The Art Of Position Sizing

Today I want to talk about a subject that normally causes participants to doze – it’s a very unsexy subject. Unsexy but very important. So bear with me.

There are two issues I have with many commercial position sizing software:

  1. The software allows only testing on an instrument by instrument basis.
  2. It reports only on dollar results

There is no problem with testing on an instrument by instrument basis if you are trading one instrument. But if you are trading a basket of instruments, then serious problems rear their heads.

One of the main issues lies in the fact, that unless you can test on a portfolio basis, you cannot assess the damage a drawdown will do to the portfolio. For example, in a diversified portfolio, a drawdown in one instrument may be saved by a profitable run in another. Or, if all instruments suffer a drawdown simultaneously, then their drawdown would have a much greater impact on capital.

The commercial package I like best is the successor to Trading Recipes: Mechanica Standard Edition

http://www.mechanicasoftware.com/products.htm

I don’t own a copy (I had my own program written) but I have seen it work and I am impressed with it.

The second issue arises because all dollar results are treated equally. But in the real world of trading, this is clearly not the case. The volatility of the market plays an important role in assessing the reasonableness of the return. For example, a risk of $1000 would be very different in an instrument that has an Average True Range of $3000 to one that has an Average True Range of $200.

The Expectancy Formula I quoted in previous blogs is not the one I use for this reason. The formula quoted has been:

(Avg$Win x Win Rate) – (Avg $Loss x Loss Rate) = Exepectancy

I prefer to normalize the result by dividing the result on a one contract basis by the initiating price. Let’s say I bought gold at US$850 and sold it at US$930. The Initiating Price % result would be:

((930-850)/850)x 100 = 9.4%

What I am doing is substituting the $ expectancy with a % of initiating price then translating that to dollars.

For example, let’s say my long-term expectancy is 10%. I enter the ES tonight at 1377. My expectancy for the trade would 1377 x .10 = 137 points x 50 x number of contracts. If I were trading gold and my entry is 890, my expectancy would be 890 x .10 = 89 x 100 x number of contracts.

I find using the % of initiating trade price a more accurate way of assessing expectancy than dollar values.

So then, the Expectancy Formula I use is:

((AvgWin%IPrice x WinRate) – (AvgLoss%IPrice x Loss Rate)) = % Expectancy

2 thoughts on “The Art Of Position Sizing”

  1. Ray

    What Position sizing?

    With the Lunar New Year of the Rat, here is a treat:

    Year of Rat May Portend Losses in Asian Stocks, Astrologers Say

    By Chen Shiyin

    Feb. 5 (Bloomberg) — Chinese astrologer Tony Tan, a former broker at DBS Securities, made money for his clients in 2007 by telling them Asian equity markets would turn in “peak performances” in the Year of the Pig. He’s predicting losses in the Year of the Rat, which starts this week.

    “Just like a rat, investors will have to be nimble,” said Singapore-based Tan, an astrologer since 1995 and founder of the Harmony Academy of Chinese Metaphysics. “It’s going to be a highly competitive year.”

    Chinese astrology, based on a mix of philosophy and astronomy dating back more than 3,000 years, has 12 animals that combine with five elements to define each year, making up a 60-year cycle. This year the Rat, a “water” creature, combines with the “earth” cycle, another unstable combination according to Tan.

    Stock markets are already falling. The MSCI Asia Pacific Index dropped 9 percent in January, its worst monthly performance since September 2001, after a 12 percent gain last year. Benchmarks in 11 of the region’s 14 largest markets including China, Hong Kong and Singapore reached all-time highs in the Year of the Pig. MSCI’s Asian index reached a record on Nov. 1

    Tan expects markets to bottom out in April, a “dangerous” month for stocks because of clashing elements. Prices may rebound as the Year of the Rat continues, without setting new highs, he said.

    “The Year of the Pig was one of optimal strength,” Tan said. “We’re not going to see a repeat of those gains.”

    More than 60 percent of 1,572 South Koreans surveyed recently said they had consulted an astrologer for the Lunar New Year or planned to do so, according to CareerNet Co., an online job- information provider in Seoul.

    Favorable Elements

    Some fortunetellers are more bullish than Tan. Malaysia-based Joey Yap, whose feng shui seminar in Kuala Lumpur last month drew a crowd of more than 3,000 participants, said there will be plenty of opportunities to profit this year.

    “There’s uncertainty, but there’s also a lot of activity and growth,” Yap said. Investors should buy shares of companies in the commodity-related, medical and transportation industries, he said, citing their favorable elements in this lunar year.

    In the last Earth-Rat Year between Feb. 10, 1948, and Jan. 28, 1949, China was divided by civil war and Japan was still recovering from its defeat in World War II. The MSCI Asia index fell 19 percent in the most recent Year of the Rat, a “fire” year, between Feb. 19, 1996, and Feb. 6, 1997.

    The new lunar year begins Feb. 7 in many Asian countries including China, marking the start of a week-long holiday.

    Beat Lenherr, who helps oversee about $20 billion as chief global strategist of LGT Capital Management in Singapore, has consulted a fortuneteller — who makes divinations based on readings of the stars, numbers and energy flows — for both personal and professional advice for the past eight years.

    “Uncertainty will prevail and volatility will continue to be high,” said Lenherr.

  2. PS

    On a serious note of the market,I would like to share:

    Extracts of a financial view:
    The ISM report showed the non-manufacturing or service component of the economy at 44.6%. A reading of 50 is neutral while anything lower means a contraction.

    This represents the first contraction in nearly 5 years and definitely increases the chances of a recession.

    The dollar gained against other major currencies as there was a belief that weak economic data out of Europe would cause the ECB (European Central Bank) to also lower interest rates.

    The ISM report is alarming because Americans cannot stop spending on essential services like health care and transportation.

    The rapid decline is partly due to a new calculation method but also underscores how damaged the economy is.

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