Risk-Based Position Sizing

About the Author Jeff Swanson

Jeff is the founder of System Trader Success - a website and mission to empowering the retail trader with the proper knowledge and tools to become a profitable trader the world of quantitative/automated trading.

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  • Red says:

    Method 2 – Fixed Dollar
    You use 25% of your starting equity and get an answer of $25,000 implying that your starting equity is $100,000.

    Yet, at the beginning of the article, you state that the starting equity was $50,000?

    I am going to guess that you meant to say 50% of starting equity.

    Have a good one.

  • Robert says:

    I’m not sure that this shows the benefits of risk-based position sizing as much as just the effects of compounding your equity. In methods 1 and 2, you are not compounding your equity. In methods 3 and 4, you are. (I.e., in those methods, the number of shares being traded depends on the current amount of equity, which is increasing.) There is a greater return in methods 3 and 4, given the effects of compounding.

    In practice, nearly every trader will use some form of compounding. If you have a system that has positive returns over a period of months or years, you’ll naturally increase your position sizing as your equity increases. Methods 3 and 4 just make that explicit.

    • This is a good point. While the benefits of risk-based position sizing can be debated the main point was to demonstrate how different position sizing models can produce different results. The compounding effect is powerful and as you pointed out, method 1 and 2 do no use it. Thus, it’s a good illustration of what compounding can do for you. It is also interesting to note that method 1 (not compounded) and method 4 (compounded) produce similar net profit but method 4 has a better profit factor and higher average dollar per trade.

  • Mark says:

    Hi Jeff,

    With methods 1 and 2 not compounding, why does method 1 generates $31,752 profit ($30,905 if reduced proportionally for the total trades) vs. $33,140 for method 4? These numbers are very close.

  • Brooks says:

    Nice post. For position sizing software, check out Mike Bryant’s MSA (Market System Analyzer). Best $350 I’ve spent on software (right next to Amibroker). No relationship to Mike, just a happy customer. MSA has a tie into Tradestation, too. He’s great about answering questions/emails.

  • Hi Jeff,
    Some time ago, over 10 years ago I launched my Money, Risk and Trade Management program called JBL Risk Manager. It is much simpler to use than most, simple reporting at a glance and uses a risk based percentage position sizing metric and I would value your opinion, thank you

    Joseph

  • Justin says:

    Hi Jeff

    Can you please explain why you have used 3 x ATR. I now understand how to calculate ATR from a spreadsheet I made because my trading platform does not do it for me but I am confused why people advise to find a multiple of the ATR that suits your style or system. Most people advise to subtract the ATR from the entry price and I have settled on using the 10day ATR for my calculations as I understand the the shorter the ATR time frame the more quickly the ATR is responding to volatility much like a shorter moving average compared to a longer moving average. (the longer average is more smoother) But I dont have understanding of the multipulcation factor 1 or 2 or 3.
    Thanks in advance Jeff for this good article.

    • Hello Justin. The value of three was simply picked based on some rough experimentation. I wanted the stop value to be well out side of the noise of normal market movement, so three times that average true range, worked out to be a decent value. In essence we are setting a “wide” stop value based on the current volatility. Three times the ten-day ATR means we need an extreme price move which exceeds the current ATR value by three times. Again, it’s no magic number but one that could easily be modified based upon your needs.

      • Justin says:

        Hi Jeff
        I have since reading your response set my atr(10)multiple at 1.5.

        I am not trading for real yet but doing simulated trading but with real market figures and I have found that a 1.5multiple is just too tight for my system. I have been stopped out so far by what seems to be market noise so I am changing my atr(10) multiple to 3.

        I have read that many people use 2 and many also use 3 so for now I will try a multiple of 3.

        Thanks for the response back in June. I read it but never got back to you because I need time to learn more. Thanks heaps Jeff

  • Alex says:

    RE: “Let’s use 5% of ETF price as the amount to risk.”

    This is where mean reversion strategies like this that lack a hard stop first become problematic. You could use the average losing trade instead of the arbitrary 5%, but there will be just as many larger losses than the average as there will smaller losses. You could use the largest historical losing trade (summer of 2011?), but who’s to say that future losses won’t be larger?

    One method that I have used is an ATR with a lookback equal to the average bars in a winning trade – but using strategy performance metrics for position sizing actually creates a feedback loop into the strategy itself, which can be problematic.

    At the end of the day, without actually introducing a hard stop into the strategy, it’s pretty difficult to arrive at anything more meaningful than an arbitrary percentage that is larger than the largest historical loss.

    • Larger losses are always in the future. This is something everyone must accept. In the case of not having a stop you could simply position size based upon the past 10 or 20 days volatility, which is basically what you recommended with your ATR method. Here is a link to a function which will do that: http://www.systemtradersuccess.com/downloads/free/_CE_Normalize_Units_vs_Volatility.txt

      At least this will adapt the number of shares based upon recent volatility. Furthermore, you could always place a catastrophic hard stop with each trade to limit risk. Thus, you’re adjusting your risk based upon volatility with the added safeguard of a hard stop limiting those rare occasions where the market just falls apart, such as summer of 2011.

  • Windy says:

    Could you test by, after the 60th trade, using the Kelly formula:

    Kelly % = W – [(1 – W) / R]

    Where:
    W = Winning probability
    R = Win/loss ratio

    This should give a much larger profit.

    See: Money Management Using The Kelly Criterion https://www.investopedia.com/articles/trading/04/091504.asp#ixzz5PPFHZmgl

    • I generally stay away from the Kelly formula because it’s often too aggressive. But it would be kind of interesting worth testing. I’ll put it on the to-do list and update the article. Thanks for the email!

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