In a recent conversation with a trader, the discussion about “when to swing for the fences” came up and we talked through a plan that would allow him to exploit part of his aggressive nature in the markets, without putting undue strain on the account.
Most retail traders have small accounts and look for quick, outsized gains, without considering the risk (in terms of volatility) that their accounts will sustain.
Especially if you want to trade other people’s funds one day, you need to show maturity as a trader and know when to get aggressive and when to remain conservative.
That’s what we will address today.
A Perspective on Return Volatility
In a recent webinar of ours, we utilized our own signal results to compose a portfolio. From the whole conversation, one key aspect is Annual Volatility of your trading results. Here is the calculation:
Annual Standard Deviation of Returns = Standard Deviation of entire sample size*SQRT(N* trades per year).
Here are the implications:
- as the number of trades increases (as is the case for day traders or short-term traders), the Annual Volatility of returns increases
- big fluctuations in single returns (as is the case when using large position sizes) impact the Annual Volatility of returns
As an example, our London Open Signals have an Annualized Volatility of 6.45% if risking 1% per trade. Our End of Day signals have an Annualized Volatility of 13.85%. I would encourage you to do the same calculation with your own trading results and see what kind of numbers you get.
How to interpret the result? Systematic traders know that the maximum annual drawdown of their systems can be anywhere between 1 and 2.5 times the Annualized Volatility. So effectively, this means that with a 7% Annual Volatility, you can expect to have a drawdown of anywhere from 7 to 17% over the course of a year. That’s realistic and it’s still conservative by some standards.
I have been in touch with traders that were heavy into the scaling game. Without even talking about profit potential, we spoke about risk, and it turned out that their annual volatility was upwards of 150%! That means that, sooner or later, from a purely statistical point of view, they will blow up their account. Not because of a poor trading model, but simply because the normal oscillations in their P&L exceed the account’s value.
Do the exercize yourself, and you may realize your position sizing needs work.
Risk Of Ruin
We spoke about this in a previous article, but it’s worth recalling because it is closely tied to the Annual Volatility calculation from above. Here is how to identify your likelihood of blowing up your account.
What you will need:
- Your annual average return (for example, 18% for our London Open Signals)
- Your annual standard deviation of returns (for example, 6.45%)
The risk of losing 1 standard deviation, or 6.45% of the account, on any given year is:
e^(-2*Avg.Ret/Stdev)
which becomes 2.71828^(-2*0.18/0.0645) = 37,69% chance. The trader will spend on average 38% of his time at least 6.45% below a prior maximum equity high.
These equations offer a good idea of what is possible, but they also assume that the tradercannot modulate his position size as the account value falls or rises. The monthly standard deviation and average return are considered constant – and this makes sense only over large sample sizes. So there are some caveats.
Longevity Through Position Sizing
The numbers above should show you that blowing up your account is quite easy to do. Basically:
- if you constantly risk more than 1% per trade, your risk of ruin will be dangerously high
- if you trade too frequently, and have no quality filter, you are exposing your capital to excess risk once again.
Trading is a job, and the keys to success lie in consistency and longevity. Only with proper position sizing, is longevity possible.
The Scale-In-Simple Position Sizing Plan is one tool that you might want to consider. It combines 4 considerations into a simple model:
- risk budgeting (taking into consideration how much you want to risk each month)
- risk per trade (how much you are willing to lose on any given trade)
- drawdown cutoff (diminishing your risk per trade beyond a certain level of drawdown)
and also
- Additional Profits to Risk (market’s money)
It’s true that we talk a lot about the downside of trading and managing risk. So for once, let’s talk about the upside. Working with realistic numbers, let’s say you have:
- a monthly goal of 3% with a MaxDD of 3% or less;
- a regular position size (compliant with the amount of QUALITY trades the market offers you on average each month) of 0.3-0.5%. So we have around 10 trades per month in our example;
- a drawdown cutoff of 1.5% (after which you cut your position sizes in half).
Let’s hypothesize that within the first 5 trades of the month you make 4% already. What’s to do next? You still have at least 5 trades left, on average for the month. Here is where things get interesting.
Once you overcome 3% for the month, you can start to risk these extra profits. How? Simple.
- Take the excess return (4% – target) = 1%
- Divide it by the number of trades outstanding (which means your next trade won’t be 0.5% but instead 0.7% of equity) OR (more aggressive option) use half of it on the next trade (risking 1% on next trade).
In the first option you have 5 chances to use up the excess return in order to gain a higher return on each trade. The more aggressive option uses up your excess return quickly, but it also allows to “Swing for the fences” as they say.
The important concept is this: first play good defence. Trade well, attempt to reach your objectives for the month. Only once you have the objective in the bank, can you use the excess profits to push the boundaries of “sound position sizing”.
It allows for “controlled exhuberance” if you will.
Van Tharp’s Famous Marble Game
In his workshops, Van Tharp plays a marble game to demonstrate position sizing and how profits and losses affect people’s psychology. In the game, 60% of the marbles are winners (with 5% returning 10 R and 55% returning 1R) and 40% of the marbles are losers (with 5% returning -5R and 35% returning -1R). Marbles are replaced after every draw.
This game has an expectancy of 0.45 times your risk on every marble draw. It’s a pretty good trading system. However, the results that traders obtain are pretty interesting. Typically, there will be fifty marble draws, replacing each marble after it is drawn. And despite the positive expectancy, usually 33% of traders go bankrupt, 33% of traders lose money, and 33% make a large amount of money . That is an interesting result because everyone in the room was responding to the same draw of marbles.
What’s even more interesting is that Van Tharp has people in the audience pull out the marbles. And when someone draws a losing marble, the person must continue to draw marbles until they get a winner. Inevitably, during a 50 trade game, a long losing streak of 5-9 losers occurs, which also might include the big loser.
Now pay attention.
At the end of the game, Van Tharp asks “how many of you think you lost money because this person pulled all of those losers.” Many hands often go up in response to that. In other words, they lost money because someone pulled out losers.
The net result of blaming someone for the loss is that people have no chance to learn from their mistakes. They lost money because their position sizing was terrible and risked bankruptcy. If they don’t understand that and blame someone else, they will get the same outcomes over and over again:
- there will always be someone or something to blame for their losses (lack of accountability);
- they will continually repeat the mistake because they have not taken responsibility for it.
Over to You
The Scale-In-Simple Position Sizing Plan is simple yet effective. It will force you to think about money management and position sizing in a realistic yet conservative way. It will eliminate bad habits and replace them with sound money management principles that will help you maintain discipline and never risk blowing up your account.
Furthermore, once you reach your objectives for the month, you are also able to “swing for the fences” with the additional profits generated.
If you find yourself either not moving with your equity curve at all, or moving too much and facing some tough drawdowns, this simple position sizing tool will enhance your trading and put you on the right path.
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.