How do you determine the best position size? The answer is not simple, it’s dependent on many factors and nothing is guaranteed to succeed. Martingale and Anti-Martingale methodologies are two categories in which position sizing strategies can fall. One of the more basic anti-martingale position sizing strategies is the percent risk model.
Percent Risk Model Position Size
Determine how much you’re going to risk on each trade in terms of the percentage of your trading capital. Studies prove that over the long term, traders who risk more than 2% of their capital in any one trade are not normally successful. Another factor to consider when setting this percentage is the win rate. Specifically how many winning trades your system is expected to have versus the number of losing trades. Once this loss percentage has been determined, setting your stop then becomes a function of knowing how large a position size can be traded while still being below your maximum risk level.
You have $100,000 trading capital and your strategy is 2% risk. So $2,000 of your trading capital is an appropriate amount to risk per trade. When analysing the crude oil futures market you spot an opportunity to sell crude oil at $90 a barrel. You feel there’s a good chance it’s going to trade down to $88 a barrel. You also see strong resistance just below $91 and feel like $91 is a good level to place your stop. This also gives you a reward to risk ratio of 2:1 which is reasonable.
The next thing you need to know is how much a point costs. How much will it cost if oil moves by 1 cent? Let’s assume a 1 cent move in the crude oil contract is equal to $10. Now you can determine how much that move from $90 to $91 (which is your stop-loss level) is going to cost you. This move is 100 cents (100 points). Our move in crude oil of 100 points multiplied by $10 gives the risk per contract which equals $1,000.
Once you have that information it is relatively easy to determine the contract size with the formula below:
Number of contracts = $ risk per trade divided by risk per contract
The 2% risk amount, as covered above is $2,000. The risk per contract is $1,000.
Using this method, the number of contracts = 2
The advantages to this style of position size are that it allows both large and small accounts to grow steadily. It equalises performance by actual risk. Conversely, it will reject some trades because the risk is too high.
Percent Volatility Method Position Size
Let’s introduce another position sizing method known as the percent volatility method. Volatility is a measure of how much the price of a financial instrument fluctuates over a given time period. Just as the average true range can be referenced when determining where to place your stop, it can also be used to determine how large or small a position size you should trade in a given financial instrument.
Let’s revisit the example above but this time determine our position size using the percent volatility model.
The first step in determining what your position size will be using the percent volatility model is specifying what percent of your total trading equity you’re willing to risk as it relates to volatility. For this example, we will allow daily volatility as represented by the Average True Range to account for a maximum of a 2% loss of our trading capital. In this example, as before, we had $100,000 trading capital so that would equate to a maximum volatility based loss of $2,000.
The current price of crude oil in our example is $90. By pulling up a chart of crude oil we would see that the current Average True Range (ATR) for crude oil is $2.55. Remember the 1 point (1 cent) movement in the price of crude oil equals $10.
To work out the Average True Range per contract we multiply $10 (equal to a 1 point movement) by $2.55 (ATR for crude oil). This gives us an ATR per contract of $2,550.
Since we’ve specified that the maximum amount that we’re willing to risk of our trading capital is $2,000 and the current ATR for crude oil is $2,550, the number of contracts that we can trade in this example is 0 because the dollar per contract Average True Range is greater than what we need to to stay within our 2% volatility based loss limit ($2,000).
The advantage of this model is that it standardises the performance of a portfolio by volatility. It doesn’t allow the financial instruments with higher volatility to have a greater effect on performance than financial instruments with a lower volatility and vice versa.