The Essential Job 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 strongest concepts available to traders and yet often the least accepted. Position sizing should manage risk, reinforce returns, and improve robustness through market normalization. Position sizing can finish up being rather more significant than where a trader buys or sells! However , most trading systems and testing platforms either ignore position sizing or use it illogically.
A big problem with many trading systems is they risk far 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 specific trade. This same idea applies to the total risk for each sector. For example, if a trader is risking two percent of his equity on each trade in some highly linked markets such as 2 year bonds, 5 year bonds, 10 year bonds, and 30 year bonds, this is essentially the same as risking 8% in the same trade. Although over trading in this way can produce phenomenal looking results with returns of 100% or even more, this is generally just a case of using too much leverage, taking too large a proportion of risk on each trade ( or sector ), and / or “cherry picking” the best starting date ( for instance, right before a sequence of winning trades ).
When running a study 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 beginning on the wrong day, could cause an investor to lose everything ( or at the least have a giant drawdown ).
The bottom line is that when putting on a trade, a trader should know what share of his equity he’s going to lose if he is wrong. This should really only be a tiny part of his available trading capital. This also means that he needs to know the risk he is taking on when entering a trade. Some trading systems, moving average systems, for example, don’t even know how much risk they’re taking. This is because the trading system does not know how far the market needs to go to trigger an exit. We believe it is dangerous to trade this way and do not recommend it.
Another huge problem is the lack of market normalization ( such as single contract based results ) in trading systems. We do not think it is logical, for instance, to trade one contract of natural gas with a mean daily volatility of almost $2,000 for one Eurodollar contract with an average daily volatility of about $150. To try this would mean that the natural gas market is more important than the Eurodollar market. If the Eurodollar market trends, we want to give it equally as much weight as the natural gas market ( or any other market ). In the previous example, a trader could simply take away 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 is not going to cancel out a $2000 average losing trade in natural gas!
We endorse trading a basket of commodities for diversification, but if traders don’t normalize the info and most of their profits and losses arise from just a few of the markets in their portfolio, that’s clearly not diversification. The issue is that as time goes forward, traders are going to be dependent on that tiny handful of markets to perform. It is far better knowing that all markets have the capability to perform at an equal level rather than being dependent on just a few of the markets in the portfolio.
Most software packages 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 the many back testing products for sale for sale ; we are only aware of 2 programs that may correctly perform position sizing and money management testing. Although there are many products that claim to do it, we have found that almost all these products aren’t able to perform position sizing and money management properly ( there are many reasons for this, please feel free to talk to 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 Problems include vendors that only report smaller drawdown numbers like “closed trade” drawdowns or “average yearly” drawdowns. There are also issues with position sizing concepts such as “Optimal F” or “Fixed Ratio.” We feel that both of these ideas are simply a threatening form of hindsight biased curve fitting.
Another common fallacy claims that traders should find their “best” single contract based trading system FIRST and THEN apply position sizing to it. This isn’t the right 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 similarly weighted for robustness.
For all the reasons cited above, we here at DH Trading Systems develop trading systems with correct position sizing logic. We believe this not only raises the robustness and significance of the testing results, but can also help to circumvent the inadvertent optimizing that can occur with other kinds of position sizing / money management based testing software.
Commodity trading carries risks and is not suitable for all investors. Past performance is not indicative of future performance.
This article was written by Commodity Trading Advisor and trading systems developer Dean Hoffman. For more information click the links