position sizing in trading Methods for Enhanced Trading Performance

Choose your path

In the prior chapter, we examined how to discern equity using three distinct models. Each model successfully encourages position sizing discipline, yet more needs to be done to establish an independent method. Therefore, let’s explore some of Van Tharp’s strategies regarding position sizing in the following section.

Let us consider three primary methods of position sizing right now, which are –

Unit per fixed amount

Percentage margin

Percentage of volatility

Please note, these techniques apply to any asset, whether it’s stocks, stock futures, commodity futures or currency futures. You can also use them across all time frames with equal ease – intraday, short-term trading sessions and even trades that last for several months.

To really get a grip on this, I advise selecting a trading system; something as basic as a moving average crossover system will do. Identify entry and exit rules and assess the returns from the given timeframe. After that, apply one of the position sizing techniques to measure the performance. You’ll see a huge improvement with regards to both P&L and stability of the system.

To illustrate the complexity of this, let me shed some light on this.

Assume you have a trading system – a simple moving average cross over system

You plan to invest money into this and trade every signal that the system produces.

There are three models for determining equity and at least three basic approaches to sizing positions.

By utilizing a 3 x 3= 9 position size, you can vary the size of your investment for the same opportunity in nine different ways.

The P&L for each will vary. 

In my experience, you should focus on one method of estimating equity, and possibly one or two useful ways to size positions. However, introducing too much complexity is not helpful, and it does not necessarily result in improved performance.

As a trader, you’ll need to choose the right path according to your temperament. Now, let’s delve into the essential position sizing techniques.

– Unit per fixed amount

The model merely calls for you to indicate the number of lots or shares that you would like to trade for Rs.200,000. Suppose there are five potential assets (futures) in your investment universe, such as –

Nifty

SBI

HDFC

Tata Motors

Infosys

Given this, you could simply state that you would not want to trade more than 1 lot of futures per 100,000 of the asset at any given point. So, in the case of a signal to buy Nifty with 2L in your account, you can decide whether to purchase one or two lots.

This model simplifies decision-making, but there are some issues with it.

Take this into account – you have 2L in your account and the trading system provides you with a signal for Nifty Futures and Tata Motors. A single lot of each requires a margin of 60K and 72K respectively.

Irrespective of the margin, the 1 lot per 1L rule assigns an equal weight to both contracts, disregarding the ‘risk’ factor of each asset. For example, Nifty Futures has an annualized volatility of roughly 14%, compared to Tata Motors’ 40%. As a result, you are taking on more risk at the portfolio level.

This has both advantages and disadvantages. On the one hand, it prevents trades from being rejected because of their risk factor; on the other hand, it fails to take into account potential risks.

There is another perspective worth considering: if you use a trading system that requires a 1 lot per 100,000 position size rule and have a capital of two lakhs, then with each signal you can only buy two lots. This means scaling up the system is difficult, as you would either need to double your capital or wait until your profits accumulate to double it. The only way to bypass this obstacle is to invest more money in the beginning.

For these reasons,I am not inclined to favour the ‘unit per fixed amount’ position sizing technique. Nonetheless, it is worth considering this method and finding out your own level of comfort with it before making a decision on whether or not to adopt it as your main position sizing technique.

– Percentage Margin

The percentage margin is an intriguing position sizing approach. Comparatively, it is much more organized than the ‘unit per fixed amount’ strategy, which could be extremely beneficial for intraday traders. This technique requires basing your size of position on the margins.

You can allocate a certain portion of your capital as margin for any given trade. Let’s illustrate this with an example.

Assuming you have a capital of Rs.500,000/-, you are only willing to risk up to 20% as margin which equates to Rs.100,000/- in each trade.

Spotting an opportunity to trade Nifty Futures is easily achievable with a margin of around Rs. 60,000/-. However, if you have your sights set on ICICI, the margin requirement being close to Rs.105,000/- might be out of reach. Therefore it’s important to increase capital only as a result of accumulating profits in the account and not for accommodating every trading opportunity.

Once you open a position in Nifty, you may see an opportunity in ACC with a margin of 90K.

Are you interested in accepting this job?

The resolution of this issue hinges upon the method you use to evaluate equity.

Taking into account the whole equity model, your capital stays at 5L, 1L of which is 20% – thus granting you the confidence to make an investment in ACC.

If the reduced total equity model is taken into consideration, then employing a 20% position sizing rule will result in the following process.

Starting Capital = 5L

Margin blocked = 60K

New capital = 4.4L

Margin @ 20% = 88K

This leaves you short of the 90K position by 2K, so you’re required to decline it. Recognising the weight of equity estimation in this scenario is paramount.

Assuming you find an opportunity that requires 40K in margin, you can confidently commit to 2 lots of the position since you have 88K.

And so on.

The percentage margin rule guarantees the same margin for all positions in your account; however, volatility among them could differ drastically. This can result in some fairly risky bets and alter the risk profile of your portfolio overall.

This risk can be mitigated through the use of a different position sizing model.

– Percentage Volatility

The percentage volatility rule takes into account the underlying asset’s degree of fluctuation. Rather than using ‘standard deviation’ as a measure, it utilises the daily prospective movement in that asset.

The OHLC of SBI can be expressed numerically as 276, 279, 274 and 278. This implies that the day’s volatility is the difference between the lowest and highest numbers.

279 – 274

= 5

For a more comprehensive understanding of volatility, I can consider Van Tharp’s advice and turn to ‘Average True Range’. This tool allows me to take into account the difference between low and high as well as any gap up or gap down openings over the last ‘n’ days. Averaging all this together should provide a clearer picture of the stock’s activity.

For the purpose of position sizing, the ‘Percentage Volatility’ approach requires us to identify the maximum amount of volatility we can handle with the allotted equity capital.

For example, with an equity capital of Rs.500,000/-, I could institute a rule not to subject more than 2% to market fluctuations.

To illustrate, let us take a look at the chart of Piramal Enterprises Limited (PEL).

The 14-day ATR for PEL is 76, indicating that each share adds Rs.76/- to my equity capital variance.

Suppose I identify a trade chance in PEL, the inquiry is how many stocks should I buy being aware that my equity amounts to 5L and I have set a ceiling on my volatility exposure of no more than 2%.

2% of 5L amounts to 10,000/-. Consequently, I should purchase the quantity of shares in PEL such that the combined instability caused by PEL is not above 10k.

To determine the number of shares I can purchase, I must simply divide 10,000 by 76.

10,000/76

= 131.57 or about 131 shares.

PEL is trading near 2700, which would mean your exposure is –

131 * 2700

=Rs.353,700/-

I would advise utilising the reduced total equity model for computing equity. By doing so, the funds accessible to utilize for the next transaction should be –

500,000 – 353,700

=146,300

At 2% volatility, the capital exposure has dipped to Rs.2929/-. This means that the trading capital will be reduced in the next transaction, yet the exposure to volatility will stay the same.

Van Tharp advises that if you’re looking to employ the percentage volatility technique, determine how much total volatility you’d like to apply to your portfolio. This can be determined by calculating 15% of your portfolio’s total capital; for example, for a portfolio of 5L, this would equal Rs.75,000/-.

It’s worth considering, if everything works against you, you could be out of pocket 75k from a starting capital of 5L in one day. How does that sound? If it makes your stomach turn, then maybe 15% volatility on your portfolio is too much.