“So where was he going wrong? Position size. For every one contract I traded he traded ten. He would double his money on two different occasions every year, but still end up flat” – Bruce Kovner, Market Wizard
“Position sizing is the key to meeting your trading objectives.” – Van Tharp, Market Wizard
“Limit your size in any position so that fear does not become the prevailing instinct guiding your judgement” – Joe Vidich, Market Wizard
When you’re working on your trading strategy, the lure of the charts is tempting.
I know I’m guilty of this deadly sin, and my trading has suffered for it.
Now it’s time for a remedy – to stave off your addiction. It’s time to shift your attention away from your charts and onto position sizing.
What is position sizing?
“Your position sizing strategy helps you to determine how much equity to risk on every trade. Its purpose is to help you meet your objectives” – Van Tharp, Market Wizard
Position sizing is the “how much” part of the equation when you trade Forex. More precisely, it is how much will you buy or sell in each individual position when you place a trade. Or for an expanded definition:
“A series of rules about “how much” of each currency you should trade to meet your long-term goals and effectively manage your risk depending on the quality of your trading system.”
A bit of a mouthful, yes. But it’s super important. If you can master this idea, it will transform your trading for life. Why? Because it is the number one thing that traders get wrong.
It has the power to make or break your trading account.
Trading is an uncertain endeavour. No matter the research you put in or what an expert “says”, there is a chance that the currency you trade will go against you.
Position sizing allows you to limit this risk by taking small losses and preserving your money to fight another day. But it also does much more than that. As well as protecting you from risks, you can use position sizing to your own great benefit.
It allows you to:
- Trade more in ideas that have a better potential for reward, or in strong trends.
- To scale into trends to build large positions while keeping your overall risk small.
- To go for big wins while conserving your trading capital by risking market’s money.
You achieve this by overlaying a position sizing model or “algorithm” on top of your entry and exit rules.
Your position sizing model is an overlay
“Your trading system employs a set of rules to tell you when and how you trade. The purpose of a trading system is to make sure you can achieve your objectives easily through effective position sizing” – Van Tharp, Market Wizard
This is one of the most important things to understand about trading Forex:
Your position sizing is a completely separate decision from your entry and exit decision.
Let’s take a look at an example.
Say you find a trade you might like to take, risking 50 pips. If the trade goes well, you manage to sell it for 150 pips or three times your potential losses. If the trade goes against you and hits your stop-loss then you would lose 50 pips: your risk.
Pretty simple, right?
Now let’s see how applying different position sizing models to the same trade generates completely different results.
In each model let’s assume you have $10,000 in your Forex trading account.
Model 1: Number of lots
In this model you decide to buy 1 lot (100K of currency).
If the trade goes for you, then you would have made 150 x $10 or $1,500. If it goes against you, then you would lose 50 x $10 or $500.
Model 2: Account leverage
In this model you decide that because you have 100:1 leverage, you will use all of that to take a trade of 10 lots, worth $1,000,000.
If the trade goes for you, then you would make 150 x $100 or $15,000. If it goes against you, then you would lose 50 x $100 or $5000.
Model 3: Fixed percent of equity risk
In this model you decide to risk 2% of your capital on the trade or $200.
This means that you buy $40,000 of the currency you are trading.
If the trade goes for you then you would make 150 x $4 or $600. If it goes against you then you would lose 50 x $4 or $200.
As you can see the profits or losses on the same trade are altered dramatically depending on which model you used. This is only the barest bones of the different position sizing models you could choose to use when you trade Forex.
So to reiterate, you can have exactly the same entry and exit, and have a completely different result depending on your position-sizing model.
That is why position sizing is so critical. Are you ready to switch your focus to position sizing yet?
How top traders use position sizing to achieve their objectives
Top traders think in terms of risk multiples, or as Van Tharp calls them, R-multiples.
Tharp is perhaps the world’s number one authority on the concept of position sizing, and is still the ultimate font of knowledge on the topic. To deep dive into position sizing, the best resource is his Definitive Guide to Position Sizing.
You may want to review R-multiples again from lesson 5.
R-multiples are central to your position sizing
When you take a position, your initial risk is the distance between your entry and your stop loss. This is called your 1R (one times your risk). Through position sizing you make 1R worth a dollar value or percentage of your account, which finally translates into a number of lots, or micro lots, to buy.
Don’t worry, we will go into some examples and with a little bit of practice it will soon be second nature.
You have an account balance of $10,000 and you want to buy the EUR/USD with a 100 pip stop loss.
Your position-sizing model calls for you to risk 2% of your account on the trade, or $200.
Your 1R is $200 meaning you should trade 2 mini-lots or $20,000.
You have an account balance of $53,000 and you want to short the AUD/USD at 0.8700 with a stop loss at 0.8750.
Your position-sizing model calls for you to risk 1.5% of your account on the trade or $795.
Your 1R is $795 meaning you should trade 10.65 mini lots or $106,500 (use the tools listed above to work this out).
Once you have defined your 1R, then your profits are expressed as multiples of this initial risk (R-multiples).
For example if your 1R risk is $795, and you make twice that ($1590), then you would have made 2R. If you made five times your risk ($3975), then you would have made 5R.
How position sizing is used to meet your objectives and goals
Before we get into some specific position-sizing models, I would like to review how some of the decisions you have been making over the past few lessons all come together in the topic of position sizing.
As you can see in the following diagram, your broad financial goals as expressed by your financial freedom number lead you to develop your trading objectives.
To achieve those objectives, you devise a position-sizing model. This in turn, with the help of R-multiples, tells you exactly how much to trade.
If any of these parts are missing, or unclear, then traders tend to struggle with their trading system, and either not make as much as they could, or lose more they should.
Each of the system objectives you identified in lesson 6 should be considered when developing your position-sizing model:
- Profit objective
- Maximum drawdown
- Chance of maximum drawdown
- Trading opportunity
- Win rate
- Targeted risk/reward ratio
If you want to limit your chances of the maximum drawdown, you may trade smaller sizes as you enter into a drawdown.
Or, if you have a low win rate, then your position size will need to cater for the inevitable string of losses you will encounter while you wait for the big winning trades to arrive.
Your position sizing model depends on the quality of your system
The better your system, the more you can invest, the easier it will be for you to achieve your goals.
While you achieve your goals through position sizing, the better your overall trading system is, particularly your entries and exits, the easier it will be for you.
You will be able to:
- Trade larger sizes
- Achieve more consistent returns
- Suffer less drawdowns
- Protect your trading capital
It’s important to understand that your position-sizing model, while it is independent from your entries and exits, should be logical and relevant to the type and quality of your entries and exits.
How to build a position sizing model: A basic example
“One of the first lessons my first boss taught me is that price is irrelevant; It’s all about controlling the size of your positions” – Steve Clark, Market Wizard
To help this all become clearer, let’s work through an example.
Say I have a financial freedom number (FFN) of $5000 per month. That is, when I am making $5000 per month on average from my Forex trading, I am financially free.
The objectives I have for my trading system are:
- Profit objective of 10% a month
- No more than a 2% drawdown a month
- I am willing to risk a 50% chance of experiencing my maximum drawdown
- 40 trades a month
- 50% win rate with a 3:1 risk/reward ratio.
My trading system has a targeted profit objective of 10%, meaning I would need $50,000 in my Forex trading account to be financially free (50,000 x 10% = $5000).
If I can achieve my 50% win rate with a 3:1 risk reward ratio, my trading system has an expectancy of 1 (see lesson 5 to review the concept of expectancy). This means that on average each time I place a trade I can expect to make on average 1R.
Over the course of my 40 trades for the month I would end up with 40R (40 x 1R).
It can be helpful to think about R as a percentage, i.e. if I make 1R, it’s 0.5%, 1%, 2% or 3% per R etc.
If I take my 10% profit objective and divide it by 40R, then I get 0.25%. This 0.25% risk is now my position size when I place a trade.
0.25% of my starting capital ($50,000) is $125, meaning each time I trade I would risk $125.
I have a maximum drawdown level of 2%, which I hope to avoid, so I may need to trade smaller at the start of the month until I have some profits. Then I can trade a bigger size (otherwise it will be too easy for my drawdown limit to be hit).
(Note that these choices are discretionary based on my objectives.)
By understanding your broad goal as expressed by your financial freedom number, and extrapolating this into your system objectives, you are able to be very accurate about how much to trade in order to meet your objectives when you enter into a position.
In the real world you will be faced with a number of subtleties and complexities as you react to the market and the growth or depletion of your account balance.
When you are making decisions under these circumstances, always think back to your goals and objectives and you will find guidance.
A game of marbles
“I am wrong all the time. If I can be right 60% of the time, and when I am right I have some big winners, and when I am wrong, I staunch the losses quickly, I can make a lot of money” – Martin Taylor, Market Wizard
When I attended a 9-day trading course with the aforementioned Van Tharp, we played his “marble game”. In this game, trades are simulated by randomly drawing a marbles from a bag.
While there are several different variations of the game, the basic premise remains the same:
- Each marble pulled from the bag is a trade in R-multiples. I.e. you may lose 1R or make 5R on a pull;
- Everyone has the same amount of starting capital and you must risk a certain amount on each pull from the bag;
- There is real money on the table for each game (up to $1200 at one point).
Each pull from the marble bag is considered a trade, and everyone gets exactly the same trades. Each simulation lasted at least 30 pulls from the marble bag (trades). There were up to 27 different participants in each game.
Ok, just to confirm; everyone had EXACTLY THE SAME TRADES.
The systems also tended to have a majority of losing trades, with some big winning trades on occasion. The only control that each participant had was his or her position-sizing rules.
At the end of every game, every single person had different equity, no exceptions. The variation between individuals was massive, from bankrupt through to several million dollars profit.
After playing the game a few times, it became very apparent how position sizing is not only composed of an entry and exit, with a separate position-sizing model applied on top, but the huge variety of potential position-sizing models you can choose from to meet your objectives.
Let’s take a look at some now.
If you are interested in playing the marble game for yourself, Van Tharp lets you play for free on his website. It’s highly recommended to gain an in-depth understanding of position sizing.
Model: 1 Percent of Equity Risk per trade
With this position-sizing model, you risk a fixed percentage of your account balance on each trade.
For example, you might risk 1 or 2% on each trade. That is if the trade goes against you then you lose 1 or 2% of your account. There are a number of variations you can take when using this model.
- Percent of starting balance. You risk a fixed percentage of your starting balance.
- Percent of current equity. You risk a fixed percentage of your current account balance at the time you place the trade.
- Percent of equity high. You risk a fixed percentage of the highest point of your account balance.
While the differences here may seem subtle they can lead to quite different performance over time.
Model 2: Market’s Money
“The way to build long-term returns is through preservation of capital and home runs. You can be far more aggressive when you’re making good profits. – Stanley Druckenmiller, Market Wizard
“When I am more attuned to the market and playing with market money, I will increase my position size.” – Scott Ramsey, Market Wizard
I’m sure you have heard how important it is protect your initial trading capital.
You will have also heard about how some people become very rich trading currencies with very little money. This is where a market’s money position-sizing model can help.
With a market’s money position-sizing model, you use profits you have made to trade larger positions, while trading small with your own core trading capital. For example say you have a $100,000 account, you risk 0.25-0.5% of your account per trade, but when your account gets into a profit you risk 2-5% or more to trade larger sizes.
This way, you limit the risks on your initial capital, yet you can still go for big wins when the opportunity presents itself.
One question you will need to answer is: when does the market’s money become your own? That is, when do you lock in your profits, and consider them part of your core capital?
You could do this based on:
- A time period, such as a year
- A profit objective such as 50%
- A combination of the two
Have a think about how you would feel risking some of your profits to make large gains, and see if it would suit you.
It’s important that you don’t start to engage in risky trading behaviour when you are using market’s money, just because it’s not “yours”. Market’s money is to be used in a controlled fashion.
At FX Renew we have some position-sizing algorithms built around the market’s money concept.
Model 3: Scale in to the trend
“The Trend is Your Friend” – Trading Adage
A scale in position-sizing model takes advantage of trends to add to winning positions.
As your trade goes into profit, you add additional smaller positions to create one large position. As you add positions, you would move your stoploss to keep your risk on the overall position small (1R or less). This way if a trade goes for you then you could have a big win, but at no time are you exposed to a large loss.
For example: when you see your initial entry, you buy your first position risking 1% of your account. Once the currency pair goes up in price, you add another position and move the original stop loss up. You then continue to add positions and trail the stop loss up until you have your core position.
As the trade continues to go up, you trail the stop loss higher until you eventually have a large position that is essentially “risk free” or with locked in profit, because your stop loss is above your entry points.
Note that you don’t want to be scaling into losing positions. Paul Tudor Jones, a Market Wizard, has a plaque on his wall saying “losers average losers”, so don’t be that guy or girl.
Different types of trades
“Varying position sizes can be as important as the entry methodology. Trading smaller, or not at all for lower probability trades, and larger for higher probability trades can transform a losing strategy into a winning one” – Jack Schwager discussing insights from Edward Thorp, Market Wizard
Good traders adjust their position-sizing based on the timeframe of the trade. If they are more active, they tend to trade smaller, whereas traders who take a longer-term approach will be comfortable with a larger degree of risk on the position.
You can consider trading with different levels of risk depending on the timeframe of the trade. For example you may risk more on a longer-term trade, and less on a shorter-term trade.
It makes sense to trade smaller when you are not in form, or in touch with the markets, and to trade bigger when a great trade is lining up, or you are on a hot streak.
This is a critical difference between the amateur trader and the professional. The professional knows when he or she is on form, and it is a good time to swing big. The amateurs treat all trades the same. The amateur trader loses more than they should, and never wins as big as they could.
Milestone and goals
When you achieve certain goals or milestones, you may want to adjust your position-sizing.
For example, if you hit your monthly goal – what will you do? Will you stop trading? Reduce your position size? Perhaps you will decide to swing big, using some of your monthly profit to date as market’s money.
Milestones are points to note on the way to your goals. For example, if you get close to your goal for the month, you might decide to trade smaller to avoid turning a winning month into a losing one.
Your position size is the most influential decision you will have on your success.
“90% of performance variation among professional traders is due to position sizing strategies.” – Van Tharp, Market Wizard
Take your thoughts on position-sizing and put them down on paper. How well you answer the questions will have a significant impact on your success, so take your time.
Do it thoroughly.
But as always, remember you can change your model in the future as you learn more, so if you are feeling stuck in an area simply move on.
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Till next lesson,
- Write down your position-sizing model in the My Position Sizing Model Worksheet.
- Practice your new position-sizing model using your trading platform.
- Play Van K. Tharp’s position-sizing game at least three times, using different position-sizing models. What are you learning from each game? In particular, what do you think are the lessons Van wants you to learn in each of the first three levels?