| How Position Sizing Can Make or Break Your Trades |
Now that we’ve discussed some of the factors to accounted for as you design the entries in your system, we need to spend some time on measurement. This is important to understand before you start working on exits.
A vitally important factor to understand that is related to positioning is risk. What are you risking per trade in, or out of a system? How much can you afford to lose? We encourage forex traders to trade ONLY Risk Capital. Risk capital is money you can afford to lose. You should never trade with money that will leave you in a financial bind if you lose it.
Understanding risk will give you benchmarks that must be met while designing a system. It will also help you develop backtesting results and determine the optimal size of each position. The concepts are relatively simple to understand, but it is surprising to see how infrequently they are used by traders.
The goal here is to develop a system, or hopefully, series of systems in your portfolio that give you rules for structure and consistency, while minimizing risk and optimizing profit potential. Each of these factors is of equal importance.  These dealers have a couple key factors they look for to identify a likely “loser” to add to the pool. One of those factors is highly variable position sizing and risk amounts in the same account. This is an indication that the trader is likely emotional and erratic, and is not trading a plan or system. Historical data shows this type of trader is HIGHLY likely to panic and lose money. This course will help you avoid the “loser” pool. There are three considerations you must address when designing a system:
1. What is your risk per trade? 2. What is the ratio of risk to my average reward per trade? 3. How much do I invest in any single trade?
Risk per Trade This can be a simple or complicated problem, depending on the system you are trading. Most commonly, the risk you are exposed to per trade is your stop loss, plus trading costs. Without a stop-loss, your risk is theoretically infinite. However, using options to protect a position or leaving stops off can add a layer of protection too, that we will discuss later.
It is important to note that when designing a system, it is best to be as conservative as possible. Prepare for the worst but hope for the best. So although you may frequently preempt your stop losses in real life as fundamental changes impact the market, assume that the system cannot do this. That way you are eliminating bias that may create incorrect results in the back-testing stage.
Let’s assume that you have determined that a 240 pip stop loss is sufficient to keep you in a position through normal market volatility in a long term system you are designing. That stop loss is most of the risk you need to account for. Add transaction costs and slippage, and you have total risk. Like we discussed in the previous section, I usually estimate slippage as a % of the normal trading range. In the forex, stops can be slipped but it does not happen very often. Therefore we think it is justifiable to keep the slippage factor on stops at about half the size of what you assume the slippage on your entries.
So if you assume that your slippage on exits is 10 pips, your risk is now 250 pips per trade. That is an important number, and is a major factor in determining how much you invest per trade, as well as what profit you expect to make over the long term. Adding slippage to the amount you have at risk is a component of backtesting. What you are trying to do is make the backtested results as realistic as possible by adding some inefficiency that will likely occur when you are trading the system into the future.
Risk to Reward Ratio Everyone will have some losing trades. The real issue is how big and frequent those losses are compared to your gains. To answer this question, you need to know what your average winner is, so you can compare it to the risk. This is usually something you learn in the backtesting process and will be validated as you trade the system into the future. We'll discuss in depth in a later lesson.
Assume again that your risk is the 250 pips we discussed above. If, in the past, your system makes 750 pips on average in a profitable trade then you have a risk to reward ratio of 1:3. That means every time you take a risk you plan to make 3 times that amount if the trade closes profitably.
In most cases, having a system that returns a few multiples more than you have at risk is a good thing. Many traders are not going to have a very high winning percentage, so making more on winners is critical to running a profitable system. As we proceed into the next sections and talk about exits, we will be bringing this information together to develop a full expectation of system performance.
Investment in a single trade How much to risk in a single position is a function of the total capital you want to use for a given system, your risk tolerance, or the maximum loss that is tolerable for you. The last variable is something that you have to determine for yourself. However, here is an example based on the numbers we have been using so far.
Position size = (Capital x Tolerable loss) / Risk
Imagine that you have $20,000 of capital set aside from your portfolio for this particular system. You think you can handle a loss of 3% of that capital in a bad trade. The risk we used above was 250 pips or $250 per mini lot. That means that your position size is
2.4 mini contracts = ($20,000 X 3%) / $250
Now what if you are a big risk taker? If you can tolerate a lot more volatility in your account, you can adjust the % tolerable loss which will increase the number of contracts you invest with. The inverse is also true. Imagine that you decide a 5% loss is acceptable. Here’s how that fits in the calculation.
4 mini contracts = ($20,000 X 5%) / $250
The important concept is to make sure that you are consistent. Randomly selecting the amount you will invest in a trade creates inconsistent results and will negatively impact returns. At that point, you have no system, just random gambles.
The images below are good illustrations of what happens to a system when you change your variables frequently. This system was mechanically backtested with two different position sizing strategies, one that was constant, and one that was changing.
The system above returned 1,347 pips over the testing period and had a constant 5% tolerable loss.
This was the exact same system, over a similar period of time, but with a randomly selected tolerable loss between 5 and 10%. The inconsistency created volatility in the account, which ultimately made it impossible to make up larger losses with smaller winners. Next: Avoiding Bias in a Trading System Keep up with us:
Comments deemed inappropriate will be removed
3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved." |
| Learning Markets Partners More Partners | Become a Partner |
 |  |  |  |  |
 |
| Learn to Invest | Reviews of Stock Brokers | Stock Picks | Technical Analysis | Broker News | Investor Education | What to Invest In | Live Market Analysis | Should I Invest? |
