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Position sizing – it is important(pt1)

As your trading progresses the emphasis should move away from the trading system into areas such as money management and position sizing. (As well as two or three other very important lesser known areas  that are well covered on both the beginners/intermediates course and auto trading course)

So what is position sizing ?

It is that part of your strategy that tells you how many contracts or dollars per point to bet on the next trade.

The basic rules of position sizing are to start slowly.  Especially so if you are risking your own starting capital rather than previously earned profits. Then  become more aggressive as your profits increase and less aggressive as your profits decrease.

The first rule of trading has to be to preserve one’s capital. The biggest crime in trading is to blow your trading account up.  Remember the old adage  “The market will always give you plenty of new trading opportunities but will never give you any more trading capital”.

So three simple rules of position sizing are:

Keep it small when risking your own starting capital

One of the problems traders often have when they start trading a new method or system is excessive optimism. We tend to be so sure that this is THE system that we throw caution to the winds and “bet the farm” or at least a big portion of the farm right from the off. This almost invariably ends badly and consequently must be avoided at all costs. There are a lot of lessons to be learned in trading a new method and those lessons are always better learned with small risks than with large risks. The initial goal always has to be to survive and learn those lessons in as pain-free way as possible.  Once the lessons have been learned we can start scaling up our trading with the markets money not with our own. So there is a very big difference between how much of your own starting capital you risk (which  you always want to keep to a minimum) and how much of the markets money, i.e. profits, that you are prepared to risk . Be aggressive with the markets money and cautious with your own.

Use a proven position sizing method

This essentially means using an anti-martingale betting strategy.

The martingale betting strategy is basically to increase position size after a losing trade and to reduce position size after a winning trade. This technique is often used on the roulette tables.  The logic in support of this technique is what is known as the gambler’s fallacy. This is the belief that after a series of losing bets somehow the odds change for the next bet and make it more likely that it will be a winner. Clearly on a roulette wheel each spin is entirely independent of the previous spin, and this is most certainly not the case, hence the term gambler’s fallacy.

In trading this is still generally the case (ignoring for the purposes of this article sequential correlation and non-correlation).

Consequently we should be using an anti-martingale or reverse martingale betting strategy. This means reducing your position sizes as your account equity declines and increasing position size as your account equity increases. This is also  consistent with the basic concept of being cautious with one’s own capital and aggressive with the markets money. So do not be tempted to double up after a losing trade or try and chase losses. If anything you should be reducing position size after a losing trade.

My own experience in trading hundreds of systems is that on occasion you tend to encounter high sequential correlation between  trades.  in other words you get streaks of winning trades , when the market is in sync with your methodology  and indeed streaks of losing trades, when the market is out of sync with your methodology. Consequently if you use an aggressive reverse martingale betting strategy during those sequences of positively correlated winning trades you can trade your account equity up very very quickly indeed.

Income goals

One of the most common mistakes I have found traders  make is to pursue time based profit goals in the form of daily or weekly profit targets. “I look to earn 20 pips each day and then shut up shop and go and play golf” etc. This is  absolutely the wrong way of approaching trading. Firstly because it implies a degree of consistency that simply cannot be obtained in real life trading. Secondly it ignores the principle of serial correlation between trades. In my own trading I prefer to do the opposite and sometimes use the principle of “three strikes and you’re out” . In other words if a system  give you three losing trades in a day it may well be telling you something. That something is that the system and market are not in sync and maybe you should shut up shop and take the rest of the day off.

Conversely if you have say three winning trades in a row it may indicate that the market is  currently tightly in sync with your system and under those circumstances you absolutely should carry on trading. To pack up your computer at that stage is foolish. You should be cancelling all your appointments and trying to get as much money out of the market as possible whilst it is in such perfect sync with your methodology.

Pursuing income goals also tends to push the trader down the route of asymmetric bet sizing ie  for instance doubling up after losing trades. If you are  down a two hundred Dollars with two hours left in your trading day and you have a goal of earning $100 Dollars per day there is very strong pressure on you to increase your bet size to try and recover your losses and  hit your daily  target. This is the slippery slope to financial oblivion.

 

 

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