Defensive Money Management Explained: Better Position Sizing
Traders, discretionary and mechanical alike, are often puzzled on how to properly scale their trading with respect to their trading account size. Classic rule of 1% or 2% risk of investment capital just does not work because traders are here to take risk, not trying to be conservative investors. So, what can a trader do to find the correct position size that fits their needs?
(Part of Defensive Money Management Explained series)
The Problem with Scaling Based on Total Accumulated Capital
Many traders adjust their position size whenever they hit certain level of accumulated profit. It works in the beginning most of the time without much issues. After all, everyone starts from somewhere trading one lot or two. Scaling up to trade another lot does not produce significant issues. However, as the size of the position grows faster while profit accumulates, much worst drawdowns are also experienced.
And if the trading method is unstable, the sizing up can often lead to spectacular crash and burn of the trading account.
This approach to position sizing is simply Martingale betting in disguise. Even though you may have waited for certain amount of money to be accumulated first before you increase your position size by your pre-determined corresponding size increase, it is still betting everything you’ve accumulated. It feels logical but it is not. Every trading method, including the profitable ones, has drawdown period. Betting everything accumulated at a bigger size means taking losses at a rate faster than the original expected average.
In short, it is the fastest way to maximize the profit, until it does not.
Normalization of the Performance Is the Key
Remember that in the beginning of trading a strategy / method, scaling up works fine and feels fine. Trouble only happens after several rounds of quick increase of position size. So what went wrong with scaling based on the total accumulated capital?
Well, that’s because the total accumulated capital is the total return of many trades with varying position sizes. It does not reflect what the strategy is doing on a single unit. To increase position size at sustainable rate, it should be based on the performance or accumulated capital of a single trading unit.
For a mechanical trader, it is easy to figure out the single unit performance because they can generate the hypothetical performance on their trading platforms.
For a discretionary trader, if they do not keep track of the information themselves, they just can’t tell if it is the right time to scale up or down. That’s why position sizing often destroy a discretionary trader without them knowing what went wrong.
Periodic Evaluation Promotes Stability and Consistency
Once a trader knows the single unit performance, scaling up becomes much more sustainable. However, for best practice, it is better not to increase (or decrease) position size purely based on the accumulated capital. The reason is that if you do that, you are not letting the strategy lives through enough trades to play out its cyclical or seasonal volatility. Thus you may increase your position size too fast after several home runs and suffer significant losses right after which in turn force you to reduce your position size back down quickly.
Personally, I find that for frequent trading strategies that trade several times a day, evaluation every quarter works well. For trading strategies that trade once a day and only several times a week, evaluation every six months is enough. Swing trading strategies that do not add up to 20 trades a year should only go for position size change every few years.
Some of you may be wondering – that’s not what I heard from those hedge fund legions. They trade other people’s money for a living and faster the accumulation of profit the better for their bottom line. Whether that is the right thing to do is really a judgment call.
Case Study – Big Game Hunter ES
Big-Game Hunter ES is a stable day trading strategy overall but just like any other trading strategies it has drawdown periods. Those drawdown periods may look insignificant on the chart below, but in reality, they are very significant in terms of percentage drawdown against the initial capital.
Using $12500 as the initial capital for trading one contract, Big-Game Hunter managed to generate more than $165,000 over almost 21 years period. So the average return per year is about 62% while the worst drawdown happened in year 2016 at about 34%. Even in year 1999, the first year included on the performance chart, there was a drawdown period at 27%.
The most recent drawdown period happened in 2019 at 25%.
Just imagine that you are trading one lot and just doubled your size to two lots right before the 34% drawdown, the realized loss would be double in amount but on percentage basis it will stay the same, provided you increase your position size only when you have made $12500 (the initial trading capital for one contract).
If you do not scale up mindfully, your net loss in percentage basis will be way worse than 34%. For example, if instead of trading two contracts, you jump up to three contracts hoping to make more money quickly while your trading capital was that $25,000, your drawdown will be 51% instead. That means all the profit you have made are wiped out.
This is why I do not use the standard practice of month to month equity changes in percentage in BGH’s performance summary. They are useless because the minor dent to the equity curve is not what concerns a trader most. They cannot help a trader at all in understanding the actual risk faced by a trader.
Using my scaling method of re-evaluation every six months based on the performance of a single contract, here is the resulting performance.
Using my scaling scheme, a trader would be trading up to 13 contracts in year 2019. If a trader scale up the position size based on actual equity change, the number of contracts one should trade would be more than 10,000 by year 2019. Not only being unrealistic in terms of execution, it is also useless and misleading to someone who is not aware of its impracticality.
In Real Life We Extract Profit from Our Trading
Notice that by detachment of the total accumulated gain from the calculation of the position size, we also enabled the trader to take out profit from the trading account without affecting the growth of the trading business itself. It is important to take this into consideration because trading is just the means to make money. So being able to take money out of the account regularly should be part of every trader’s business plan.
Using the example above, with my position sizing method, a trader can extract more than $950,000 profit from trading over the years while leaving the account a healthy amount for trading up to 13 contracts.
Of course, you may have some other thoughts about your trading business and instead of taking all those profit from the account, you may want to swing harder and make more money by retaining more money so that you can trade at much larger size. That’s not a problem. As long as you approach this with a consistent scheme, and willing to accept the risk you are taking, you will be able to live with the equity swing and enjoy your trading.