“Risk is like fire: If controlled it will help you; if uncontrolled it will rise up and destroy you.” – Theodore Roosevelt
Too often, traders concentrate on perfecting their entries. Countless hours are spent studying Japanese Candlesticks, Indicators, Setups and basically zero thought goes into the more “boring” but evermore important aspects of position sizing and risk management.
Hopefully our recent article on the relative importance of entries can help shift the focus away from trade tactics (which are the tip of the iceberg) and towards the more fundamental aspects of a trading model, such as position sizing and risk management.
Without a decent position-sizing formula it really does not matter how good the trading rules are. In particular, I always make sure my position sizing is tied to the volatility of the asset. Even if we only trade currencies as an asset class, different forex pairs do have very different volatility profiles. For position sizing, what we are concerned with is the potential price fluctuations of different instruments based on their recent past.
Professional Position Sizing
Believe it or not, the methods used by most Commodity Trading Advisors (CTAs) are based on the same grounding as you will learn in this article. The principle is simple: take larger positions on instruments that possess lower volatility, and take smaller positions on instruments that possess higher volatility. This way, each position should theoretically have the same impact. You can get a feeling for just how important this volatility-scaling is, by comparing the Daily %-moves here.
FX Volatility List: Observe how different the average daily moves are between GbpNzd and EurUsd for example.
Here is how you can calculate a volatility-based position size:
Inputs
- Consolidated Equity (for example $25000)
- % Amount at Risk per trade (for example 1%)
- Stop Loss Distance (Pips) (for example 50 pips)
- Pip Value (for example $10 per Standard Lot)
And the formula is: ((%Risk * Equity)/(Pip Value * Stop Loss Distance))*100000
So in our example that comes out to: ((0.0125000)/(1050))*100000 = 50.000 or 0.5 Lots
This means that if price dips all the way to your stop loss, you will lose 1%.
You can find an Excel Sheet with these calculations here. Experiment with it, until you have a working knowledge and a true understanding of the reasoning behind it.
Turtle Style Risk Management
We have spoken about the Turtles’ Trading Style in a previous article but here we shall focus on their risk management method. Finding the correct position size is just one part of the risk management procedure.
For example, when issuing our proprietary trade signals we calculate the position size as stated above (Entry – Stop method) but then we split our trade into 2 parts. We allocate 50% to a market entry, and 50% on a retracement entry.
One reason for doing so is to mitigate the risk of being stopped out completely. Always remember that the real risk of any trade is the probability of being stopped out. So by calculating our initial position size based on volatility, and then splitting that allocation into 2 parts at separate levels, we are reducing the probability of our stop loss being plucked.
The Turtles also knew this. They did not simply enter positions based on the Entry-Stop method. Once they calculated the position size, they also had a stop loss on the position that was typically 2*20Day ATR away from the entry price. That means that their stop was essentially 2% total risk.
The key here is to not simply consider the position size as the end of your risk management journey. It’s just the initial step. It’s your Size. Then, how you distribute your size & manage your size depends on what works best for your method.
For example, the Turtles had very strict risk limits:
- Maximum 4 positions (so 1 initial entry + 3 pyramid positions based on certain criteria) on 1 single market.
- Maximum 6 positions on closely correlated markets (think EurUsd and GbpUsd, AudJpy and NzdJpy, Heating Oil and Crude Oil, Gold and Silver, etc). This is essential because when the proverbial hits the fan, all markets tend to correlate and any benefits of diversification go out the window.
- Maximum 10 positions in loosely correlated markets (think Gold & Copper, Silver & Copper, many Soft-Commodities)
Over To You
The markets are very fickle entities: drivers change, volatility changes, and sometimes even the best preparation is not sufficient to keep up with Mr.Market’s mood swings. The name of the game, then, becomes survival and consistency.
Survival will not come from your entries and setups. It will not come from indicators or complex mathematical solutions. Survival comes from managing risk like a pro. Keep your position sizes anchored to the volatility of the markets. Create solid risk limits that allow you to diversify but not to overexpose your portfolio on any given trade, or on any given basket of trades.
Good Luck!
About the Author
Justin Paolini is a Forex trader and member of the team at 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.
The post Volatility-Based Position Sizing appeared first on www.forextell.com.