Position sizing is the process of deciding how many contracts you will take in response to a ‘buy’ or ‘sell’ signal generated by your system. If you are a systems trader, this process will be automatically dealt with as it is built into your methods and software.
What is position sizing?
Every time your system produces a signal to enter the market, the position sizing calculation is made. Your account balance will alter all the time and the commodity to which the signal applies will vary too, of course.
If your position size is too great – you will be overtrading. If it is too small, you will be missing opportunities. If it is correctly sized, then you will have the best chances of a successful outcome to the trade.
Actual position sizing is a very simple process but it is the culmination of a series of steps that reveal a great deal about the systematic approach taken by successful professional traders.
Having decided in evaluation tests, where he will place his protective stop, it is a very simple matter for the trader to calculate the loss this will produce on a single contract if the trade goes against him. Then by dividing this number into the total amount he is prepared to risk on a trade, he will know how many contracts he can afford to buy or sell.
From what has been said, it is clear that you need to know the total amount of risk you will permit on a trade. This depends on a number of interconnected things, beginning with your own attitude to risk, then moving on to what risk you will accept for a particular return - then progressing to tests to discover what is called the risk resonance of your selected system.
The risk resonance test will enable a percentage stake per trade to be obtained - that will be used in further tests to find out whether the selected system appears capable of producing the required performance under real market conditions.
It is only after all this that the information used in position sizing becomes available – allowing that simple calculation to be made that reveals how many contracts should be taken on this occasion.
Thankfully, once he has the right method and has made a few simple decisions, the systems trader can rely on all of this work being done for him automatically. There is no complicated work for him to do every time he wants to evaluate a new system. However, most traders want to know how it all works and want to reassure themselves that they can rely on their methods to cover all the essential aspects of trading commodities.
The best way to acquire this confidence is by selecting methods and software that have been produced by professional traders.
Copyright David Bromley 2006
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