The Importance of Position Sizing
I did a retreat with one of the world's greatest traders in 1989. At that retreat he talked about a simple trading system. It was a system in which you flipped a coin. If the coin came up heads, you won twice what you bet. If the coin came up tails, you lost what you bet. Now, this is actually a very good trading system. You win 50% of the time and your winnings are twice what you lose. How many of you have a system that is that good?
However, the point of describing the system was to ask the question, what is the most important question you must ask yourself about that system? So think about it for a second. What would your answer be? You win half the time and your winnings are twice as big as your losses. What's the most important question you can ask yourself about as a trader?
Okay, the answer is to determine how much to risk on every bet. That's the answer that the great trader gave. However, I'll actually refine the answer from my years of coaching traders and modeling the trading process. The real answer is to determine what your objectives are playing the game and then to determine how much to risk on every bet to achieve those objectives. Is that the answer that you came up with? Probably not. And if you didn't, then don't feel bad, most people probably didn't. But it also shows you how much education you need to become a great trader.
Now every trading system is characterized by the rmultiples that it generates. This particular coin toss system, really generates two Rmultiples: 1)  1R (when you lose, you lose what you risk and R stands for your risk); and 2) +2R (when you win, you win twice what you risk).
So let's assume that as a trader that's your trading system. You get to make one trade every trading day or about 22 trades per month. What I'm going to do is plug those Rmultiples into a simulator. I will randomly pull out one, record the results and replace it. I'll do this 22 times to represent a month's worth of trading. And using a simulator on my computer, I'll do this 5,000 times. Let's look at the result.
First, the expectancy, the average Rmultiple generated by the system is 0.5R. And since you have 22 trades each month, you will make an average of 11R each month of trading. In fact, my simulator shows that you have a 94% chance of making money every month with this system, so probably 11 of 12 months of trading would be up months. That's a very good system.
But how much should you bet? And how does that relate to your objectives?
Well, most people assume that one's objective should be to become rich overnight, without thinking about the negative potential of the system.
However, I decided that an outstanding goal would be to make 100% each month and that if you lost 50% you might decide to abandon the system.
I then decided to run 10,000 of 22 trades each at risk levels ranking from 0.2% to 48% in 0.2% increments. That means I ran 10,000 simulations of 22 trades at 0.2%, and another 10,000 at 0.4%, and another 10,000 at 0.6% all the way up until I reached 48% risk. By the way, we stopped just before 50%, since that was a definition of ruin. The figure below shows a graph of the result of those simulations.
The top line shows the average return that you'll make from this system. Notice that the more you risk, the more you'll make on the average. And at 48% risk per trade we are making an average return of over 10,000% per month.
The second line shows the median return. This is another form of average in which half the numbers are above and half the numbers are below. Notice that this one peaks at 22% and then starts to fall dramatically. It actually looks like risking from 7% through about 22%, we'll make our goal of 100% on the average. But when we risk 28%, our median return is about 1%.
Now I've shared a little bit about this system with you. Next week, we explore in more detail, how to use position sizing to meet your objectives with this simple system. Until then why don't you think what your objectives might be and how would you answer the question “how much” to best meet those objectives. Until then, this is Van Tharp.
Dr. Van K Tharp
TradingEducation.com
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