Let’s take a trip back in time a few weeks.

In lesson six of this course, we talked about the importance of setting objectives for your trading, and then in lesson seven we discussed how you achieve these objectives through your position-sizing model.

But building a position-sizing model should not necessarily be that simple. There are two areas where complexity can significantly boost trading performance: in your exits, and your position sizing. If you get it right, your position-sizing model can offer a powerful boost to your trading system’s performance.

In addition, your model plays an important part in your risk management plan. If it is not robustly designed, then any number of unlikely but very possible scenarios could have a devastating impact on your account’s equity. In this lesson, we will look at how you can use advanced position-sizing algorithms to maximize your returns.

If you have not mastered the concepts in lessons five, six and seven, please go back and review them now. For deeper coverage of some of the topics in both lesson seven and this lesson, I suggest you read Van Tharp’s Definitive Guide to Position Sizing Strategies. Much of the subject matter in this post is inspired by the Definitive Guide.

Different types of R-multiples

“Always define an exit point before you enter a position.” – Van Tharp, Market Wizard

Back in lesson five, we introduced the concept of R-multiples.

R-multiples are a method of defining your initial risk developed by Van K. Tharp. If you risk $100 on a trade, you are risking 1R for example. Thus, $200 would be 2R. This is a more detached way of looking at profit versus risk.

Van also provides some additional ways of classifying R that are useful:

  1. Risk per unit (Ru). When trading currencies, this is your initial risk in pips. For example, your initial risk might be 100 pips on a trade, so your Ru would be 100 pips.
  2. Total risk (Rt). This is your initial risk times your total quantityF. So if you traded at a size of $50,000 and risked 100 pips your Rt would be $500 (If you purchase $50,000 of currency, you are risking $5 per pip. If your stop-loss is 100 pips away your total risk would be 100 x$5 or $500).

There is more than one definition of R-multiples, so be aware of this when the concept is discussed. In particular, traders will often be referring to Ru when discussing R-multiples.

Group control: managing correlations in Forex

“My money management was poor. I had too many correlated trades.” – Bruce Kovner, Market Wizard

One of the major position-sizing errors made by Forex Traders using a multi-pair system is failing to take correlations into account. No currency is an island.

You may find that all your USD trades go against you at one time for example. You can view correlations across a number of majors and exotics here. Note that the relationship between currency pairs changes depending on the timeframe your data is across.

Also note that some positions are inversely correlated, meaning they tend to move in opposite directions to each other.

Correlations make selecting your system’s pairs critical to how you construct your position-sizing algorithm. If you want to hold multiple correlated currency pairs, then you may need to trade smaller sizes than if you hold a limited number of less correlated instruments.

One way of doing this is to limit the percentage of open risk per group of correlated markets to a set amount, such as 3%.

Other traders, such as Jim Langlands, choose to focus on a smaller basket of currency pairs, as their method of managing correlations.

This is where it can be useful to add markets outside of Forex (such as indices and commodities) to your basket of traded markets. But remember, there is no guarantee that an index or commodity is not correlated with a currency pair.

Portfolio heat

“The moral is you have to know your net exposure comfort zone.” – Jack Schwager

Even if you think you are trading a number of non-correlated markets, when things turn to custard you might find that everything starts to move against you at one time. The concept of portfolio heat protects you during this type of scenario.

Your portfolio heat is the amount of risk that your portfolio of trades has at any one time. For example, if you have five trades on, all risking 2%, then your portfolio heat would be 10% (5 x 2%).

The amount of risk you have in your portfolio should be dependent on the quality of your trading system. If you have a poor quality system, and have 20-30% of your equity at risk at one time, you are asking for trouble. But if you have an excellent system that is run across a number of non-correlated markets, with a limited amount of leverage, then this level of risk could be acceptable.

As a general rule, most systems should not have a portfolio heat above 15%.  If you are inexperienced, or risking your core capital (as opposed to your profits), then you will want to have significantly less than this.

The importance of understanding your system

“One of the fundamentals that you as a trader must know is how to evaluate the effectiveness of your trading methodology.” – Van Tharp, Market Wizard

The better you understand the distribution of R-multiples that your system produces, the better you will be able to size your positions.

Your R-multiple distribution is simply what a series of trades might look like. For example over 100 trades you might expect to have 40 -1R trades, 8 -2R trades, 2 -5R trades, 25 1R trades, 15 2R trades, 8 5R trades and 2 10R trades.

Armed with this information, along with your objectives, you can run functional simulations of your trading system. If you risk different amounts and record the results, you can come close to finding an optimal amount to risk per trade to produce the best returns.

Alternatively for the discretionary trader (who does not have access to a simulator), this information will help you to make more informed decisions about how to size your positions. You can then run manual tests using Van Tharp’s position sizing game.

The better your system, the more you can risk

“Position sizing is not only in avoiding trading too large, but in trading larger when warranted.” – Jack Schwager

While it is important to understand the distribution of R-multiple results your system returns, it is also important to understand the quality of your system. Simply put: the better your system, the more you can afford to risk per trade.

You can determine the quality of your system. Van Tharp has developed what he terms a system quality number (SQN). How the SQN is derived can be found here. The greater the SQN, the more you can feel comfortable risking on each trade.

The good news is the folks at Tradervue will automatically calculate this for you based on your system’s performance.

Managing open risk (risk on profits)

If you trade effectively, especially if you use a scale-in technique, at some point you will end up with a large open profit.

While this is a nice scenario to get into, holding onto your profits requires careful management. One news event, and all your hard earned profits could be wiped out.

Because of this, you may need some rules in your position-sizing algorithm that help you make sure you hold onto your profit. Without these, you could see some wild swings in your account. To do this, you could allocate a maximum R drawdown you are willing to experience in a trade. Alternatively, you could use a trailing stop that serves to achieve the same thing.

You may also want to have this rule based on a group of trades, or account wide. For example, if your account has a 3R drawdown in profits across multiple positions, you might start to trim back all your positions.

Position sizing based on market or trade type

“Traders need to adjust position size in response to the changing market environment.” – Jack Schwager

You may use different position sizes based on the type of trade you are looking to place. For example, if you have a portfolio that contains a mix of short and long-term positions, you generally will want to have different sizes for each.

For example, you might risk 0.3-0.5% of your account on a short-term position, but risk 1-2% on longer-term trades. In addition, you may decide to trade smaller in sideways market types, and larger in trending markets. Or perhaps you choose not to scale-in during sideways market types.

Remember to fit the right position-sizing approach to your strategy.

News event management

The currency markets can be significantly volatile around news events. Sometimes days or even weeks of profit can disappear in a heartbeat.

But the good news is, as you know the event is coming you can prepare for it.

If a potentially volatile event is on the horizon, then you have a few options.

  • Trim your position size
  • Place a stop on your position close to the market in case it goes against you
  • Protect part or all of your position with options.
  • Use short-term binary options that win if your positon moves rapidly against you

Often a combination of some or all of the above will work best. Think about your objectives, and how much you are willing to give back if the market does move against you.

Position sizing on your initial core capital

“The most important thing is to keep enough powder for a comeback.” – Marty Schwatrz, Market Wizard

If you don’t protect your trading capital, you will be out of the game.

Many traders start out by risking large chunks of their own funds. But what they don’t know is that when they first start trading is the time that they are most likely to lose.

Instead, you should have a position-sizing model that you use on your core capital to protect it in the initial stages, before your normal position-sizing model kicks in.

Generally, you want to keep the risk as small as possible when you begin, and then once you have profit, you can start to trade at a larger size. For example, if your normal position-sizing model calls for you to risk 1% on a trade, you might risk 0.2% of your core capital, just to start with. Once your core capital is up 1 or 2% you might then start to risk 0.4%, and so on, until you are well into profit.

This serves to protect your capital when it is at its most vulnerable, and gives you the best chance to become a winner.

The courage to be a pig: Conviction based position sizing

“If a trader does better on high confidence trades, then the degree of confidence can serve as a proxy for probability of winning. The implication then becomes to trade larger on high confidence trades and smaller, or not at all, on low confidence trades.” – Jack Schwager

Conviction based position sizing is often what separates a great trader from a mediocre one, (and great returns from mediocre ones).

Your good ideas should make a lot more than your mediocre ones. But most position-sizing models don’t offer a great framework for this type of approach. Your high conviction trades might merit a leverage of several times your account size, and a level of risk far greater than a typical trade.

Generally, you don’t want to build to this level of risk all in one go. You may want to use a scale in approach as outlined in lesson 13. As the trade goes for you, add more size. When you build your position-sizing model, keep this as systematic and possible, while giving yourself room to trust your judgement.

Watch your eggs closely

Stanley Druckenmiller does not believe in diversification as it is taught in business school. He would instead prefer to put all his eggs in one basket, and watch them closely. This approach lead to some spectacular returns. If you had invested $1000 with Druckenmiller at the start of his career, it would be worth $2.6 million now. In addition, he has never had a losing year in his career.

You may find this 2015 interview of Druckenmiller well worth the read.

Using account based goals

Some traders prefer to adjust their position sizing model based on where they are at throughout the month or year.

Marty Schwartz would “be poor in January”, effectively starting from scratch each year. At the start of each year, all his money is “core capital” which he is miserly with. Once in profit for the year, he expands his position sizing.

Similarly, Stanley Druckenmiller seeks to grind out the first part of the year until he is up by 30%. Once he has hit that level, he will then start to trade much bigger on his high conviction ideas. Creating milestones like this can be a powerful tool to help you generate outsized returns while limiting risk.

Market’s Money

We touched on market’s money in lesson 7, but the topic is worth expanding on here.

Market’s money is possibly the best way to increase your returns, so it’s very important for the trader to learn different ways of employing it so they can best fit it to their strategy.

Closed trade vs. Open trade

“Once he is ahead on the trade, he will allow for more risk latitude. This approach all but ensures losses on new trades are likely to be moderate.” – Jack Schwager, discussing Market Wizard Scott Ramsey

The first distinction to make when planning to use market’s money is to consider whether you will use market’s money during a trade (i.e. scaling in). Maybe you’d prefer to apply it to your account over a set time period (i.e. if you are up 5% for the month, you may decide to risk more on your next trades – like the 2&25 position sizing model).

You have a choice of using either, or you could combine the two, and scale-in aggressively when your account is already in a profit for the time period.

When does market’s money become core capital?

Your next consideration is to decide when market’s money is “banked”, and becomes core capital.

At some point, you will want to lock in the profits you have made. The timing will depend on your objectives, though a common way to do it would be over a time period, such as a week, month, or year. Alternatively, it could be based on some form of return goal.

A variation of the market money approach: Two pots

In the Definitive Guide to Position Sizing, Van Tharp outlines a variation of the market’s money approach he terms “two pots”.

When employing the two-pot approach, a trader would add a percentage of their profits to a separate account, which is treated as market’s money. For example, 20% of the profits on a trade might go into another account that aggressively targets large gains, while the other 80% is treated as core capital and traded conservatively.

Using market’s money to create an asymmetrical risk profile during a trade

“It helps greatly to have a long-term objective that you have derived by really doing your homework. You combine the long-term objective with the protective stop that you move as the position goes your way.” – Gary Bielfeldt, Market Wizard

If you add to your position once you are in profit, and then combine the stop on the positions, you can have the effect of creating a position where the risk is limited to the downside, but the profit potential is significant, whilst still maintaining a wide stop.

Let me use an example of a longer-term trade on the EURUSD.

On this trade, we are looking for 1000 pips with a 300-pip stop-loss, giving a risk/reward ratio of 3.3:1. Let’s see how this trade was converted into one that could generate 15 times our risk or more, using market’s money and a scale-in approach (a risk reward of 15:1).

Firstly, you still want to stalk a good entry. It will improve your success rate, and the risk/reward even more. Preferably, you also want a catalyst that triggers the trade.

When you get your entry signal, establish your initial position as you would normally – but make sure you keep your stop-loss well out of the way of any noise. Try tripling what you normally use.

(By the way, another benefit of this approach is that you can tend to trade larger positions, as the quality of your trades goes up. This means your profits can be greater.)

Chart 1

 

As the market goes for you, scale in to an additional position. You will want it to have gone another 100-150 pips. Preferably, you want to stalk another good entry point for the new position.

When you add the additional position, combine the stops and move them up jointly so that you are risking no more than the original amount of money. I.e. if you were risking 2% of your account, then move the stop until you are still risking no more than 2% on the combined position.

As you had some profit from the first position, you will still be able to maintain a wide stop, even though your position size is twice as large. If you set a new profit target for 1000 pips on the additional position, then you have the same risk of 2% of your account, but you stand to make an additional 3.3R on the trade. Your risk reward is 6.6:1 now.

Chart 2

You can put the profit target on the second position at the same place as the original position if you like. But having only one profit target is trying to be right about the exit. Better to have multiple targets, and other exit rules that cater for changing market conditions (not all trades go as swimmingly well as this one).

Once you have added the second position, keep adding as the price goes for you until you reach your maximum position size. For example, on a trade like this, you might look to add up to five positions as it goes for you. Each new position gives you an additional 3.3 to your risk reward, without increasing your maximum risk of 2% of your account.

Chart 3

Can you see how this method of position sizing using market’s money allows you to generate large gains while still limiting the risk to your core capital?

The Step Method

Another way to use market’s money to scale-in to positions is the step method.

As opposed to the above approach of combining your stop-loss, with the step method each new position has a separate stop-loss. But at the same time, the stop-loss orders on the earlier positions are trailed higher, limiting the risk.

For example, you might start by risking 0.5% on your first position, then as it goes into profit you add a new position risking another 0.5%. You then move the stop on the original position higher, so your overall risk would be 0.75%.

You can then continue to add to the trade until you reach your maximum risk limit. Using this technique you both:

  • Keep losses small if the trend does not eventuate
  • Build a large position while limiting the potential risk

You also have a variety of stop-losses, so that even if one position gets stopped out, you will still have some skin in the game in case the market goes for you.

Position sizing for day trading: Bullet Method

In the fast-paced world of day trading, if you are not switched on mentally, or the market conditions are unfavourable to your strategy, you can lose large sums very quickly. To counter this, day traders should have very strict rules including:

  • Maximum number of positions they can take in a day
  • Maximum number of positions they can hold at any one time
  • Maximum loss in a day before they stop trading

Ken Long, an instructor from the Van Tharp institute with a military background, developed a position-sizing model designed to achieve this, called the “bullet method”.

Ken divides his risk capital into several bullets, which he can fire each day. To do this, you split your daily risk capital into several parts (or bullets), and that is the number of trades you can place in that day. For example, if you were prepared to risk a maximum of 1.5% of your capital, and you wanted to place three trades a day, you might risk 0.5% on each trade.

Of course you can get quite intricate with how you apply this approach. You may decide to replenish your bullets if you have a winning trade, or if you have two losing trades, you might split your remaining bullet in half, so you have two smaller trades you can place. You could also use bullets to scale-in to profitable positions, or for any other purpose that fits your personality and trading style.

Allocating capital across multiple systems

In time, you will want a number of trading systems that work across a variety of strategies, timeframes and markets (Forex, commodities, stocks etc). There are several position-sizing considerations when you run multiple strategies:

  • Objectives of the system. You may decide to allocate more to a conservative long-term growth strategy than to an aggressive system for example.
  • The amount of leverage required. Some systems will require more leverage than others, which could be a factor in your allocation.
  • Correlations across the systems. Some systems may be correlated, or even hold the same currency pair at the same time.
  • The SQN of each system. You may want to allocate more to higher quality systems.
  • The maximum drawdown of each system. You may want to allocate more capital to a system with a lower drawdown.
  • The holding period of each system (Daily, weekly, monthly). A day trading discretionary system may require less capital than a long-term trend following system.
  • The recent performance of each system. If a system is going through a rough patch, you may increase or decrease its capital allocation depending on its recovery profile.
  • The current market type. Some systems don’t work as well in certain market types. You may decide to increase or decrease your allocation to certain systems in unfavourable market types (this includes decreasing it to zero).

To rebalance or not to rebalance

In the Definitive Guide to Position Sizing Van Tharp covers the results of a study on rebalancing done by market wizard Tom Basso, which was then critiqued by Jack Schwager (the author of the Market Wizards books).

Schwager found that if he rebalanced five non-correlated systems monthly, by taking from the winners and adding to the losers, then it improved the performance of the systems by reducing the overall drawdown (but not necessarily by increasing returns).

However, extrapolating from Basso’s earlier study, if the systems show a degree of correlation then taking from the winner to add to the loser is not a successful approach.

Spend your energy here

“Most people have psychological biases that cause them to want to understand the markets, predict the markets, and be right in their trading. As a result they totally ignore what is important – cutting their losses short and letting their profits run.” – Van Tharp, Market Wizard

As you can see, when you start to get sophisticated about your position-sizing, you can come up with an infinite combination of algorithms that you can fit to your particular strategy and goals.

You will be far better off if you focus the majority of your attention and energy on designing your position-sizing model, and keep most other aspects of your trading to the side. In terms of importance, it is right up there with psychology. If you get this wrong, you are setting yourself up for major losses, but if you get it right, you can magnify the performance of your trading system significantly.

So forget your charts and news, and dive deep into your position-sizing model. You won’t regret it.

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Until next week,

Sam

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