Saturday, June 24, 2017

Some thoughts on position sizing

In my own trading, I use fixed fractional position sizing - that is, while the monetary value of risk per trade will vary as my equity goes up or down, I risk the same amount in percentage terms.

A trader friend of mine has implemented varying the percentage risk per trade based on a look back period of performance. 

Both methods have been used by successful traders and Market Wizards. Both have strengths and weaknesses.

I risk the same percentage of equity per trade, come rain or shine. By doing this, as the equity held reduces the monetary risk on each subsequent trade will also go down if I go on a losing run. My drawdown however will be higher than someone who reduces their percentage risk during the same period.

Against that, once I start getting back into some winning positions, I should be able to recover from those drawdowns quicker by still risking the same percentage per trade, compared to someone who has completely shrunk their position size using a much smaller percentage risk per trade. How much this is will depend on how quickly the variable percentage risk on each trade is allowed to increase back to its maximum level.

What my friend has found is that, while his performance in terms of R over recent months is positive, his actual monetary performance has been negative. This has been a result of his biggest winning trades (expressed in R) being achieved using the smallest position size!

As a very basic example, picture a scenario where you suffer 10 losing trades of -1R using 2% risk per trade, before you decide to reduce your percentage risk per trade. This is then followed by 2 winning trades of +10R using 1% risk per trade. 

Over the 12 trades, in terms of R, you have made a net gain of +10R, but in monetary terms with the negative compounding effect you would end up making a loss!

It is this very reason why I have shied away from varying my position size in percentage terms. To me, using a look back period of prior performance is a lagging indicator. And it is another layer of complexity that I want to avoid. I much prefer to keep things simple...

Of course, this suits me whereas other traders may find more benefit in varying their position size. 

This is another example of how one element of a trading plan may be completely different between traders, and may have a positive (or negative) effect on their performance.

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