Position Sizing

Discussion in 'Risk Management' started by peregrinecap, Aug 29, 2012.

  1. I am looking for a logical/theoritical approach to position sizing. I have read about the kelly criterion in articles and books, but I find it hard to apply in practice. how do you guys know of any other mathematical/logical methods of position sizing other than kelly?

  2. lindq


    I've always found value in the old rule-of-thumb that a single position should never put more than 2% of capital at risk.

    That's as good a starting point as any, and if I'd paid more attention to that the first couple years of my trading career, I'd be a wealthier person because of it.
  3. as i said rather cleary, i am looking for a logical/analytical methodology, not a rule of thumb
  4. The higher your drawdowns the higher the win rate required to stay positive. Position size itself isn't important... It's how much of a drawdown that position size creates when it hits your stop out point.

    If you work with a 100% drawdown... You need a 100% win rate.

    If you work with a 2% drawdown... You need a 51% win rate. You also need to calculate for commissions/spread handicap.

    If a trade costs $10 with a capture/stop of $100 you have a 10% handicap.

    All of these different factors must be accounted for.

    To calculate win rate required per drawdown... Lets say you have $100 and have a 2% loss to $98. You need to win 2.05% back to get back to $100. So you have a half a percent handicap actually with that drawdown only... Doh... Thought it was more.

    So anyway, you get it... Pretty simple. Take amount, divide total/drawdown result amount. Calculate percentage gain required to be back to breakeven. Percentage difference will be handicap.

    Let me calculate out for 5% just because I never have...
    100/95 = 1.0526315789

    To get back to breakeven... You need 5% plus the extra... Result: 5.26315789

    So, quarter percent handicap actually... If you have two losses in a row it compounds though.

    Anyway, you get it!
  5. Hugin


    Even if I understand why they exist (easy to understand, apply and at least give some thinking about risk into the process) simple rules of thumb like ”never risk more than 2% in any position”, I think they often miss the point.

    First, they only refer to the risk of one position whereas normally people normally wants to manage risk for their account. So this kind of rule only transforms the question into how many positions and which positions to take. And then the correlation/co-movement between instruments becomes a factor.

    Second, if you take it literally it means that you can only invest 2% in a position, since there is always a (minute but still existing) risk that the position becomes worthless. If you want to use this kind of rule then I believe it should be restated to something like ”no more than 95% risk of losing more than 2% on any day”, i.e. you need to introduce some kind of probability. Maybe this is what is actually meant with these rules…

    One option is to implement Value-at-Risk (VaR) and manage this. A good description of this is given in ”Red blooded risk” by Aaron Brown, but there are probably many other places to find information about this. Depending on what instruments you trade this could be easy or very hard. This gives the risk on the account level but you still need some way to push this down to the individual positions. One way is to look at how much a new position contributes to the VaR.

    Of what I’ve seen the best formal work that is usable for trading is the work of Ralph Vince. I often recommend to take a look at his work. I especially like the book ”The Leverage Space Trading Model”. One good thing with this approach is that it actually works with the risk people normally care about - account drawdown risk.

    But ”caveat lector” - it is also often misunderstood. The reason behind this is probably that it is rather mathematical and sometimes not so easy to understand. So he has taken a lot of heat by people that claims that using his methods will blow up your account. In my opinion the main problem is not in the methods per se, but in the assumptions we make around the input data used for the calculations.

    Using your backtest data to size real trading positions will very likely result in overbetting your system. Normally the returns distributions from your backtest are susceptible to overfitting and/or selection bias. In my opinon every system, also those systems that has not been created through automated optimization or learning suffers from this, simply because they have been tested against market data and found to be working. So always assume that the returns distribution of your walk-forward activities will be more adverse than those of the back-test.

    So, I think more focus should be on the how representative the input data really is. In the end, if the returns distribution for real trading is so different from the ones used for positioning that you blow up, you cannot really blame the method, can you?
  6. jcl


    Aside from the money management books by Ralph Vince, Edward Thorp's fundamental article about using the Kelly criterion can be found as PDF on the Internet - google for "Thorp" and "Kelly".

    Both use different methods. The Kelly criterion is the best method for allocating capital among different assets, and the OptimalF factor by Ralph Vince is an upper border for re-investing profits. The leverage space model by the same author is, in my opinion, too sensitive to deviations from past performance data.
  7. Van Tharp's position sizing is very simple and sensible.

    Size the position such that if your stoploss is hit you'll lose a defined percentage of your capital.

    If your max risk is 1% and your account has $10,000 in it then your max risk is $100 per trade.
    If your entry is $200 and the SL is say $190 according to your TA or whatever then 200 - 190 is $10 risk on 1 share.
    Your position size would be 10 shares.
  8. The quick answer: risk an amount that will not bother you at all if you lose it...but no smaller than that.

    Long answer: Position sizing should be determined by % win rate/loss rate, not by expectation or risk/reward ratio - since drawdown size is determined by amount risked * number of losses in a row (which is determined by % loss rate), not by profits or expectation (since a drawdown, by definition, has few or no winning trades in it). Here is the approximate formula:

    High win rate (70%+): risk 2% of capital
    Medium win rate (30-70%): risk 0.5% of capital
    Low win rate (<30%): risk 0.1% of capital

    This will insure modest drawdowns, and if you suck or make mistakes, which most traders do, then it will save you during times when you are off-form.

    If you are an experienced and seriously profitable trader, then you can increase those positions sizes by 1.5-2 fold e.g. risk 3-4% on high win rate trades, rather than 2%. Just be aware that this will increase your risk substantially.

    The only real exception I can think of is those trades that come along once every 2-3 years, with exceptional payoffs and high win rate e.g. the subprime housing trade, or stocks/credit in March 2009. In this case I think one could risk up to 5% of capital. However, this is an advanced move for expert traders, and most will do much better by sticking to the lower size limits.
  9. This simple position sizing method has not been invented by Tharp. I believe it was mentioned by Ed Seykota in Markets Wizards in the 1980s but people have been using it for ages.
  10. this topic is rediculuos.

    how much or how large your account is? if your account is not big as 1M+. there is no need for position sizing.

    if you your account is just 50grands. you get to learn: all in.

    why? trading is a war.

    if you divide it too many pieces, you may protect you. but it distracts you, you lost focus, and your profitability greatly impacted.

    in the "the art of war" by chinese ShunZhi, the key to win a war is: use all your strength & resources to one place, attack those places where enemy is weak and you can be sure you can win. if you divide your army (already small) and your resources, your army is weaker, not stronger. so this is a sure way to lose!

    suppose you have a 50k army, and the enemy has 100k army, with others are the same. you are already in an inferior status. if you use 10th of your army to fight with 100k army, before you fight, you know the results is you will lose.

    but you can win it, if you can divide the enemy into peieces,while consolidate your army into one unit (make yourself stronger), for example, didvide the enemy into 10 peieces (use cheating or gain ahead information etec.), your 50k army easily defeat 10k enemy army, one by one, you finally win.

    I once just had 4k account when I started, if I divide my account, I can not trade, for example, divide it into 4 pieces, 1k a trade, one round commision will cost me 10bucks for a stock, if four trades, then will cost me $40 bucks, that is 1% of my account! I almost feel I am dying!

    so it is a sure way to lose and demolish your account. what I did is: foucs on one trade, do it all in. luckiliy I did several succesful trades in a row in all in strategy, I quickly passed PDT and my account grows 10 folds more. even there, I still use all in strategy.

    only when I feel my acount is too big to become akward to trade, I feel I need divide my account into suitable size to fight suitable wars.what I did is not divide or position sizing, I just withdraw those profits and deposit into my banks, I do not want "too big, not move around easily" weakness affects my trading war! when I fail some wars, and I need help armys, I just deposit back.
    #10     Sep 1, 2012