Nowadays, beginner traders scour the internet for the most profitable strategies, with many failing to make meaningful progress.
However, what most people neglect (which also happens to be a crucial key to profitability) is how they manage their position sizing.
The thing is, your system may have an edge, but how you size your trades does not.
In fact, sizing is an important aspect of trading that differentiate many losing traders from consistently profitable traders.
In this post, let's find out why tweaking your position size may just be what you need to profitability!
Assumption
Assuming you have a trading system where you categorize the quality of trades into A, B, and C, with the occurrence, win rate, and risk/reward differing respectively. Here's a breakdown of these trades in a sample size of 40 trades:
Quality | Win Rate | Trades/Occurrence | Risk Per Trade (R) | Expected Reward (R) |
|---|---|---|---|---|
A | 70% | 3 | 1 | 2 |
B | 55% | 12 | 1 | 1.5 |
C | 30% | 25 | 1 | 1 |
Note: Mind that 'Risk' and 'Reward' in this post will be represented in 'R' units. R could be in % or $ format.
Below, we test 3 different sizing scenarios, and explore why tweaking your position size may be just the break you need to consistent profitability:
Note: I used the following formulas to do the calculations for the tables below.
[PROFIT = (WIN RATE * TRADES) * EXPECTED REWARD]
[LOSS = (100% - WIN RATE) * TRADES * RISK]
[NET OUTCOME = PROFIT - LOSS]
Scenario 1: Fixed Sizing
Most traders are taught to use a fixed risk (eg. 1% or a fixed dollar amount) for each trade.
Let's see how well fixed sizing fares based on our assumption above:
Quality | Risk Per Trade | Profit | Loss | Net |
A | 1 | 4.2 | 0.9 | 3.3 |
B | 1 | 9.9 | 5.4 | 4.5 |
C | 1 | 7.5 | 17.5 | -10 |
[Total Outcome: -2.2R]
As you can see, with a fixed sizing approach that most traders are familiar with, this system returns a negative outcome.
What if we tweak the sizing approach for a bit?
Scenario 2: Linear Sizing
In this scenario, we double the size of our A trades, and half the size of our C trades.
Let's see if this makes a difference for the trader:
Quality | Risk Per Trade | Profit | Loss | Net |
|---|---|---|---|---|
A | 2 | 8.4 | 1.8 | 6.6 |
B | 1 | 9.9 | 5.4 | 4.5 |
C | 0.5 | 3.75 | 8.75 | -5 |
[Total Outcome: 6.1R]
Now, by just adjusting the sizing based on the quality of trades, the trader that supposedly is a losing trader turned a profit.
Did this trader turn green because he/she overhauls the strategy? No.
This trader turns into profitability by just making sizing adjustment that makes sense!
By now, I hope you can see why position sizing is as important (if not more important) as the trading strategy itself.
What if you can bring this to another level: a level that can turn good traders into phenomenal ones?
Scenario 3: Exponential Sizing
Now, considering a trader is so familiar and confident with his/her strategy, why not up the size of the A trades, and completely get rid of the subpar C trades?
I mean, why take poor-quality trades if we are so good with our best ones?
Quality | Risk Per Trade | Profit | Loss | Net |
|---|---|---|---|---|
A | 5 | 21 | 4.5 | 16.5 |
B | 1 | 9.9 | 5.4 | 4.5 |
C | 0 | 0 | 0 | 0 |
[Total Outcome: 21R]
In this case, the trader may be taking fewer trades as he/she completely got rid of the subpar C trades.
That said, the trader ends up with better gains since he/she bet exponentially higher on the best A trades.
This is very similar to professional poker players that make the highest bet when odds are in their favour.
As you can see, exponential sizing turns good traders extraordinary, as long as they know what they are doing.
Pre-requisites to linear and exponential sizing
Now, before I let you go crazy with your position sizing, here's a few heads up:
Know what are your A/B/C trades: The key to playing with your trade size is to be able to identify your best to the most subpar trades.
Risk Appetite: Not everyone can go from fixed sizing to exponential sizing overnight. Start small and raise your size slowly as you build up your emotional resilience to trade with a bigger size.
Verdict: Position sizing could be your break to profitability
I hope this post is insightful and gives you some new perspectives!
More importantly, I hope I've convinced you why you should spend more time thinking about position sizing instead of trying to find different strategies from Youtube or TikTok!
Subscribe for more content on Algorithm and Futures Trading!
Now, it is impossible for me to go through trading in detail in a short article like this.
But don’t fret, consider subscribing to ALgopedia's FREE newsletter at the bottom of this post, and be the first to know when we publish any new updates!
Disclaimers
Any of the information above is produced with my own best effort and research.
This post is produced purely for sharing purposes and should not be taken as a buy/sell recommendation. Past return is not indicative of future performance. Please seek advice from a licensed financial planner before making any financial decisions.
Leverage is a financial tool that comes with its advantages and risks. Please learn and understand both the upsides and downsides of leverage before using it for trading.
Comments