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guru_trader
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5/20/2007 8:27:35 PM

Another interesting article about position sizing ...

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Monday, July 4th, 2005 at 12:12 pm

Position Sizing
By Michael

Position sizing could very well be the most important aspect of a trading system, yet, like expectancy, it’s rarely covered in trading books. A position sizing model simply tells you ‘how much’ or ‘how big’ of a position to take. Position sizing can be the key factor in whether or not you stay in the game or whether your gains are huge or minimal.

Dr. Van K. Tharp did an experiment which shows the importance position sizing. In his book “Trade Your Way to Financial Freedom” Van gives the results of his testing of four different position sizing models. He tested the models on the same trading system, so the only variable was the position sizing. The simulations were run with an initial equity of $1,000,000 and took 595 trades over a 5.5 year period. The models produced drastically different results:

1. The worst was the baseline model which just bought 100 shares of stock whenever a signal was given. That model returned $32,567 or 0.58% annualized.

2. Fixed-amount model: This method traded 100 shares per $100,000 in equity. It returned $237,457 or 5.75% annualized.
Equal leverage model: Each position in this model was 3% of the account equity. So at the start of the trial each position was $30,000. This method returned $231,121.

3. Percent risk model: According to this model positions were sized such that the initial risk exposure was 1% of the account equity. So with $1,000,000 equity the initial risk would be $10,000. So if the initial stop on a trade was $1 the system would trade 10,000 shares. For an initial stop of 50 cents the system would trade 20,000 shares, etc. This model returned $1,840,493 or 20.92% annualized.

4. Percent Volatility model: Positions were sized based on each stock’s volatility — the more volatile the stock the fewer shares are traded. For this trial positions were pegged at 0.5% volatility (initially $5,000 per position) — so if a stock’s average true range was $5 the system would trade 1,000 shares. This model returned $2,109,266 or 22.93% annualized.

You can see how important position sizing is by that simple experiment. Remember that’s the same trading system with the only difference being the size of the positions.

In the past when I was swing trading I used to simply divide my equity by 5 and that would determine my position size. I wanted my maximum risk per trade to be 1% of my equity so that dictated that my maximum loss per position was 5%. I still do that with my long term account but I’m seriously considering changing that.

Now that I’m daytrading it makes a lot more sense to me to use the percent risk model. I always liked that model but I never felt comfortable using it when I was holding stocks overnight. Now that I don’t have to worry about overnight gaps I feel much better about using this method. It allows me to put a lot of money to work when I have an entry with a tight stop. But despite the fact that I could have 2 or 3 times as much money in play versus my old position sizing model I can still keep my risk per trade very small. It’s also kept me out of trades that were just too risky because it forces me to really look at where my initial stop will be. Often the stop will be so wide that I can only buy a handful of shares so it becomes clear that the trade isn’t worth the effort. This method also allows me to equalize my 1R risk across all trades which helps in my expectancy calculations.

Source: http://tradermike.net/2005/07/position_sizing/

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