Two Advanced Position Sizing Techniques to Consider in Your Trading

Irrespective of what vehicle you are choosing to trade, position sizing is a crucial part of your trading risk management. It is position sizing, along with effective exit strategies, that have an undoubted major impact on your trading results both now and going forward.

At a basic level, the following are part of a position sizing system:
a. Identify a tolerable risk level per trade based on your account size (often 1-3%) meaning you aim to keep any loss sustained within this tolerable limit.
b. Using any stop level for specific trades and your tolerable limit to work out how many lots/contacts you can enter to achieve this goal.
c. Ensuring you are not inadvertently over-positioning in one market idea (e.g. broad-based USD strength or weakness, by entering multiple trades across currency pairs/commodity CFDs that will multiply the impact of USD movement).

But what then? How do we explore refining our position sizing to potential optimise results?

Here are two initial ideas for potential testing…

Idea 1 – Position sizing according to volatility

When exploring using volatility for any trading decision it is not just the level but potentially, more importantly, the direction of the volatility i.e. increasing/decreasing. Volatility is often seen as a reflection of market certainty but perhaps consider volatility as a measure of the likelihood that an asset e.g. Fx pair, is more likely to move away from its current position (and that can be either positively or negatively of course).

Logically, therefore, increasing volatility in either direction could represent an increase in risk (and of course visa versa). Consequently, it is not unreasonable to consider altering your tolerable risk level according to this. So, for example, if your standard is 2% of account capital on any one trade, if you were to implement this as an idea, increasing volatility could mean a decrease in risk level to 1% and decrease to 3%.

The challenge, of course, is to determine a method through which you can determine this change. The ATR is a volatility measure commonly used and would be a potential tool that can assist. Of course, the other aspect is to choose the timeframe to measure this variable. Logically, the shortest timeframe should be the timeframe you are trading but there may be wisdom in looking at longer-term timeframes also.

Idea 2 – Ensure that trail stops account for your tolerable risk level.

Arguably a common mistake made by many traders is to view trades on their P/L and make decisions on the fact they are “up” on the deal and as long as the trade is closed before getting back to breakeven then they have a win.

An alternative and logically an advanced approach is your net worth in the market is where it is right NOW and hence any pullback in any position is a “loss” from your current place. This is the rationale behind trailing a stop in an attempt to still have access to the further upside (“letting your profits run”) whilst capping any pullback to a new an improved level to that of your initial stop.

There are many ways of trailing a stop e.g. retracement, price/MA cross but again would it not make sense to use your tolerable risk level as part of your trail stop equation.
So lets see, for example, use an account size of $10,000 and you are trading a 2% maximum risk level to set your initial stop. This means that your contract/lot size is based on your technical stop and $200.  You have a position that is now up to $350 if you were to adopt this approach when you trail your stop you should ensure that it is placed at a level that would mean that the worst scenario would be that you would close the position at $150 profit.

There are of course other advanced position sizing techniques you could test which will be the topic of an upcoming Inner Circle session.
Make sure that you are part of this through registering for these sessions so you can jump on board with this advanced trading education group to access the topics applicable to your trading development.

In the meantime, we would be delighted, as always, to hear from you, so if you are using an advanced position sizing technique it would be great to hear from you at [email protected]