The Holy Grail of Position Sizing When Trend Following
Traders without a plan have no idea of the importance of position sizing. Money management, proper trading psychology and position sizing are what make the difference between a consistent winning trader and a gambler without a trading plan. Believe it or not, it is possible to have eight trades in a month, with two winners and six losers, and be profitable. It is also possible to win 5 out of six trades, and then have the single losing trade wipe you out and return you to baseline level for the month.
The Mistake of Fixed Dollar Amount
The idea of having a fixed dollar amount per trade would be saying you are willing to risk a fixed $1,000 per trade. Risking a fixed dollar amount per trade is a big mistake. There are times they will benefit less or even lose more when risking a fixed dollar amount per trade due to lack of position sizing. This is wrong. There are times when you might be able to put on a greater position due to a low‐risk trade. At times when these trades work even greater returns can be generated due to position size.
Position Sizing is the Holy Grail of Trading
The difference between traders and great traders is determined by their position size throughout a trade. Position sizing is exactly how much to buy or sell based on the dollar size of the trading account and the volatility of the issue. There exist various books on money management, but most of them talk about one of the results of money management (risk control) rather than the subject itself. Trading plans need to answer the following:
What to buy
How much to buy
When to exit with a loss or profit
Money management is essentially that part of your system that determines your position size-that answers the question “how much” throughout the trade. There is the Martingale position sizing that some swear by however I prefer my methods. The Martingale position-sizing strategy in which the position size increases after you lose money. The classic martingale strategy is where you double your bet size after each loss. I feel this can lead to a potential blowup.
Position sizing tells you exactly how much to buy or sell is based on the dollar size of the trading account and the volatility of the issue. The volatility is the $ dollar risk from entry signal to the initial hard stop exit in case the trade does not work. (Further on I will discuss how to determine the hard stop).The concept of position sizing is shown in the following examples. I have presented an example for stocks but is applicable of all time frames and all markets such as forex, commodities and futures;
You have an entry signal of Buy of Share XYZ at $20.00. Your worst case exit signal or hard stop protection is $17.00; you are risking $3.00 to see if the trade works. If you have a $100,000 account size and willing to risk 1% or $1,000 you can put on approximately 333 shares. You divide your 1% risk on your account size or $1,000 divided by $3 which is 333 shares.
You have an entry signal of Buy of Share ABC at $15.00. Your exit signal or hard stop protection is $13.00; you are risking $2.00 to see if the trade works. If you have a $100,000 account size and willing to risk 1% or $1,000 you can put on approximately 500 shares. You divide your 1% risk on your account size or $1,000 divided by $2 which is 500 shares.
Any trade is 50/50 however if Share XYZ share moves $2.00 you can profit $666 dollars. Contrarily if you Share ABC move that same $2.00 you make $1,000. This is what can make trend followers who think in terms of position sizing much more successful than others.
Changing the Percentage risk changes the equation
You have an entry signal of Buy of Share XYZ at $20.00. Your exit signal or hard stop protection is $17.00; you are risking $3.00 to see if the trade works. If you have a $100,000 account size and willing to risk 1% or $1,000 you can put on approximately 333 shares.
The difference on Percentage risk per trade is increased if you are willing to risk 2% and since you are risking $2,000 of your $100,000 account you can put on 666 shares. If Shares XYZ moves $2 you profit $1332 versus $666 on the same $2 move. However you took on more risk (Potential loss of $2,000) and there is no free lunch in trading & taking larger risk per trades can increase drawdowns dramatically.
As I have presented to you most trades do not work with trend following therefore possibly you are more apt to lose $2,000 versus $1,000 initial risk. Deciding on how much to risk per trade is a personal choice. Many times with new traders greed a sense of false security kicks in and they are more apt to risk more per trade. However after going through drawdowns this hubris subsides and they learn risking 1% can help them achieve their goals of compounding money over time. There is a trade or trading period when you go through a draw down that if it is too steep can put you out of business.
Past performance is not indicative of future performance