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.

Talking in terms of R - updated

Note: this post originally appeared in July 2014, and has been updated to reflect performance since then.

1R is the amount you risk on each trade. Profits or losses are calculated by taking the result and dividing by the initial risk. For example, if you risk £100 per trade, and you end up with a profit of £500, that's a +5R profit. If you lose £80, that's an -0.8R loss.

A visual version of tracking trading efficiency

In the Chris Sayce podcast on Chat with Traders, he talks about keeping two portfolios and equity curves - one relating to his actual trading, the other being what he calls his 'Discipline' portfolio, where he is able to track the theoretical performance had he followed his own trading rules to the letter. As he mused, the returns of the theoretical portfolio far outperformed reality. The closer his equity curve can mirror that of his Discipline portfolio, the better his ultimate performance.

This is a visual version of tracking what Van Tharp calls trading efficiency. He advises keeping a log to track your mistakes and quantify them in terms of R. I talked about this here.

Accepting the bumps along the way

If you think you can adopt a trend following approach, and then guarantee that you can pull X% out of the market each month/quarter/year, then you are very much mistaken. Your performance when utilising a trend following strategy will go through peaks and troughs. There may be periods when you are fully invested (up to your own portfolio risk limits), and there may be times when you are fully in cash.

Look at any performance record of a trend follower and you can quickly identify these peaks and troughs. Why do these happen? Very simply, trend followers need trends in whatever markets they are trading to appear. If they don't, then a trend follower will struggle. That you have to accept.

Losses, your mindset and risk

Most unsuccessful traders fall into the trap of assuming that the next trade will be a winning one. They can only see the potential profits – not the potential losses and the subsequent reduction in their equity.

To avoid this mindset, I recommend assuming that every trade you take will generate a full 1R loss. I do this, even though 99% of my losing trades end up being closed for a loss smaller than that.

The ebbs and flows of open profits

As mentioned in previous posts, I am more concerned with tracking my cash equity rather than open equity (i.e including profits on existing positions) when reviewing my own trading performance. The main reason for doing this is that, when trend following, you allow each a position a certain amount of 'wiggle room' or volatility that will keep you in a position, reducing the possibility of needlessly being stopped out.