I will keep cutting my position down as I have losing trades. That way I will be trading my smallest position size when my trading is worst. – Paul Tudor Jones, Market Wizard
As we have explained previously, all Market Wizards agree that the main ingredients for successful trading are:
- your risk:reward ratio (cut your losses short and let your profits run);
- your position sizing algorithm (how much you allocate to each bet);
- being systematic with your approach (having the discipline to not wander).
Today we are going to illustrate a position sizing model that assists on two fronts: establishing key risk limits for each trading month, and connecting those risk limits with the number of opportunities available. Together, this simple yet effective position sizing plan kills at least 3 bad habits of retail traders with one stone:
- risking too much on each trade;
- risking more after a losing streak (also called Martingale strategies);
- overtrading.
Have an Asymmetrical Risk:Reward Objective
The first ingredient for a good position sizing plan is an asymmetrical risk to reward profile which can be defined by identifying:
- the maximum acceptable drawdown;
- the target return.
It is not advantageous to risk 3% per month, in order to make 3%. Instead, we should be attempting to make 6-9% per month, by risking 3%. This means your returns will be skewed in favour of the upside and your risks well constrained. It’s a mindset, more than a specific number.
Know Your Trading Model
The second ingredient for a good position sizing plan is knowing what kind of results your trading model produces over time.
For example, since incorporating our findings from the drawdown period, our London Open Signals have produced on average:
- Avg. Trades Per Month: 8
- Win Rate: 70%
- Largest Losing Streak: 6 in a row
- Largest Winning Streak: 15 in a row
- Avg. Win 0.45 R
- Avg. Loss 0.37 R
- Expectancy 0.2R
We are aiming at improving our expectancy over time, but for now let’s use this 0.2 for our example. What an expectancy of 0.2 R means, is that per each trade – over a long sample size – you can expect to make 0.2*risk so if I am placing 8 trades a month risking 1%, I am going to make 1.6% a month, or 19,4% per year.
However, we cannot just focus on profit. We actually need to focus on our losses first & foremost, in order to control our drawdowns. We want to limit our maximum drawdown to 3% per month. Our largest losing streak was 6 trades in a row.
This means that with a similar average performance, we should be able to use up to 0.5% per trade, and remain within our risk limits. With 0.5% per trade, we would be looking at 0.8% average return per month, and 10% per year.
Risk Control vs. Trading Opportunities
Evidently, smaller position sizes keep your risk in place but also imply more conservative profit objectives. In order to have stronger profit potential with the same system, we would either have to push our risk limits (for example risking 6% per month instead of 3%), have a quality filter that allows us to take only the best opportunities for the trading model, or augment the number of trade opportunities without reducing the quality.
Our bet, at FXRenew, is to focus on quality. Just as an example, since the start of 2018 we have had a much higher expectancy: 0.61 R. Let’s see how this would change our profit objectives, all else being equal:
0.61 (Expectancy) * 8 (trades per month) * 0.5% (risk per trade) = 2,44% per month or 29,29% per year.
The Scale-In-Simple Posizion Sizing Plan attempts to focus your attention on quality, and not on quantity. The model allows for 10 trades per month, which (based on your trading strategy) may be conservative. However, most retail traders have the bad habit of trading too often, going after the money and not considering the incremental risk they are facing as they place all the extra trades.
Quality is hard to come by for any trading model, and a good position sizing plan will require that you find a way to “filter” quality trades. However, we do need a backup plan in order to continue trading even through a string of losses and the most logical way to do this is:
cut the position size by 50% if you lose half of your initial risk for the month.
Let’s imagine starting at 0.5% and after 3 trades out of the 10 allowed, We’re down 1.5% At this point, we will reduce the trade size to 0.25%.The 7 remaining trades will still allow us additional opportunities, which will hopefully make up for the initial loss.
Go Asymmetrical
As we have illustrated previously, it pays to “gamble with the market’s money”. Instead of risking the same 0.5% of your account on each trade, attempt to risk mode when you have accumulated some profits, and cut back to your original risk per trade when you hit a loss.
This is the same asymmetrical reasoning the position sizing plan instills in you from the ground up: limit losses but aim for the fences when things are going well.
Over to You
The Scale-in-Simple Posizion Sizing Plan is a simple yet effective way of keeping losses under control, limiting your overall portfolio heat whilst allowing for asymmetrical profits. It really does kill various bad habits that continuously pop up in retail space, which means your risk capital is in some fashion “less at risk”.
Furthermore, as you enhance your position sizing prowess, the emotional response should also diminish. Nobody likes to lose, but by knowing that you’re always in control of your capital, you can have peace of mind. A string of losses will not blow your account up if you follow the plan.
An old trading adage says “if you take care of the losses, the profits will take care of themselves“. With a proper position sizing plan, not only will the profits take care of themselves, but they will be architected in a way that achieves key objectives and allows for home runs as well.
About the Author
Justin is a Forex trader and Coach. He is co-owner of 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.