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Stocks & Commodities V. 41:05 (8–12): Risk, Volatility, & Position Sizing by Alfred François Tagher

Copyright © Technical Analysis Inc. www.Traders.com

Stocks & Commodities V. 41:05 (8–12): Risk, Volatility, & Position Sizing by Alfred François Tagher
TRADING TECHNIQUES

Three Steps Closer To The Holy Grail

Risk, Volatility, & Position Sizing

This may be the insight you wish you had gotten when
you first started trading, and it’s something every
trader can benefit from. You can attain a positive skew
for your trade outcomes if you start with the correct
position size for each trade. Find out how.
trade, one must clearly distinguish between trade risk
and market volatility.
Trade risk and market volatility
Take the following proposition: a game in which every
time you win, you win $130, and every time you lose,

We
are living in an era of information you lose $100, and you have a 50% chance of winning
overload. From earnings announce- and a 50% chance of losing.
ments to earnings revisions and “al- Your starting equity is $300,000. Under these con-
ternative facts” or “fake news,” the ditions, how much would you bet per trade? Figure
trader who attempts to tackle the markets without a 1 shows the effect on equity as bet size per trade
well-thought-out plan is doomed to failure from the increases.
outset in large part due to the sheer abundance of The “percent of equity to trade” curve is calculated
information. as follows:
Here is a thought I’ll offer that could be an antidote
to your information overload: First trade loser:
Formula = Equity × (1 − % of equity)
Trading, when done correctly, should be boring
and repetitive. Second trade winner:
Formula = (First trade loser × % of equity + Payout
A well-thought out-plan needs a clearly defined set constant) + First trade loser
of rules, which can be applied repeatedly, across a
wide range of markets. Let us assume we decide to bet 20% of our equity
These rules must address the
following four points:

1. Where to enter a position

2. Where to exit with a profit
3. Where to exit with a loss
4. How much to bet.

I would like to focus on point

number 4, which for me is the
cornerstone of systematic trading.
MICROSOFT EXCEL

Bet sizing is often overlooked or

misunderstood by the novice trader
and at times by professionals as FIGURE 1: BET SIZE AND RISK PER TRADE. This graph displays the effect on equity as bet size per trade
well. To get the proper bet size per increases. You can see how a profitable betting strategy deteriorates as bet size per trade is increased.

by Alfred François Tagher

Copyright © Technical Analysis Inc. www.Traders.com

Stocks & Commodities V. 41:05 (8–12): Risk, Volatility, & Position Sizing by Alfred François Tagher

MULTICHARTS
FIGURE 2: IMPACT OF MARKET VOLATILITY ON RISK PER TRADE (LOW VOLATILITY). Here is an example of a low-volatility trade in corn. On 5/29/2018, a
trend-following system sold CN18 at 400.75 (the magenta dot toward the upper-right) with an initial stop-loss at 410.25. The trade risk in points is 9.50, the trade risk
in dollars is $475, giving us a risk per trade of $4,500. The histogram at the bottom is the range showing the market’s volatility. Given the low volatility level in the
market at this time, the calculation suggests a trade size of 9 lots.

per trade. The calculation is: experience, trading both trending and congestion markets.
This ensures that the trader will never blow out, but more
First trade loser: importantly, that he or she is indifferent to the outcome
$300,000 × (1 − 0.20) = $240,000 of any individual trade.
With starting equity of $300,000, say we decide, on the
Second trade winner: basis of the curve in Figure 1, to bet 1.5% of available equity
($240,000 × 0.20 × 1.3) + $240,000 = $302,400 per trade. This works out to $4,500 risk per trade.

Notice that the first trade is a loser and the second trade Market volatility
is a winner. The results are identical if you invert the Now let’s see how volatility impacts the equation with
winning and losing order. Figure 1 clearly shows how two recent trades.
a profitable betting strategy deteriorates as bet size per See Figure 2 for an example of a low-volatility trade. On
trade is increased. May 29, 2018, a trend-following system sold corn (CN18)
at 400.75 (the magenta dot toward the top-right in Figure
Risk per trade 2) with an initial stop-loss at 410.25.
Given this, the ideal percent to bet on any given trade is
anywhere between 1% and 2% of available equity—the left- Trade risk in points = 9.50
hand side of the curve, where the values are clustered. Big point value = $50
These percentages have been arrived at through personal Trade risk in dollars = 9.50 × $50 = $475
Risk per trade = $4,500

Therefore, at this level of volatility, we can trade

$4,500/$475 = 9.5 lots, rounded to 9 lots.
To get the proper bet size The indicator below price in Figure 2 is the range that
per trade, one must clearly shows the market’s volatility, where green represents up
distinguish between trade risk closes, and red represents down closes.
and market volatility. See Figure 3 for an example of a high-volatility trade.
On February 1, 2018, the same trend-following system
sold the Nasdaq emini (ENH18) at 6,887 (the magenta

Copyright © Technical Analysis Inc. www.Traders.com

Stocks & Commodities V. 41:05 (8–12): Risk, Volatility, & Position Sizing by Alfred François Tagher

FIGURE 3: IMPACT OF MARKET VOLATILITY ON RISK PER TRADE (HIGH VOLATILITY). Here is an example of a high-volatility trade in the Nasdaq emini. On
2/1/2018, the trend-following system sold ENH18 at 6,887 (the magenta dot toward the upper-right) with an initial stop-loss at 7,052. The trade risk in points is 165,
the trade risk in dollars is $3,300, giving us a risk per trade of $4,500. The histogram at the bottom is the price range showing the market’s volatility. Given the high
volatility level of this market at this time, the calculation suggests a trade size of 1 lot.

dot toward the top-right in Figure 3) with an

initial stop-loss at 7,052.

Trade risk in points = 165

Big point value = $20
Trade risk in dollars =
 165 × $20 = $3,300
Risk per trade = $4,500

Therefore, at this level of volatility, we can trade

$4,500/$3,300 = 1.3 lots, rounded to 1 lot.
The risk for the Nasdaq trade may seem quite
large, but this can often be the case if you trade
weekly bars and volatility increases.
These two examples clearly illustrate the
FIGURE 4: POSITIVE SKEW IN TRADE DISTRIBUTION. When position sizing is geared to market
impact of volatility on a given level of risk per volatility and risk per trade, then risk per trade is known and investing capital can be protected.
trade. Also, this bet sizing model is adaptive: In this sample of 98 trades, the trade distribution consists of some small winners and small losers,
As equity increases, so does bet size; if equity with a small advantage to the winners and with occasional big winners. There are no big losers. This
decreases, bet size will decrease as well. positive skew in the distribution of trade outcomes helps ensure a positive equity line over time.
This amounts to standardizing position siz-
ing across a broadly diversified basket of mar-
kets. What we are doing in effect is trading futures, ETFs,
and individual stocks as we would trade options, without
having to worry about time decay. Our risk is clearly
Our risk is clearly defined; our
defined; therefore, our downside is known in advance downside is known in advance and
and our upside, in theory, is unlimited. This is known as our upside, in theory, is unlimited.
positive skew. Figure 4 illustrates this phenomenon. This is known as positive skew.

Copyright © Technical Analysis Inc. www.Traders.com

Stocks & Commodities V. 41:05 (8–12): Risk, Volatility, & Position Sizing by Alfred François Tagher

Notice that there are no big losers. What may

and does occur is a string of small losers. The
“Pareto principle” is at work here, because you
can expect 80% of your profits to come from
20% of your trades.
Figure 4 illustrates good trading practice.
This is trading for the long run.
Figure 5 shows the results of trading a di-
versified basket of commodities and currencies
using the standardized position method. Again,
winners are given room to run, while losers
are cut short. These results are from January
2017 to mid-July 2018.

FIGURE 5: PROFIT & LOSS FOR SAMPLE TRADES USING POSITION-SIZING MODEL. This A practice trading strategy
shows the results of trading a diversified basket of commodities and currencies using the stan- Finally, Figure 6 provides EasyLanguage and
dardized position method. Winners are given room to run while losers are cut short. The results MultiCharts code for a simple Donchian trend-
are from January 2017 to mid-July 2018. following system. You can use this example
trading system to try applying the principles
outlined in this article.

Trade risk, market volatility,

FIGURE 6: CODING FOR A PRACTICE TRADING SYSTEM. Here is some code for a simple trading markets.
system that is based on breakouts in the Donchian channel. You can use the system to practice
applying the position-sizing principles discussed in this article.
Positive-skew trade distribution
Figure 4 shows a sample of 98 trades, where risk per trade
is set at 1.5% of available equity.
Most of the losers are in the $500 range while the winners
are left open-ended. This conforms to the trading adage
“cut your losses short and let your profits run.”
The trade distribution will consist of a number of small
winners and a number of small losers, with a small ad-
vantage to the winners and the occasional three or four
big winners that come along every year.
This bet sizing model is adaptive:
As equity increases, so does bet
size; if equity decreases, bet size
will decrease as well.
and position sizing
An understanding and correct implementation
of the relationship between risk, volatility, and
position sizing will empower the trader with
a valuable edge in today’s rough-and-tumble
May the trend be with you.
Alfred F Tagher is an independent trader with 32 years
of market experience. He is currently based in Austria.
He can be reached by email at fredtag@club-internet.fr.
The author wishes to thank Mark Ritchie for providing
a seminal “aha!” moment with his “percent of equity to
trade” chart.
The spreadsheet used for Figure 1 in this article is available
upon request from the author at fredtag@club-internet.fr.
Further reading
Crabel, Toby [1990]. Day Trading With Short Term Price
Patterns And Opening Range Breakout, Traders Presss.
Pardo, Robert [2008] The Evaluation And Optimization
Of Trading Systems, Wiley Trading.
Ritchie, Mark Andrew [2015]. My Trading Bible, Island
Lake Press.

Copyright © Technical Analysis Inc. www.Traders.com

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