The topic of position sizing is nothing new to traders and many have written, correctly so, that trading success has much more to do with money management than one would think at first blush. If you are trading a system, then you're in luck. There are robust methods for calculating position sizing based on the expectation of your system and other metrics, such as drawdown tolerance and profit motives. For discretionary trading, the formula is a bit more opaque, because your system's expectation is very difficult to pin down.If position sizing is boring, then read on, because this is not about position sizing. It's about learning stuff by doing stuff.
I offer my own trading tale of joy and despair to illustrate, and to reinforce the notion that one learns best by doing and least by reading books and following others. I decided to experiment with a trading style using real money. The market: forex. The style: discretionary. The money management: light position size with no stops. Profit taking on a regular basis is done to keep the experiment alive, at least long enough to learn something. I first set out to document my emotions on trades to see if I could glean some valid information from the journaling process. I am sad to report I learned nothing. Except that I can have more emotions while trading than adjectives I could come up with. Sad, discouraged, mortified ... eventually you reach a limit. I am not interested in eliminating emotions, thereby completing my metamorphosis into a robot, because I like being human. Humans have emotions (I know, duh right). Since I set natural targets ahead of time and had no stops, emotions really became the background music.
But surprisingly, I did learn something about position sizing along the way. Last week, my account value on Sunday night was $4,900, and had open short positions in the Euro and Aussie Dollar. When markets opened, price action went my way and I saw the account swell to $5,300 in a few hours. I dispatched my 10-year old to tell mom that dad has just made a cool $400 while doing nothing, and to prepare to splurge on summer vacation. As the week progressed, the account grew more and peaked at $6,100. That's half a mortgage payment in a couple days, I thought. Cool. But now the lesson. I could tell you what I learned but you really had to be there. I added a short Euro/Yen trade and set targets on it and the Aussie Dollar. They didn't get hit, barely of course. Now the market is going against me. And the account is back to where it was at the beginning of the week. Forget eating out every night at Hilton Head. And then it gets worse. Where is that emotional spreadsheet when I need it! What's a good word for horrified, mortified and terrified all rolled into one? The account value is $4,000. Over a 30% drawdown from peak in a matter of like one day. Volatility cuts both ways. It's been said before, I've heard it before, but I get it now.
Which leads me to a necessity. I need a method of levering a little lighter. I had to take off the profitable Euro trade to lever down a little and give the Aussie and Euro/Yen a chance to recover, so that was another bummer. And now I start thinking thoughts about leverage, volatility and emotional stability. And what I come up with is a heuristic for position sizing that includes both market-defined settings and emotional tolerance.
To clarify terms, let's define heuristics. The raw definition is that it's an aid to problem-solving derived from the process of trial-and-error. When used pejoratively (ie, "you're just applying heuristics, knave"), it suggests that you've just pulled a methodology out of thin air and deemed it good (put your thumb up and squint with one eye for effect) with complete disregard to a formal process. But not all heuristics are bad. Use them judiciously please, not because you're lazy and wanton, but because your attempts for precision have been thwarted by the complexity of the problem.
The formula is not exciting, really. Take your account size and determine what is a acceptable pain in terms of percentage, let's say 10%. This number is called maximum tolerable pain (MTP). Then calculate the market volatility by using average true range (ATR) and set a level such as 2 ATR to represent an unusual but not unlikely excursion. If your position moves 2 ATR, how much money is that? That number is your expected pain (EP). Now the formula:
--1 If MTP > EP, then lever down, else go to next
--2 If MTP < EP, lever up, else do nothing.
Simple, huh? Where did I get the numbers 10% and 2 ATR? Now you know why it's called heuristics.
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