Traders are constantly looking for the secrets of trading success, but they keep looking in the wrong places and at the wrong things. Typically they tend to gravitate towards high win rate systems, or variations of that same theme (the desire to be right). However, being near-perfect with your market timing has nothing to do with your overall success in the market.
All Market Wizards agree that the main ingredients for successful trading are:
- your risk:reward ratio (cut your losses short and let your profits run);
- your position sizing algorithm (how much you allocate to each bet);
- being systematic with your approach (having the discipline to not wander).
Today we will explore the importance of Position Sizing and how an inadequate strategy can be absolutely dismal to your trading.
Expectancy vs. Probability
Before going any further, we need to clarify the concepts of Expectancy and Probability.
A trader’s Expectancy is the mathematical description of his “edge”. It tells you what the average win has been, given the trader’s return series, and is best described in “R” terms and not just in %-terms. Mathematically it is (Avg. Win*Win%) -(Avg.Loss*Loss%)
Vice versa: the probability of a given result is connected to the trader’s accuracy rate. It takes into account the “winning streaks” and “losing streaks” and has little to say about the overall profitability of the trader.
In our experience, systems with a very high win rate tend to have a lower probability attached to their positive results. But at the end of the day, it’s the bottom line that counts. Large R-multiples in your favour are much more significant than “being right”.
The Importance of Position Sizing
Having a working knowledge of position sizing models helps traders avoid the common mistakes that often put aspiring traders out of business:
- risking too much on each trade;
- risking more after a losing streak (also called Martingale strategies);
- being too conservative and obtaining inefficient results compared to the effort involved;
- not letting profits run;
- failing to protect profits during a winning trade.
As a side note, remember how much work is necessary to get out of a drawdown:
- A 10% Loss of Capital requires an 11,11% Gain to reach Breakeven
- A 20% Loss of Capital requires a 25% Gain to reach Breakeven
- A 30% Loss of Capital requires a 42% Gain to reach Breakeven
- A 40% Loss of Capital requires a 66,66% Gain to reach Breakeven
And we need not continue because the odds of equalling the 2016 performance of Market Wizard Bill Lipschutz (65%) are very thin. Plus, that would just take you back to breakeven. It’s much better to never be in such a position in the first place.
This is where your position sizing model comes in handy.
The first objective of a position sizing model is to preserve capital and avoid disaster. Ray Dalio talks about “failing well”: this means losing, or making mistakes, without being kicked out of the game. In trading, if you lose all your risk capital, you’re out of the game.
However, if you are only concentrated on capital preservation, perhaps you are too risk averse and trading just isn’t your piece of cake. If you are attempting to trade, you should have risk capital in your trading account (i.e. capital that you can risk losing without fretting).
This leads to the second objective of position sizing : to maximize your profits.
Here are a couple of examples that should get you on the right path for finding a model that suits your own objectives.
Symmetrical vs Asymmetrical Position Sizing Models
To do these tests we have utilized a random number generator on Excel. The top curve represents the cumulative sum of wins and losses for 1000 random extractions. The bottom (and more interesting) chart represents the hypothetical equity curve using 2 position sizing models:
- A symmetrical model in blue: fixed fractional. The trader risks the same amount (1%) per each trade, independently from the situation.
- An asymmetrical model in orange: start with 1%. Whenever there is a win, risk 1% + half the amount you previously won. When you lose, cut back to 1%.
As you can see, so long as there is an actual edge to be exploited, being more aggressive can really offer significant profits whilst keeping drawdowns quite similar in nature (much more upside with slightly more downside).
Of course, as we have stated previously with our own trade investigations, position sizing and trade management alone cannot rescue a system that has no edge. (and if you’re in that situation, don’t worry: we’ve got your back)
Over to You
Position sizing is what can help you minimize drawdowns and go for exceptional gains. But it’s not easy to find a suitable model. There is no “one size fits all” – as with many aspects of trading.
To help you, we have put together a whole course on Position Sizing within our Education section, showing you the models we use for single strategies and showing you also what we recommend for portfolios of trading strategies.
This way you can get the most from your trading strategy.
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.