Skip to main content

A Primer on Position Sizing and Compounding a Winner

In trading, controlling the risk in a portfolio is determined by position sizing.  Most trading firms employ a fixed fractional contract position sizing method.  Under this methodology, positions are determined using the following formula:

Fixed fractional bet sizing:
Amount risked per trade = closing equity * fixed percentage risked per trade (e.g. 25bps)

Once the Fixed-Fractional Contract Position Sizing Formula has been used to calculate the amount of risk to put on with a trade (in dollar terms), the Risk-Basis Position Sizing method is employed to determine how many shares or contracts of an instrument to buy or sell.  The Risk-Basis Position Sizing method considers the risk for each security, where risk per share is the entry price minus the stop-loss point.  It divides the total risk allowance (e.g. 25bps in dollar terms) by the risk per share to determine the number of shares to trade.  Legendary systems and Trend Following trader Ed Seykota offers the following insight on this method, “over time the fixed-fraction system grows exponentially and surpasses the fixed-bet system that grows linearly.”  In other words, one is trading larger size positions (in dollar terms) as the account balance expands.  This is when one’s trading is at its best.  Conversely, one trades the smallest when experiencing a drawdown or when a trading process is out of favor. 

While this form of position sizing offers a solid starting place for building a trading system, there are many deviations employed by professional traders. For example, position sizing algorithms can be customized according to position volatility or correlations across the portfolio. In other words, if a security or market exhibits larger price swings over a specified time period a process can be built to allocate less risk to this position so that the position moves will not be excessively large and cause too much disruption in the equity curve. Additionally, if a proposed trade behaves too similarly with existing holdings (i.e. it displays a high correlation)  the trade can either be ruled out or scaled down since it ultimately will be nearly the same as adding to the existing position’s risk budget.

In addition to position sizing traders must determine a method for scaling into a position that works in one’s favor. In his book “Trading Systems and Methods” Perry Kaufman offers three solutions for systems traders when profits accumulate after initiating a position. These compounding structures offer different forms of leverage and risk management. The first is called the Scaled-Down Size or Upright Pyramid. Each incremental addition to the initial trade is progressively smaller and offers only a little compounding. The second option allows the addition of equal amounts of risk on each trade for a position. This is commonly referred to as an inverted pyramid and offers the most compounding. Lastly, the Reflecting Pyramid provides leverage and profit taking. When building a position using a Reflecting Pyramid, it will resemble the upright pyramid where incremental risk units diminish in size. However, when closing out of the position a trader gradually scales down the risk proportionately.

Having a foundational understanding of position sizing and compounding of a position will better equip traders to run profitable trading businesses and take advantage of an opportunity get the most from a winning trade, respectively. Through back-testing as well as actual trading an ideal position size can be determined based on the risk tolerance of the trader. The style of compounding will require some experimentation as well as rules are established for the system design and testing. Ultimately, a trader must find a process that best fits his or her personality while providing the most desirable risk adjusted returns. 

As always, please feel free to contact me with any questions.

JD
Labels:

Comments

Post a Comment

Popular posts from this blog

Research Review: Does Trend Following Work on Stocks?

In November 2005 Cole Wilcox and Eric Crittenden of Blackstar Funds LLC* (now Longboard Asset Management) published a research report analyzing the effectiveness in using a Trend Following   trading strategy in the US equity markets.   Both fund managers were using Trend Following successfully in the futures markets for many years.   Their success with Trend Following, as well as their peer's results in similar markets , piqued their curiosity and led them to conduct this research.   The strategy tested is a long-only Trend Following program. Trend Following uses absolute price change to delineate strength or weakness in a particular security. In this case, the researchers added long exposure on positive absolute price changes that resulted in an all-time high on a one week closing basis. Before actual testing began, Wilcox and Crittenden made sure to address any data issues. For example, given the expansive time horizon for testing, the authors account for security-sp
2 comments
Read more

Managing Position Level Risk with Dr. Alexander Elder’s 2% Rule

Executing sound risk management principles in your trading is essential to having any chance of investment survival. If one position is sized too large and generates an enormous loss, this can be catastrophic to your account as well as your psychology as a trader. Fortunately, there are methods you can learn that will protect your account. In The New Trading for a Living , Dr. Alexander Elder proposes a method for controlling risk at the position level which he calls the 2% Rule. This guideline states that the total risk in any position cannot exceed 2% of the current month-end account value. For example, if you have $100,000 in your account at the end of the previous month, the 2% Rule limits your maximum risk on any trade to $2,000. That is, risk is defined as the dollar value of the difference between your purchase price and stop loss and cannot exceed 2% of the account value under this rule. Be sure to not confuse 2% with the total position size. While 2% may seem sm
3 comments
Read more

Possible Kangaroo Tail Developing from Longer Term Perspective

Despite the title of this post, the curious development of animal anatomy will not be the topic of discussion. Instead, readers will have an opportunity to observe a potential reversal move underway in equity markets and crude oil delineated by this distinctive price action. No trend can last indefinitely and being able to spot signs of a reversal will help a trader better manage a position. One such method is identification of price action through what Dr. Alexander Elder describes as Kangaroo Tails. This sort of price behavior has a unique pattern. Elder states, “A Kangaroo Tail consists of a single, very tall bar, flanked by two regular bars, that protrudes from a tight weave of prices” (How to Trade for a Living, 65). Kangaroo tails that close down indicate a potential market top whereas when it closes up a possible reversal higher is developing. As with most patterns, price action on a long term basis usually carries more weight as it represents a general shift in the market
1 comment
Read more