5 Steps to Constructing a Position Sizing Model That Fits You by Sam Eder

Your position-sizing model allows you to play not only great defence, but also superior offense.

Even so, many traders stick to a rote-learned rule, such as “risk a fixed 1 or 2% per trade” which gives them little flexibility to protect or maximize their trading account.

Instead, they rely on their entry for their edge, which is not what retail traders should be doing. Most retail traders are not that good at picking good trades, because they are up against professional traders who have been doing for years, and have access to a lot more information and time.

Where retail traders have a big advantage is in their position sizing model. Compared to trading institutions, they have unparalleled flexibility in “how much” they can trade without impacting the market. You ask an insto trader if they would like to have this advantage – they are likely to give you a resounding “hell yeah!”

So how do you go about building a position-sizing model that will give you an edge?

Step 1: Objectives are Key

To build your position-sizing model, you first need objectives.

There are a number of objectives that we cover in the Advanced Forex Course for Smart Traders, but you can start with two:

  • Profit objective
  • Maximum drawdown objective

You should select these over a certain timeframe. For Forex trading, I like monthly, though you need to pick what fits you. If you don’t know yet what suits you, then consider what you might like:

  1. Do you want to day trade (Intra-day)? If so then you might have weekly goals.
  2. Do you want to swing trade (trades last up to a week)? Then monthly goals could work well.
  3. Do you want to position trade (trades are long-term)? Then you might use quarterly or annual goals.

The profit objective and drawdown objective need to work in harmony. If you have a large profit objective then your drawdown objective might need to be larger.

But this might not be what you think.

Market Wizard Dr. Van Tharp (if and when he is short-term trading) has a drawdown objective of 2% a month in order to make 25%. You can do something like this too, but note that the larger the target, the more of you winnings you might have to sacrifice to get there.

Step 2: Trading opportunity

If you have a goal of making 25% and risking 2%, and you only have one trade a month, you are not going to give yourself much opportunity to get there. If you can place one trade a month and consistently earn 25% – please – come and be a signal provider for us!

It is more likely that you will need to generate a certain number of trades to reach this target. If you are going for 25%, you might need around 40-50 trades a month (that have an edge) to hit your objective.

So when you are building your position-sizing model, take into consideration the number of trading opportunities you have per month. You can then either adjust your goals to fit, or work out how to add more trades to your system.

Step 3: Quality of your system

The next step in constructing your trading system is to know the expectancy of your trading system. The better your system, the easier it will be for your position-sizing model to achieve your goals.

(For those new to my writing, I don’t mean a mechanical or automated system; I mean the rules you have for entering and exiting the markets.)

You can start by working out:

  • Your winning percentage
  • Your average risk/reward on your trades

If you have a very good system, you can trade more aggressively and larger sizes than if your system is only just passable. If you have a system that wins 50% of the time, and the winners are on average 2-3 times the profits of the losers, then you will be able to achieve your objectives more often than not, as long as you have enough trading opportunities.

Step 4: Build an algorithm

You then need to build an algorithm that meets your objectives, considering your trading opportunity and the quality of your system.

For example: if you want to risk 2% a month to make 25%, you will need to start the month trading a small size, say 0.4%. If you have losses, you will probably need to trade even smaller.

Once you make profits during the month, you can then trade larger sizes, risking bigger chunks of your profit. This means you could be trading 2 or 3% of your account on any one trade, though your maximum risk of loss for the month is still only 2%.

This process involves some trial and error, and you might need to use a spreadsheet.

One way to integrate how to do this, if it all seems a bit tricky, is to play Van Tharp’s position sizing game. It will help you to understand how adjusting your position sizing impacts performance on a deep level.

Step 5: Test your algorithm

Once you have built your algorithm, you then need to test it.

You can do this by:

  • Trading it in a demo account
  • Using Van Tharp’s position sizing game

Using the position-sizing game is preferred, as it will allow you to run several simulations in a short period of time. You can input your own system criteria into it, and then see how your algorithm works over a series of trades. Your eyes might be opened wide by going through this experience, as I had one customer tell me they were.

Time to go live

Once you have tested the algorithm, and you are happy with its performance, it’s time to go live.

Monitor its performance and adjust how it works based on the performance of your trading system.

Over time, you can make enhancements to your algorithm. You can allow yourself to adjust the position size based on your confidence level in any particular trade, or carry over profits into the next trading period so you don’t have to start out trading small.

At FX Renew, we have built several position-sizing algorithms you can use, along with position-sizing lessons. If you don’t have a system that gives you an edge, or you need more opportunities, you can get around 40 trades per month to give you a ready-made edge for a small price from us. You can get a free trial.

About the Author

Sam Eder is a currency trader and author of the Definitive Guide to Developing a Winning Forex Trading System and the Advanced Forex Course for Smart Traders. He is a part owner of Forex Signal Provider fxrenew.com (You can get a free trial). If you like Sam’s writing you can subscribe to his newsletter for free.

This post was first published here.

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