position sizing in trading Methods for Enhanced Trading Performance

Choose Your Path

The previous chapter examined three models for estimating equity capital, each offering a different way to determine the available base from which position sizes are calculated. Knowing how much equity is available is necessary but not sufficient. The next question is equally important: given a certain equity figure, how exactly should the size of each individual trade be determined?

Van Tharp, whose work on trading psychology and risk management remains widely studied, identifies several practical approaches to this question. This chapter examines three of the most accessible and widely applicable methods.

The three primary position sizing methods are as follows. Unit per fixed amount. Percentage margin. Percentage of volatility.

An important point before proceeding: these techniques are not limited to equity shares. They apply equally to stock futures, commodity futures, and currency futures. They work across all trading time frames, whether intraday, short-term positional trades lasting a few days, or longer-duration trades held for several months.

For those who wish to truly appreciate the difference these methods make in practice, the most instructive exercise is to take a simple trading system, a moving average crossover system works well for this purpose, and apply different position sizing methods to the same set of historical signals. The resulting profit and loss figures, and the stability of the equity curve, will differ meaningfully across methods even though the underlying trade signals are identical. The signals determine when to trade. Position sizing determines how much. Both matter enormously.

One further observation before examining the methods individually. With three equity estimation models and at least three position sizing approaches available, a trader technically has nine different combinations to choose from for any given trading system. Each combination will produce different results from the same set of opportunities. This is not an argument for complexity. In practice, selecting one equity model and one or two position sizing methods that suit the trader’s temperament and applying them consistently delivers better results than rotating between multiple approaches. Simplicity and consistency outperform elaborate combinations.

Unit Per Fixed Amount

The unit per fixed amount method is the most straightforward of the three. The trader establishes a rule stating how many lots or shares will be traded for every fixed amount of capital in the account. The rule is then applied mechanically to every signal the trading system generates.

To illustrate, suppose a trader named Karan has a trading account of 3,00,000 rupees and decides to trade no more than one lot of any futures contract for every 1,00,000 rupees of capital. His investment universe includes five futures contracts: a broad market index future, a banking sector future, a consumer goods future, an automobile sector future, and a technology sector future.

When his trading system generates a buy signal for the index future, Karan’s rule allows him to buy up to three lots, since his 3,00,000 rupee account divided by 1,00,000 rupees per lot permits three units. If the system simultaneously generates a signal for the automobile future, the same rule applies regardless of the margin required for each contract.

The appeal of this method is its simplicity. There is no complex calculation required at the point of each trade. The rule is fixed, the application is mechanical, and the decision-making burden is low.

However, the method has meaningful limitations that are worth understanding clearly before adopting it.

The first limitation concerns risk. Different futures contracts carry very different levels of volatility. A broad market index future might carry an annualised volatility of around 14 per cent. An individual stock future in the automobile sector might carry volatility of 35 to 40 per cent. Applying the same one lot per 1,00,000 rupees rule to both contracts assigns them equal weight in the portfolio whilst ignoring the fact that one carries roughly three times the price risk of the other. The portfolio-level risk is therefore higher than the simple unit count suggests.

The second limitation concerns scalability. If Karan’s account stands at 3,00,000 rupees and his rule allows one lot per 1,00,000 rupees, he can trade a maximum of three lots on any signal. To trade four lots, he must either add fresh capital to the account or wait for profits to accumulate sufficiently to cross the next threshold. Growth of the system is therefore slow and somewhat inflexible.

The unit per fixed amount method is not without merit. Its simplicity makes it accessible for traders who are new to position sizing and need a clear, uncomplicated starting point. It prevents overtrading and ensures at least a basic level of capital discipline. For these reasons it is worth understanding and evaluating personally before deciding whether it suits a particular trading style.

That said, the two methods that follow address the limitations described above more effectively, and most experienced traders eventually gravitate toward approaches that incorporate either margin or volatility as a more nuanced basis for position sizing. Those methods are examined in the chapter that follows.