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Trading Education Posted by Team Topstep February 2, 2023

Position Sizing: A Key to Trading Success

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By Daniel P. Collins 

You have developed a system, you have optimized it with out-of-sample data, you have tested it and now you are ready to trade. Not quite. Defining your bet size, stop levels and profit targets are keys to successful trading. 

No one trader or trading system has ever been developed that can buy or sell at the absolute bottom or top of a market and find the perfect exit. Nearly every trade will be under water at some point. Setting stop-loss levels and profit targets are vital elements of any strategy. And those levels are based on the size of your trades because that defines how much risk you hold. 

There are several position sizing methods that have been developed over the years but many these tend to take on too much risk says Kevin Davey, professional trading coach and founder of KJ Trading Systems. The problem with methods such as the Kelly Criterion and the Martingale Method is they often assume unlimited risk capital. 

The Kelly Criterion is an equation geared to optimizing your position size. Below is the formula as defined by Investopedia: 

K= W – (1 – W)/R

Where K is a percentage of the bettor’s bankroll, W is the probability of a favorable return, and R is the ratio of average wins to average losses.

The Martingale Method simply doubles your bet size or risk following every losing trade until you ultimately win (or go broke) and then goes back to your initial bet size and starts the process over again. It was once popular for black jack players. The concept is logical in a simplistic way but rarely if ever works out. 

While these methods may work in theory, they assume near-unlimited risk capital. Retail traders do not have unlimited capital and these methods will eventually lead to a blow up. 

Davey illustrates this with a simple coin flip analogy, showing how a hypothetical coin flip strategy that produces a $2 profit on every winning trade vs. $1 loss for every losing trade with a 50/50 chance of success will still face risk of ruin with improper position sizing. 

While very simplistic this exercise illustrates the risk of overtrading and taking on too much risk. Trading 10% of your bankroll would create the possibility of risk-of-ruin even though you know precisely what your risk is and the strategy ensures you a 2-1 profit advantage on a 50/50 outcome. In reality—even with well-researched backtested results— you will never know precisely your total risk so calibrating your position size to match your projected risk is a dangerous game. As most professional traders say, “Your worst drawdown is always ahead of you.” 

A safer approach according to Davey— particularly for beginning traders— is simply to trade one contract. You can also risk one contract per a defined account size and increase the size of each trade when you account size increases. If you trade one contract for a $15,000 account, you can go to two contracts when your account grows to $30,000. 

Going a little deeper one can risk a specific percent of his account size—usually 1 to 2% — based on the results of your backtested strategy. 

Price Action Trading Expert Al Brooks puts it more simply. “A beginner is going to lose,” Brooks says. “He (or she) must trade the smallest position possible so that (he or she) will lose less as (the trader) works towards consistent profitability. My general rule is that consistently profitable day traders should risk 1 – 2 % on any one position. This is because the risk of ruin is real.”

Mark Shore, chief research officer at Shore Capital Research LLC, says that position sizing is an integral part of a trading system. “It is part of our risk management,” Shore says. 

Any technical based strategy needs to determine a price level that defines a failed trade. If your research sets that level outside of your comfortable loss parameters, then it is simply an indication that you should not take the trade. There is nothing more frustrating to a trader than being stopped out of a position only to see the market reverse. This will inevitably happen with any losing trade, but if it happens too much it is an indication that an account is undercapitalized for the specific strategy. 

Shore recommends scaling in to a trade if you have a weak signal or it falls out of your risk parameter. 

For retail traders a good option is the e-micro contracts that trade at 1/10 the size as the e-minis. “It gives you flexibility in bet sizing,” Shore says. “If you can only trade one e-mini S&P you could trade 10 micros. That will allow you to scale in or to take a small profit move stops to breakeven and let the remainder run.”

“The micros definitely improve you r ability to refine your position sizing,” Davey adds. “You don’t have to go from 1 to 2 like the big ones. A problem with position sizing in futures is you have to round down and now I have less risk, the micros help but they do cost a little more.”

No Perfect Position Size 

While proper position sizing could enhance profits and reduce risk, your system must be solid to begin with. “You can take a winning strategy, one that makers money over the long term, and if you are overly aggressive with your position sizing, you can blow out an account,” Davey says.  “The flip side, though, is not true. If you have a bad strategy good position sizing— even perfect position sizing— isn’t going to save you.”

The key to position sizing is it needs to be part of a trader’s strategy and overall approach to trading. If you have worked on a system and trust it, than you know you will have good stretches and bad stretches. The position size needs to be something that the trader can withstand—both account size wise and emotional wise—a poor performance period. 

Both Shore and Davey stress the importance of a trader being comfortable with the amount of risk he or she is capable of handling. 

While optimizing a strategy is something traders should do, optimizing position sizing is a little more fraught because by nature you are trying to find how much you can safely risk. Since you worst drawdown is always ahead of you, it is best to find a reasonable bet size and stick with it. This can be increased with the growth of your account if you choose to reallocate profits rather than banking them. 

“One important task to complete before you start trading is to have a plan for growth,” Davey says.  “Many traders who see a quick build up in their account don’t know what to do when this happens, because they have not planned for it.  The more upfront planning a trader does, the more likely they will make good decisions when new situations arise.”

“The biggest thing with position sizing is people tend to push it too much and over size,” Davey says. “Position sizing can screw up a good system or good approach. You have to be careful because the risk involved does scale with reward, there is no free lunch. “

Brooks adds, “A trader should focus on consistency rather than maximum profit.”