Tue. Oct 19th, 2021

Traders are constantly looking for the secrets of business success, but they keep looking for the wrong places and things. They usually tend to gravitate toward systems with a high rate of profit, or variations of that same theme (the desire to be right). However, being almost perfect with the market calendar has nothing to do with your overall success in the market.

All market participants agree that the main ingredients for successful trading are:

  • its risk ratio: reward (reduce losses and let profits run);
  • your position size algorithm (how much you assign to each bet);
  • be systematic with your approach (have the discipline not to wander).

Today we will explore the importance of position sizing and how an inappropriate strategy can turn out to be absolutely sad for your trade.

Hope Vs. Probability

Before we go any further, we need to clarify the concepts of Expectation i Probability.

A merchant Expectation is the mathematical description of its “edge.” It tells you what the average win has been, given the merchant’s return series, and is best described in “R” terms and not just in% -terms. Mathematically it is (Average profit *% profit) – (Average loss *% loss)

Conversely: the probability of a given result is related to the accuracy rate of the trader. It takes into account “winning streaks” and “losing streaks” and has little to say about the overall profitability of the trader.

In our experience, systems with a very high profit percentage tend to have a lower probability associated with their positive results. But in the end, it is the end result that counts. The multiple R’s in your favor are far more significant than “being right”.

The importance of sizing the position

Having a working knowledge of position sizing models helps traders avoid the most common mistakes that aspiring traders often stop working on:

  • risk too much in each operation;
  • risk more after a streak of defeats (also called Martingale strategies);
  • being too conservative and getting inefficient results compared to the effort involved;
  • not letting the profits run;
  • not protecting profits during a winning operation.

As a side note, remember how much work it takes to win a raffle:

  • A 10% The loss of capital requires a 11.11% Win to get to Breakeven
  • A 20% The loss of capital requires a 25% Win to get to Breakeven
  • A 30% The loss of capital requires a 42% Win to get to Breakeven
  • A 40% The loss of capital requires a 66.66% Win to get to Breakeven

And we shouldn’t go on because the odds of matching Market Wizard Bill Lipschutz’s 2016 performance (65%) are very low. Plus, that would get you back to balance. It is much better to never be in that position in the first place.

This is where your position size model comes in handy.

The first goal of a position sizing model is to preserve capital and prevent disaster. Ray Dalio talks about “failing well” – that means losing or making mistakes without being kicked out of the game. In trading, if you lose all your venture capital, you are out of the game.

However, if you only focus on preserving capital, you may be too risk averse and trading is not just your piece. If you are trying to trade, you should have venture capital in your trading account (that is, capital that you may risk losing without worrying).

This leads to the second goal of position sizing: to maximize profits.

Here are a couple of examples that should get you on the right track to finding a model that fits your own goals.

Symmetrical vs. asymmetric position sizing models

To do these tests we used a random number generator in Excel. The top curve represents the cumulative sum of wins and losses for 1000 random draws. The lower (and more interesting) graph represents the hypothetical equity curve using 2-position sizing models:

  • A symmetrical model in blue: fixed fractional. The trader runs the same amount (1%) for each transaction, regardless of the situation.
  • An asymmetric model in orange: start with 1%. Whenever you win, you risk 1% + half of the amount you previously won. When you lose, you reduce by 1%.

As you can see, as long as there is a real advantage to exploit, being more aggressive can offer significant benefits, while keeping the reductions in nature quite similar (much higher up with a little more downside).

Of course, as we have stated above with our own business research, position sizing and business management alone cannot rescue a system that has no advantages. (and if you’re in this situation, don’t worry: we have our backs)

More to you

Position size is what can help you minimize depressions and make exceptional gains. But it is not easy to find a suitable model. There is no “one size fits all”, as is the case with many aspects of trade.

To help you, we’ve created a whole course on position sizing within our Education section, which shows you the models we use for individual strategies and shows you what we recommend for business strategy portfolios.

This way you can get the most out of your business strategy.

About the author

Justin is a forex trader and coach. He co-owns www.fxrenew.com, a Friday signal provider of banks and hedge fund traders (get a free trial), or get FREE access toT the advanced currency exchange course for smart traders. If you like writing it, you can subscribe to the newsletter for free.

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