Editors note: The following is an excerpt from the Definitive Guide to Position Sizing Strategies book. While some readers may be familiar with this topic a refresher is always useful. For readers who have yet to learn more about position sizing, take note. This is important information!
John was a little shell-shocked about what happened to him over the last three days of volatile market activity—he had lost 70% of his trading equity! He was quite shaken, but he remained convinced that he could make the money back. After all, he had been up almost 200% before the market withered him down to the $4,500 he had left in his account.
What would you tell John at this point if he came to you for advice? Your advice should be, “Stop trading. Get out of the market immediately. You don’t have enough money to trade speculatively, and you don’t understand risk.”
John is very much an average market participant who calls himself a trader. He and people like him try to make a killing in the market, thinking they can turn a $5,000 or $10,000 account into a million dollars in less than a year. This sort of feat is possible, yet making those kinds of returns is highly unlikely while the chance of ruin is almost certain—even if the trader is very smart. Natural intelligence does not seem to help traders with position sizing strategies, which are critical for trading success.
Book Smarts vs. Smart Position Sizing Strategies
Most people would agree that PhDs are smart people. High intelligence, however, seems to be of little or no help in trading successfully. To test this idea, Ralph Vince conducted an experiment using 40 PhDs. (He ruled out doctors with a background in statistics or trading.) They were given a computer game with $10,000 and 100 trials in which they would win 60% of the time. When they won, they won the amount of money they risked in that trial (1R). When they lost, they lost the amount of money they risked for that trial (−1R).
Think about that: you win what you risked 60% of the time and you lose what you risked 40% of the time. That’s a positive expectancy system and those odds are fantastic compared with any table you might find in a Las Vegas casino.
Guess how many of the PhDs had made money at the end of 100 trials. When the results were tabulated, only two of the PhDs made money. The other 38 lost money. Imagine that! 95% of the PhDs lost money playing a game engineered to let players win. Why?
Position Sizing Strategies and the Gambler’s Fallacy
Let’s say someone started the game risking $1,000 on each trade and the first three trades all lost. Losing three in a row in a 60% winning game is a distinct probability. Now this participant is down to $7,000. He thinks, “I’ve had three losses in a row, so I’m really due to win now.” This is the gambler’s fallacy at work. He thinks that there’s a high probability of a winner after several losses. (Your chances of winning on any given trade in this game though are always 60%, regardless of the past results.) He decides to risk $3,000 on the fourth trade because he is so sure he will win. Although the probability of four consecutive losses are slim (i.e., 0.0256), it is still likely to occur once in a 100 trial game. The fourth trade results in another loss. Now he only has $4,000 left in his account and he must make 150% just to reach break even. Beyond that, his chances of making money in the game have grown very slim. If he kept playing this way, he easily could be broke in a few more turns.
Here’s another way he could have gone broke. If he started out risking $2,500 on each turn, three losses in a row would take his account down to only one more trade of $2,500. There’s a 40% chance the next trade will lose and wipe him out. Additionally, he now must make 300% just to get back to even. At this point, do you think he is more likely to experience a profitable end to the game or bankruptcy?
Nearly all of the PhDs risked too much of their equity in the game. The excessive risk occurred for psychological reasons: greed, the failure to understand the odds, and, in some cases, even the desire to fail. From a purely mathematical perspective, however, their losses occurred because they risked too much money. Had they understood the concept of position sizing strategies, they would have done much better in the game—even if they had some psychological issues affecting their decisions.
Position Sizing Concepts
In a lecture to his students at a 1991 retreat in Hawaii, Ed Seykota said that once you know the expectancy of your system, the most important question a trader could ever ask is “How much should I invest?” Your trading system’s expectancy tells you the probabilities of winning versus losing for each trade and a bit more. Given that information, you can consider your objectives and come up with a position sizing strategy that will help you reach your objectives and answers the question “How much?”
In my opinion, position sizing strategies are the most significant, and yet least understood, part of any trading system. Most individual traders and I would say even many professionals do not understand the importance of this concept. For example, I once attended a seminar for stockbrokers that explained a particular investing method that the brokers could use to help their clients. While the seminar as a whole was terrific, the topic of a position sizing strategy for this method was never covered. In the past, people sometimes referred to position sizing strategies generally as “money management” and one speaker did mention money management briefly. I could not really tell what he meant though, so at the end of his talk, I asked, “What do you mean by money management?” His response was, “That’s a very good question. I think it is how one makes trading decisions.” Well, that’s fine but those brokers walked away from that seminar unable to help their clients with the most important part of a good investing method—knowing how much to risk on each position.
Your position sizing strategy is the part of your trading system that tells you “how much” or “how many” for each trade. How many units of your investment should you put on at a given time? How much risk should you be willing to take? You can’t answer these questions until you understand both your trading system and your objectives. You need to understand what kind of results you can expect from your trading system. Knowing the expectancy and SQN® score of your system can help in this area. You also need clear objectives for your trading and an understanding of what you are trying to achieve—especially in the areas of return and drawdowns. With these two inputs, you can start thinking about your position sizing strategy.
As there are millions of traders with unique objectives, there are millions of variations of position sizing strategies. Aside from your personal psychological issues, position sizing strategies are the most critical conceptual area you need to master as a trader.
Too Much Risk?
Remember our friend John from the beginning of the article? He was up 200% and then down 70% a few days later. We can probably infer that he was risking far too much on each trade. Would you guess he knew anything about appropriate position sizing strategies?