Position Sizing: A Systematic Tool to Add to Your Trading Toolkit
When most people think about systematic trading, they likely picture a price chart with a plethora of moving averages, oscillators, and trend lines all with the goal of nailing the perfect entry right before a market takes off for the moon. While a good deal of time in systematic strategy development is devoted to entry and exit methodology, the greatest contribution to success in systematic trading has nothing to do with timing the market.
In my view, the greatest attribute of a fully systematic trading strategy lies in the position sizing and risk management. As a trader, you cannot control what the market will do. The only control you have is how much exposure you will have to the individual movements of the markets you trade and then ultimately, the total amount of exposure of the total portfolio. The good news is, the systematic risk management framework can be adapted to work with non-systematic trade selection and market timing.
There are three steps to getting started with applying a systematic risk management approach to your trading:
Set and honor a stop loss for every trade.
Size your position so that if your stop is hit you lose a predetermined amount of your trading capital.
Set your stop and position size adjusting for the volatility of the instrument.
Included at the end of this post is an interactive tool you can use to size your positions in a systematic fashion. The core idea here is to risk a set amount of trading capital for each trade. This is the essence of risk management; protecting the downside when you are wrong allowing you to stay in the game. If you already have a way of determining a stop loss with your current framework, great! If you don’t have a great way of determining a stop, the calculator can help you determine a volatility-based stop. Volatility-based stops take portfolio construction one step further. When including a measure of volatility in determining the stop, you equalize the risk between instruments with different levels of volatility. This allows each trade equal chance to impact the portfolio regardless of the instrument’s volatility.
The included video will walk you through the use of the calculator and give some more color to the theory and practice of the process.
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