Getting Comfortable with Position Sizing

In the early 1980s, I
was attending university, a teenager with a steady flow of income from fashion
modeling. After considering the options available for my savings, I began my
adventure in the capital markets by buying mutual funds simply because stocks
were fundamentally cheap.

As the broad market indices marched skywards in the mid-1980s, stocks became
severely overvalued. Fundamental analysis became less useful. By then, I had
graduated and joined a brokerage firm. On October 19, 1987, I forever gave up on
the idea of holding on for the long-term.

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This is my twentieth year in the business. I still remember my first day at the
second brokerage firm I ever worked in, a place called Brink, Hudson & Lefever
Ltd. There was no Mr. Brink, no Mr. Hudson, but Gus, the grandson of Mr. Lefever,
was still there, by then an old man himself.

As I did the new-employee walkabout, I noticed most of the folks in the bullpen
had much in common. After I shook hands with a person, my boss would give me a
quick backgrounder. Without exception, each one was a used to be, long past his
glory days. I resolved on the spot that I would never end up in the same place.

I worked at Brink, Hudson & Lefever for only a few months. I gave myself a
promotion by signing on as a stockbroker at a blue chip firm. Gus died some
years later, presumably still glued to the ticker. BHL passed into history when
the firm where I finished out my career ate it for breakfast one morning.

The evolution from the teenage mutual fund investor to a professional trader was
a long one. In all, I spent twelve years toiling at brokerage firms before I set
up my own shop. While I gained experience in sales and corporate finance on the
job, what I learned about trading came mostly from observing clients and brokers
vaporize accounts. I turned to books as well, but most of them were
disappointing. My background was in the sciences and as such, I was able to
identify facts that were nothing more than thinly veiled dogma and theories that
could not even qualify as theses.

Position Sizing is Critical

In this business, it is necessary to think for yourself, act independently, and
take advice from others with a very large grain of salt. That said, market
participants tend to align themselves with one of two camps. The first one,
fundamental research, tends to focus predominantly on analysis and selection
criteria: the what. The second one, technical analysis, concerns itself
with the when; timing is regarded by many to be the sole province of
chartists.

In my opinion, the most important, albeit the most ignored and overlooked step,
is how much. Investors refer to asset allocation while traders often call
it money management. Regardless of your time horizon or analytical approach,
position sizing may well be the crucial factor when it comes to profitability.
At best, those who ignore this issue will underperform. At worst, they
predestine themselves to leave the game broke. Appropriate position size is a
shining example of the best defense is a good offense .

Traders and investors have a single goal: to take risks that justify the
rewards. We must never forget that the market is a zero-sum game. For every
winner, there must be a loser. Those that approach the market with all
three bases covered are more likely to come out ahead than those who do not. In
particular, proper position size can eliminate deadly financial fumbles. Money
is simply the byproduct of a good overall strategy, the trophy of a game
well-played.

Principles of Position Sizing

For my money management algorithm, I use a stop loss that accounts for the
volatility and price of the stock. Avoid fixed percent trailing stops since some
positions are more volatile than others. Avoid a fixed dollar stop for the same
reason. Proper stop placement is very important. Equalize the volatility and
price of the stock. For example, a $100 stock that fluctuates $2 per day is
equivalent to a $50 stock that fluctuates $1 per day. A $10 stock that
fluctuates 50 cents per day is equivalent to a $100 stock that fluctuates $5.00
per day. Limit the risk per trade to a certain percent of my account equity. I
never exceed one percent risk. Let’s look at an example. If an account has
$5,000 in it, the distance between the entry price and the exit price should be
no more than $50 when the trade is opened. Implement an anti-martingale betting
strategy. When the account is growing, bet more. When the account is shrinking,
bet less. If the hypothetical account makes $200 on the first trade, the balance
becomes $5,200. On the next trade, one percent would be $52. If the hypothetical
account is stopped out for a $50 loss on the first trade, the balance becomes
$4,950. On the next trade, one percent would be $49.50.

Position Sizing in Action

Let’s take a look at how position sizing affects profits and losses. In the
following charts, I applied a simple long-only timing strategy. The only thing
is varies is the position sizing strategy.

Buy and Hold

Total Net Profit: $120.00

Total Number of Trades: 1

No sizing or trading strategy is used. Begin with $50. Buy, hold and hope for
the best.

Sizing Strategy #1

Total Net Profit: $237.05

Total Number of Trades: 71

Profit Factor: 2.18

Bet it all each time. This strategy compounds wins and losses without the use of
margin. Begin with $50 cash and reinvest all proceeds of each trade over time.
This approach buys $50 worth of the stock at the beginning and continues to buy
and sell according to the trade signals using the entire amount in the account.
This approach does not equalize stock price and volatility. It does not use
margin.

Sizing Strategy #2

Total Net Profit: $1,443.83

Total Number of Trades: 71

Profit Factor: 2.43

Anti-martingale fixed fraction bet with margin, using a volatility-adjusted stop
loss tied to the equity risk. Begin with $5,000 cash. Initial trade risks one
percent of the account equity, or $50. The $50 is divided by the distance
between entry price and the volatility-adjusted stop loss to calculate position
size. The benefit of this approach is that I know that the approximate loss will
be approximately one percent of the account equity at the time I put on the
trade if I am stopped out on the next bar. For example, if I put on ten
positions today and they are all stopped out tomorrow at the initial stop loss
price, I will lose approximately ten percent of my account, or $500. Margin is
used.

Sizing Strategy #3

Total Net Profit: $2,272.02

Total Number of Trades: 71

Profit Factor: 2.21

Anti-martingale fixed fraction bet with margin, using a volatility- and
price-adjusted calculation NOT tied into the equity risk. Begin with $5,000
cash. Initial trade risks one percent, or $50. This approach adjusts for price
and volatility, but is NOT tied into the stop loss. Because considerable margin
is used, the trader must continually monitor the risk to portfolio in real-time.
The position must be hedged to control potential catastrophic loss to capital.

Size Over Strategy

You can see from the examples above that while buy and sell signals are
important, the component critical to profits and losses is the position sizing
strategy. If you’re not a believer yet, let me show you one more example buy and
hold, adjusted for price and volatility.

Total Net Profit: $1,622.70

Total Number of Trades: 458

Profit Factor: 1.66

No trading strategy is used. There are no buy or sell signals as we know them;
that is, there is no timing. This approach buys a core position right off the
bat. Begin with $5,000 cash, one percent equity risk using a leveraged
anti-martingale sizing strategy (same math as Sizing Strategy #3 above).
Maintain the one percent equity risk over time by adding to or subtracting from
the core position. Again, because considerable margin is used, the trader must
continually monitor the risk to portfolio in real-time. The position must be
hedged to control potential catastrophic loss to capital.

Conclusion

Size matters. From my research, I have proven to myself that position sizing
is the difference between success and failure, regardless of in fact, even in
the absence of trading strategy. Many thanks to Mark Mills, Senior EasyLanguage
Engineer from TradeStation Securities, Inc.

Teresa Lo, the founder of
www.PowerSwings.com, is a seasoned
market strategist and trader. She retired from the securities industry in 1998
after a 12-year career. Her work is featured in numerous books and publications.

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