Trading System Position Sizing

Position sizing is determining HOW MANY contracts to trade when a trading system gets a signal. It is one of the most powerful and least understood concepts with many traders. Its purpose is to manage risk, enhance returns and improve robustness through market normalization. Position sizing can end up being more significant than where a trader buys or sells! Most trading systems and testing platforms either ignore position sizing, or use it illogically.

A big problem with many trading systems is that they risk too much of a traders equity on any given trade. Most professionals agree that traders should never risk more than 1% to 3% of their equity on any given trade. This also applies to the risk for each sector. For example, if a trader is risking 2% a trade in highly correlated markets like 2yr bonds, 5yr bonds, 10yr bonds and 30yr bonds, this is essentially like risking 8% in the same trade. Overtrading this way can produce incredible looking results with returns of 100% or more, but this is usually just a case of using too much leverage and taking too large a percentage risk on each trade (or sector) and or “cherry picking” the best starting date (like right before a series of winning trades).

When running a “Worse Case Analysis” at those high-risk levels, it becomes clear that the risk of ruin climbs dangerously high. A series of losing trades or starting on the wrong day could cause an investor to lose it all (or have an enormous drawdown).

The bottom line is that when putting on a trade, traders should know what percentage of their equity they will lose if they are wrong. This should only be a small portion of their available trading capital. This also means they need to know their risk when entering a trade. Some trading systems like moving average systems do not know how much risk they are taking. This is because the trading system does not know how far the market needs to move to trigger an exit. We think it is dangerous to trade this way and do not recommend it.

Another large problem is the lack of market normalization (such as a single contract based result). For example, we do not think it is logical to trade one contract of natural gas with an average daily volatility of around $2,000 for every one Eurodollar contract with an average daily volatility of around $150. Doing this would mean that natural gas is a more significant market than the Eurodollar. If Eurodollars trend, we want to give them just as much weight as natural gas (or any other market). In the previous example, traders could just simply remove the Eurodollar from the equation and get nearly the same performance. In essence, the results are unintentionally biased (curve fit) to natural gas. An average $150 winning trade in the Eurodollar is not going to offset an average $2000 losing trade in natural gas!

We recommend trading a basket of commodities for diversification, however, if traders do not normalize the data and most of the profits and losses arise from a few of the markets in the portfolio then that is not diversification. The problem is that going forward; traders are going to be dependent on those few markets to perform. It is far better knowing that any market has the potential to perform at an equal level rather than being dependent on markets in that portfolio.

It is likely that most trading systems ignore position sizing, or use it illogically because the design of most software packages is to work with a single contract based test. Of the numerous back testing products available for sale, we are only aware of two software packages that can properly do position sizing and money management testing. There are many products that claim to do it, but we have found that almost all these products do not do position sizing & money management correctly (there are many reasons for this, contact us for details). We use Bob Spears state-of-the-art testing software Mechanica (which sells for $25,000 a copy) for most position sizing based research and testing.

Other problems include vendors that only report the smaller drawdown numbers like “closed trade” drawdowns or “average annual” drawdowns. There are also problems with position sizing concepts such as “Optimal F” or “Fixed Ratio”. We feel both of these are just a dangerous form of hindsight biased curve fitting.

Another common fallacy says that traders should find their “best” single contract based trading system FIRST and THEN apply position sizing to it. This is not the correct approach; position sizing can change the risk-to-reward profiles of a single contract based trading system. A trading system that looked terrific, with a smooth equity curve on one contract basis, can look far less attractive when all markets are equally weighted for robustness.

For all the reason cited above, we develop trading systems with proper position sizing logic. We believe this raises the robustness and significance of the testing results. This also helps avoid the inadvertent optimizing that can occur with other types of position sizing / money management based testing software.