Another big problem is the absence of market normalization ( like single contract based results ) in trading systems. We don't think it is logical, for example, to trade one contract of natural gas with a standard daily volatility of around $2,000 for one Eurodollar contract with a standard daily volatility of almost $150. To try this would indicate that the natural gas market is more significants than the Eurodollar market. If the Eurodollar market trends, we want to give it just as much weight as the natural gas market ( or any other market ). In the prior example, a trader could simply remove the Eurodollar from the equation and get nearly the same performance. In essence, the results are unintentionally biased ( curve fitted ) toward natural gas. A $150 average winning trade in the Eurodollar isn't going to offset a $2000 average losing trade in natural gas!We recommend trading a basket of commodities for diversification, but if traders do not normalize the info and most of their profits and losses arise from only a few of the markets in their portfolio, that is obviously not diversification. The difficulty is that as time goes forward, traders are going to be dependent upon that small scattering of markets to perform. It is far better understanding that all markets have the capability to perform at an equal level rather than being dependent on only a few of the markets in the portfolio.Most programs design work on a one contract basis. It is ( likely ) for that reason that most trading systems ignore position sizing or use it illogically. Of many back testing products for sale for sale ; we are only conscious of 2 software packages that will correctly perform position sizing and cash management testing. Although there are numerous products that claim to do it, we have found that almost all these products aren't able to perform position sizing and money management correctly ( there are several reasons for this, please be happy to contact us for details ). We use Bob Spears' state-of-the-art testing software Mechanica for most position sizing based research and testing ( it sells for $25,000 a copy ).Other issues include sellers that only report smaller drawdown numbers like "closed trade" drawdowns or "average annual" drawdowns. There are issues with position sizing concepts like "optimal F" or "Fixed Ratio." We feel that both of these ideas are just a perilous form of hindsight biased curve fitting.Another common misconception says that traders should find their "best" single contract based trading system FIRST and THEN apply position sizing to it. This is not the proper approach. Position sizing can change the risk-to-reward profiles of any single contract based trading system, a trading system that could have looked terrific, with a smooth equity curve when on an one contract basis, can look much less engaging when all markets are equally weighted for robustness.For all the reasons cited above, we here at DH Trading Systems develop trading systems with proper position sizing logic. We believe this not only raises the robustness and significance of the testing results, but can also help to bypass the inadvertent optimizing that can occur with other sorts of position sizing / cash management based testing software.For a free video series on successful futures trading from award winning trading systems developer Dean Hoffman please visit us at http://www.relativitytradingsystem.com Spend a Day on the Trading Floor with Tom & Vladimir Foreign exchange Dealing Guide- How to deal with Foreign exchange Trading? 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