Trading the Risk

Position Sizing and Exit Stops

Michael R. Bryant, Ph.D. Breakout Futures www.BreakoutFutures.com
Copyright 2002 Breakout Futures

Scope of Talk
Short to intermediate-term trading Rational methods of position sizing and
stop selection; mostly quantitative Oriented towards futures but also applicable to stocks One market-system at a time

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What is Position Sizing?

Selecting the number of contracts or
shares of stock for the next trade A way to reinvest profits The way traders compound their returns

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Methods of Position Sizing

Ad hoc: trade no larger than lets you sleep
at night Margin plus drawdown Fixed Fractional Fixed Ratio Hybrid fixed fractional/fixed ratio

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Methods that Dont Work

Martingale methods: increase position size
after a loss; decrease it after a win. Equity curve methods: increase size when your equity curve falls below its moving average (reversion to mean), or increase size when you cross above the moving average (trade the trend in equity curve).
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Why They Dont Work

Martingale and equity curve methods assume

dependency between trades. In most cases, trades are independent of each other. The odds of the next trade being a win are not related to whether the last trade was a win or a loss. If trades are independent, you cant determine the likelihood of the next trade being a win or a loss based on the previous trade.
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Margin Plus Drawdown Sizing

The equity to trade one contract is the

maximum historical drawdown multiplied by 1.5 plus the margin requirement. Add another contract only when the closed profits are equal to drawdown * 1.5 plus margin. Attributable to Larry Williams; see The Definitive Guide to Futures Trading, Volume II.

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Margin Plus Drawdown (cont.)

You always have enough money to handle the

worst historical drawdown plus 50%. Designed so you only increase the number of contracts, never reduce. Theoretically safe but doesnt reduce contracts in a drawdown, so drawdowns can be large. Doesnt take the risk of each trade into account.

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Margin Plus Drawdown (cont.)

140000 120000 100000

Equity

80000 60000 40000 20000 0 12/31/97 12/31/98 12/31/99 12/30/00 12/30/01

1-Con Marg+DD

Copyright 2002 Breakout Futures

Fixed Fractional Position Sizing

Risk the same fraction (fixed fraction) of the

account equity on each trade; e.g., 5%. Number of contracts:

N = ff * Equity/|Trade Risk| where ff = fixed fraction, Equity = account equity ($), Trade Risk = possible loss on trade ($)

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Fixed Fractional (cont.)

Trade risk may come from:
Estimate. Examples: n standard deviations of the trade distribution; largest historical loss. Size of money management stop.

Using a money management (mm) stop to

define the trade risk may produce greater risk-adjusted returns than using the largest loss.
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Fixed Fractional (cont.)

300000 250000

Equity

200000 MM Stop 150000 Max Loss

100000

50000 1/1/98 1/1/99 1/1/00 12/31/00 12/31/01

12

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Observations on Fixed Fractional

As a percentage of account equity, the
risk of each trade is the same, regardless of the number of contracts. Takes advantage of trade risk. Responsive to changes in equity (unlike margin plus drawdown method). The trick is determining the best value of the fixed fraction; more on that later
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Fixed Fractional (cont.)

140000 120000 100000

Equity

80000 60000 40000 20000 0 12/31/97 12/31/98 12/31/99 12/30/00 12/30/01

1-Con Marg+DD Fix Frac

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Fixed Ratio Position Sizing

Developed by Ryan Jones; see The
Based on a fixed parameter called the
Trading Game, John Wiley, 1999.
delta: the profit per contract needed to increase the number of contracts by 1. Each contract contributes the same profit towards increasing the number of contracts, regardless of account equity.
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Fixed Ratio (cont.)

Number of contracts:
N = *[ 1 + (1 + 8 * Profit/delta) ] where Profit = total closed trade profit ($), delta = profit/contract to increase by 1 contract ($).
1/2

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Fixed Ratio (cont.)

25 20

No. Contracts

15 Fix Frac Fix Ratio 10

0 0 5 10 15 Trade 20 25 30

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Fixed Ratio (cont.)

25 20

No. Contracts

15 Fixed Frac Fixed Ratio 10

0 0 30,000 60,000 Profit

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90,000

120,000

Observations on Fixed Ratio

Performance depends on total
accumulated profits; i.e., account size. It becomes more conservative as the account size increases. Doesnt directly depend on trade risk.

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A More Generalized Approach

Consider the following equation for the number
of contracts, N:
N = *[ 1 + (1 + 8 * Profit/delta) ] where Profit = total closed trade profit ($), delta = fixed ratio parameter ($), m >= 0.
m

With m = , we get the fixed ratio equation.

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A Generalized Approach (cont.)

Consider m = 0:
N = *[ 1 + (1 + 8 * Profit/delta) ] = 1/2 * [1 + 1] =1
0

i.e., we get fixed contract trading (N = 1).

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A Generalized Approach (cont.)

Consider m = 1:
N = *[ 1 + (1 + 8 * Profit/delta) ] = 1 + 4 * Profit/delta Let delta = 4 * Risk/ff and Equity0 = Risk/ff. Then, N = (Equity0 + Profit) * ff/Risk (i.e., the equation for fixed fractional trading)
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A Generalized Approach (cont.)

Rate of Change of N with Profit:
N/(Profit) = 4*m/delta * (1 + 8 * Profit/delta)m-1 m = 1 ROC of N independent of profit; e.g., fixed fraction. m > 1 N increases faster as equity grows. m < 1 N increases more slowly as equity grows; e.g., fixed ratio.
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A Generalized Approach (cont.)

450000 400000 350000 300000

Equity

250000 200000 150000 100000 50000 0 12/31/97 12/31/98 12/31/99 12/30/00 12/30/01

m=0.5 m=1.0 m=1.5

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A Generalized Approach (cont.)

500000 425000 350000

Equity

m=0.5 275000 200000 125000 50000 12/31/98 12/31/99 12/30/00 12/30/01 m=1.0 m=1.5

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Conclusions From Generalized Approach

m < 1 works best when worst drawdowns come

late. m >= 1 works best when biggest run-up comes late. For any sequence of trades, there is probably an optimal value of m. However, the sequence of trades and drawdowns/run-ups is unknown. (Monte Carlo analysis to find the best m?)

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Finding the Best Fixed Fraction

Ad hoc; e.g., 2% rule. Optimal f: Ralph Vince, Portfolio
Management Formulas, 1990.

Secure f: Leo Zamansky & David

Stendahl, TASC, July, 1998. Monte Carlo simulation: Bryant, TASC, February, 2001.
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Best Fixed Fraction (cont.)

Optimal f: f value that mathematically maximizes the compounded rate of return. Doesnt take the drawdown into account. Typically results in very large and dangerous f values. Theoretically sound but not practical to trade.
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Best Fixed Fraction (cont.)

Secure f: f value that maximizes the compounded rate of return subject to a limit on the maximum drawdown; e.g., what f value gives the greatest rate of return without exceeding 30% drawdown? Improvement on optimal f. Only problem: the drawdown calculated from the historical sequence of trades is not very reliable.
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Best Fixed Fraction (cont.)

85000 75000 65000

Equity

55000 DD=9.3% 45000 35000 25000 15000 12/31/97 12/31/98 12/31/99 12/30/00 12/30/01
30

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Best Fixed Fraction (cont.)

85000 75000 65000

Equity

55000 DD=16.7% 45000 35000 25000 15000 12/31/97 12/31/98 12/31/99 12/30/00 12/30/01
31

Copyright 2002 Breakout Futures

Best Fixed Fraction (cont.)

85000 75000 65000

Equity

55000 DD=25.6% 45000 35000 25000 15000 12/31/97 12/31/98 12/31/99 12/30/00 12/30/01
32

Copyright 2002 Breakout Futures

Best Fixed Fraction (cont.)

85000 75000 65000

Equity

55000 DD=37.6% 45000 35000 25000 15000 12/31/97 12/31/98 12/31/99 12/30/00 12/30/01
33

Copyright 2002 Breakout Futures

Best Fixed Fraction (cont.)

85000 75000 65000

Equity

55000 DD=46.2% 45000 35000 25000 15000 12/31/97 12/31/98 12/31/99 12/30/00 12/30/01
34

Copyright 2002 Breakout Futures

Best Fixed Fraction (cont.)

85000 75000 65000 DD=9.3%

Equity

55000 45000 35000 25000 15000 12/31/97 12/31/98 12/31/99 12/30/00 12/30/01

DD=16.7% DD=25.6% DD=37.6% DD=46.2%

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Best Fixed Fraction (cont.)

Historical sequence: 14% max drawdown
on 2 contracts, starting with $50k. Find the fixed fraction that maximizes the RoR of the historical sequence with no more than 30% drawdown f = 8.2% Try f=8.2% on some randomized sequences of the original trades. One result: max drawdown = 76%!
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Best Fixed Fraction (cont.)

800000 700000 600000 500000

Equity

Original Optimized Randomized

400000 300000 200000 100000 0 12/31/97 12/31/98 12/31/99 12/30/00 12/30/01

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Best Fixed Fraction (cont.)

Monte Carlo Simulation: Replaces random variables in a simulation with their probability distributions. Distributions are randomly sampled many times. Output of simulation is a distribution. Can be used to find the best fixed fraction by replacing the trade with the distribution of trades.
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Best Fixed Fraction (cont.)

Distribution of Profit/Loss
25 20 15 10 5 0

10 00

20 00

30 00

40 00

50 00

-3 00 0

-2 00 0

-1 00 0

Trade P/L
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60 00

Best Fixed Fraction (cont.)

Applying Monte Carlo to Fixed Fractional Trading: Randomize the sequence of trades, and, for each sequence, calculate the return and max drawdown using a given value of f. The drawdown at 95% confidence is the drawdown such that 95% of sequences have drawdowns less than that. The return at 95% confidence is the return such that 95% of sequences return at least that much. Find the f value that maximizes the return at 95% confidence while keeping the drawdown at 95% confidence below your drawdown limit.
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Best Fixed Fraction (cont.)

120 100 1600 1400 1200 1000 800 600 400 20 0 0 0.02 0.04 0.06 0.08 0.1 200 0 0.12

60 40

Fixed Fraction

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Ave RoR (%)

P (40% DD)

80

41

Best Fixed Fraction (cont.)

4000 3500 100 3000 120

RoR at P=95%

2000 60 1500 1000 500 20 0 -500 0 0.1 0.2 Fixed Fraction

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0 0.3 0.4

DD at P=95%

2500

80

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Money Management Stops

Lesson from fixed fractional trading: a
money management stop defines the trade risk, which enables more precise position sizing. How do we choose the size of the money management stop? One approach: volatility.
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Money Management Stops (cont.)

ATR Volatility - E-mini S&P 500 60 50 40 30 20 10 0 9/1/97 9/1/98 9/1/99 8/31/00 8/31/01
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10-day ATR

Money Management Stops (cont.)

Distribution of ATR, E-mini S&P
200 180 160 140 120 100 80 60 40 20 0 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 10-day ATR
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Money Management Stops (cont.)

Cumulative ATR Distr - ES 100 90 80 70

% of Total

60 50 40 30 20 10 0

12

16

20

24

28

32

36

40

44

48

10-day ATR

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46

Money Management Stops (cont.)

ATR Volatility - E-mini Nasdaq 400 350 300

10-day ATR

250 200 150 100 50 0

6/30/99 12/30/99 6/30/00 12/30/00 7/1/01 12/31/01
47 Copyright 2002 Breakout Futures

Money Management Stops (cont.)

Distribution of ATR, E-mini Nasdaq 60 50 40 30 20 10 0

0 28

35

55

75

95

11

13

15

17

19

21

24

Average True Range

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Trailing Stops
Some ideas for trailing stops: Try basing the size of the stop on volatility, as suggested for money management stops, but use a smaller value. Try tightening the stop sharply after a big move in your favor (but not before). If the trailing stop is tighter than the mm stop, wait until the market has moved in your favor by some multiple of the ATR before applying the trailing stop.
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Performance Measures
Problem: If you simulate trading with
position sizing, how does this affect performance measurements? Short answer: Dont rely on the TradeStation performance summary.

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Performance Measures (cont.)

If given in dollars, some performance statistics could be skewed by the higher equity and larger number of contracts at the end of the equity curve:
Average Trade Win/Loss ratio

Largest Win
Largest Loss

Max Drawdown
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Performance Measures (cont.)

Solution: Calculate equity-dependent
performance statistics by recording the trade profit/loss as a percentage of the equity at the time the trade is entered. Consider my FixedRisk and MonteCarlo EasyLanguage user functions

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Performance Measures (cont.)

* MM ANALYSIS: PERFORMANCE OF HISTORICAL SEQUENCE * NQ_0_V0B.CSV (Daily Data), 4/19/2002 TRADING PARAMETERS: Initial Account Equity: $50000.00 Position Sizing Method: Fixed Fractional Risk Percentage (fixed fraction): 4.00% PERFORMANCE RESULTS: Error Code: 0 Total Net Profit: $119572.00 Gross Profit: $319002.00 Gross Loss: $-199430.00 Profit Factor: 1.60 Final Account Equity: $169572.00
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Performance Measures (cont.)

Number of Trades: 103 Number Winning Trades: 51 Number Losing Trades: 52 Number Skipped Trades (# contracts=0): 0 Percent Profitable: 49.51% Largest Winning Trade (%): 16.02% ($9400.00) Largest Winning Trade ($): $24400.00 (14.54%) Average Winning Trade (%): 5.85% Average Winning Trade ($): $6254.94 Max # Consecutive Wins: 5 Largest Losing Trade (%): -6.77% ($-12805.00) Largest Losing Trade ($): $-12805.00 (-6.77%) Average Losing Trade (%): -3.10% Average Losing Trade ($): $-3835.19 Max # Consecutive Losses: 5
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Performance Measures (cont.)

Ratio Avg Win(%)/Avg Loss(%): 1.89 Ratio Avg Win($)/Avg Loss($): 1.63 Average % Trade: 1.33% Average $ Trade: $1160.90 Max # Contracts: 18 Avg # Contracts: 5
Max Closed Trade % Drawdown: 21.13% ($43351.40) Date of Max % Drawdown: 4/1/2002 Max Closed Trade $ Drawdown: $43351.40 (21.13%) Date of Max $ Drawdown: 4/1/2002 Return on Starting Equity: 239.14%

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Performance Measures (cont.)

* MM ANALYSIS: MONTE CARLO ANALYSIS * INPUT DATA: Initial Account Equity: $50000.00 Risk Percentage (fixed fraction): 4.00% Number of Trades: 103 Rate of Return Goal: 100.00% Drawdown Goal: 30.00% Probability Goal: 95.00% Number of Random Sequences: 1000

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Performance Measures (cont.)

OUTPUT/RESULTS: Error Code: 0 Average Rate of Return: 249.48% Average Final Account Equity: $174741.00 Probability of Reaching Return Goal: 100.00% Probability of Reaching Drawdown Goal: 85.10% Probability of Reaching Return and Drawdown Together: 85.10% Rate of Return at 95.00% Probability: 195.31% Drawdown at 95.00% Probability: 35.16%

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