Position sizing, R (risk) units
Updated: Sep 30, 2019
Consistency in trading begins with money management and one of they key aspects is correctly sizing positions. The aim of a trader should be for each trade to have similar % impact on account balance as much as possible. With experience, trader will know which trades to scale more aggressively and which to use weaker size of position, but at the beginning and especially on the setups where trader does not have strong conviction it is best practice to always use similar % risk on each trade.
There are two components that go into sizing the positions and exposing the account that is traded, one is the strength of volatility on asset (outside) and the other is the % risk (inside) of how much % of account balance (in USD) trader actually wants to expose on each trade. Both of those variables together will dictate how to properly scale positions and defining the R unit on trade. With excluding either of those two variables the R units no longer are R units, since they do not neutralize across the large sample size of trades on account, thus keeping both variables always to measure R/%/volatility is required.
The goal of trader should be to have % risk on account where the edge comes trough and there is enough room in terms of number of losses so that account is not destroyed or drained too much before the edge turns equity balance back into neutral or positive state. That means the % risk will totally depend on many different things, it is often stated that trader should risk 1 or 2% per position max, that is just general number thrown out there, it is a good guide but lets break down how to determine how much you should risk per trade, because 2% risk might be too conservative or too aggressive for one, depending on the factors.
How much to risk per trade in terms of %?
To define % of risk on trade there are several basic factors to determine (the factors bellow significantly impact on how much can trader afford to risk in terms of account balance in USD):
-leverage / margin used on traded market / asset
-borrows costs (if trading hard to borrow assets)
-the edge on play / pattern in terms of avg draw down and win rate
-average R return on traded pattern (1, 2 ,3 or more R)
-appetite for risk and equity curve on account
Each of those components has to be given proper thought for each trader to calculate and determine how does the variable play into the % risk room that trader can afford on trade.
High leverage can allow trader to risk higher % of account since less margin will be used to actually capitalize the trade, while less leverage might force trader to risk less % per trade since more of account balance goes to cover the margin on trade.
Plays with very expensive borrows on small cap equities can impact the additional % cost per trade substantially and is something to be considered. It is additional extra cost to that initial planned % risk per trade if trader trades those frequently.
Edge on play has several metrics that allow for larger % risk or lower % risk on trade such as draw down and average win rate as two most common variables. The higher the win rate on a play and the closer to or above 1R gain per trade, the more % risk can trader expose his / her account on trade and as for draw down, the less draw down that happens on trading account over period of 30 trades the more % risk can trader put on a trade. At the same time trading strategies or patterns that have large swings of draw down in equity curve over period of 30 or more trades require for trader to be much more conservative on risk % per trade, otherwise one bad slump period of 30 trades can destroy the account.
Appetite for risk will also determine how much trader will risk, theoretically this should not affect the risk per trade at all, as it is outside of the rule-book variable but in practical real world it is something that has substantial impact on risk per trade due to many psychological or capital basis factors for each individual. Usually traders that are under-capitalized will have by default larger appetite for risk, to make any substential income.
Personally i do not believe in generalized approach to risk only 1% on all markets on anything that you trade, based on the variables presented above, each play, each market, each asset could be a little different. In general that means risk could fluctuate between 0.5% to 5%, but in general trying to keep it as even as possible for each account is best way to go, that way the equity curve is more neutralized (for example 2% risk crypto, 5% stocks, 1% FX). For beginner its just best to equalize the risk to fixed % per trade across all markets and then slowly add the variables explained above into each market / play to sharpen and adjust the actual risk % ratio per each play.
Often traders completely neglect the variables listed above that should guide the % risk per trade, instead they make the risk % on the fly, figuring it out by what they are comfortable with. In some cases they get away with it, but in some they wont if any of above variables play very strong role on that traded asset or play. It is unwise to ignore those variables.
Dynamic versus static position sizing
What happens if everything above that has been written is taken as not important, and trader just wings it into trading, using same position size in terms of shares or lots, what happens to equity curve and consistency in trading?
Many traders actually trade with fixed positions, something especially common in FX markets where trader will use static 2 lot position size on each trade, and when he is asked to specify the risk, he will outline his risk in pips and not in $ or Euro.
By default for each trader internally his risk can only be defined in R units or the $, never in pips or cents (distance of move). Using distance of move as risk guide will create un-consistent impact of trades on account and big swings on account, especially with fixed position sizes.
Bellow are two examples of using 1000 shares (fixed static size) on two different assets using the same type of play (conceptual play of short near the market open). The short entries presented on both setups are not something that one should trade or did i trade, it is just used as an equal conceptual setup to use as an example. Two tickers CODX and FRAN both with different levels of volatility and how this impacts traders who trade with fixed position sizes across all setups or assets. Those two setups are taken as example if trader is using chart levels such as last high to stop out of the trade.
Above two setups show that with static position sizing trader is risking twice as much (and potentially rewarding twice as much) on FRAN play that is on CODX whether he / she realizes that or not, many traders are completely aware of the volatility they trade, but many especially less experienced traders are unaware of it. That is why many traders without understanding the impact of volatility scale will sooner or later have large losses on heavily volatile plays such as AKTX, BPTH (2019), USDTRY (2018), USDRUB (2014), Nanocoin (2017), DRYS etc....
Examples from gold market bellow. As theoretical / conceptual example lets say that this trader is entering into short position when price retests previous high (on candle close), using stop loss above highs. The examples bellow show, how drastically different those trades would impact the P/L and account balance as the volatility on asset changes over time IF trader is using static position sizing. Basically the impact is so large that just not addressing that issue alone can make the strategy fail completely.
Example above shows that the distance of stop loss in 3rd setup is twice as large as in first setup. This means that trader with using fixed / static position size if he / she enters with 1 lot size that leaves respectively P/L account balance impact:
1. -40 EUR
2. -60 EUR
3. -80 EUR
This means that volatility is taking the control over traders performance, rather than trader doing it the other way around. Trades should each leave same impact on account balance UNLESS trader decides to intentionally size more on specific setup because the setup has A grade variables present. That is however completely different story.
Or the example bellow, if trader was to use the same "strategy" as shown above and static position sizing, where the stop loss size above high would be around 20 pips.
If trader would be stopped out of this trade that would leave such account P/L with 1 lot:
- 200 EUR
This means that overall the trades impact on the example of gold to such traders account balance would vary from -40 EUR all the way to -200 EUR, creating huge swings. And again lets point out, such swings are normal in any trading account, but it is completely different if those swings are results of trader intentionally risking more on specific setups or risking less on other setups due to A or B grade variables. The above gold example is used where trader is actually treating each trade as neutrally adjusted to the rest of the trades, and that is where static position sizing will kill a trading strategy. One can really have edge at reading markets or price good, but if this concept is not understood by trader it can be enough to bury the trading performance.
Bellow are my examples of how i quickly determine the position sizes on FX and equities (excluding the variables explained above that weight additionally to size of position adjustment):
FX (using simple indicator to input SL distance in pips and to determine lot size):
Equities (using simple distance measure tool in TC2000 to measure cents and then multiplying by the required number of shares to achieve % acc risk):
Some traders just use spreadsheet which is also a quick way, but if you are visual trader always using highs or lows or some sort of chart area to use stop loss by, then the above methods will suit you to calculate position sizes quicker.
The general rule is, use less shares / lots on highly volatile assets and more shares / lots on less volatile assets. But also keep in mind, less volatile assets will cost you more in commissions due to more shares or lots being used usually, unless all orders are filled without removing liquidity on limit.
One thing i always do before entering asset is measuring the volatility, using the simple measurment tool in any trading software. A must before any planning of entry. If this step is not done, then easily everything else can cascade with further bad decisions if trader gets all of sudden large red P/L without realizing what is going on.