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Back To The Basics
87

For the past few months I have seen a quite a jump in new subscribers which of course is quite positive from a business perspective – the more the merrier. However this slightly changes the dynamics in the comment section and on the blog as an influx of noobs means a more mixed bag of trading skills. That’s however not necessarily a bad thing as even old timers may benefit from the occasional refresher on some of the basics. We all have a tendency of falling into our own habits and I believe getting rattled out of your comfort zone on a regular basis is a good thing. So, based on pertinent commentary over the weekend I decided to cover a rather important subject matter – position sizing! Yes, one often ignored but essential piece to the puzzle of becoming a profitable trader.

Most likely you have already heard of the 2 percent rule as a basic tenet of risk management. Even if the odds are stacked in your favor it is inadvisable to risk a large portion of your capital on a single trade.

Larry Hite, in Jack Schwager’s Market Wizards, mentions two lessons learned from a friend:

  1. Never bet your lifestyle — never risk a large chunk of your capital on a single trade; and
  2. Always know what the worst possible outcome is.

The latter has become my personal prime directive. Hite goes on to describe his 1 percent rule which he applies to a wide range of markets. This has since been adapted by short-term equity traders as the 2 percent rule, which basically implies that you should never risk more than 2 percent of your capital on any one position.

So here’s is the traditional way of calculating your position size:

Position size = 2% of your account / stop size * dollars per point

Example: SPDR
Symbol: SPY
Exchange: NYSE
Point Size: 1$ per point (Moves roughly approximates 1/10th of the price of the SPX)

Account size: $100,000
Stop size: 3 points

Position size = 0.02 x $100,0000 / 1 * 3 = 666 shares (clearly evil and bent for market domination)

Which means that if 666 shares move 3 points against you then you will lose $3 per handle which is a haircut of roughly $2,000 (i.e. 2% of your capital). Or in other words – if you buy 666 shares @ $124 (the current quote) you pay $82,584 which is a good portion of your capital. Now if it drops to $121 per share next week (those 3 bucks you set as your stop) then your position is now worth $80,586 – a delta of $2000. Got it?

Now, I personally do it a bit differently using a method inspired by the old Turtle trend trading system:

Unit size = 2% of account / N * dollars per point

Since the turtles originally traded commodities let me show you a more complicated example, which also helps you define your unit sizes for various types of instruments. In the end it always simply boils down to how many dollars you earn/lose with each point move:

Example: Crude
Symbol: CL
Exchange: NYMEX
Contract Size: 1,000 U.S. barrels (42,000 gallons).
Contract Months: all months(Jan. – Dec.)
Price Quote: price per barrel. Ex $65.50 per barrel
Tick Size: $0.01 (1¢) per barrel ($10.00 per contract).

Account size: $1,000,000
Dollars per point: $1000 (100 hundred ticks at $10) – you can click on that.

So, before we get the formula let me define how we arrive at ‘N’ – which basically defines a contract’s (or stock’s) volatility:

There are many ways of how to define N but a very basic one is to simply slap an ‘average true range’ indicator on a daily chart. We can see that the ATR for crude right now hovers around 3.25. Obviously I am going to put my stop at or slightly below that. Great, now let’s plug that missing piece into our formula:

Unit size (that’s how the turtles call it) = 0.02 x $1,000,0000 / ~3.25 * 1000 = 6 contracts

So that is the risk I am limiting myself to – 2% of my capital. Now, if I want to be less risky and use 1% I can use 3 contracts instead.

This simple table shows you why capital preservation and thus capital commitment guidelines are of prime concern for any serious trader. Simply, excessive loss of trading capital means that it takes an increasing amount of returns to get back to where you started out from! If you lose 25% of your capital that means that you have to earn 33% to bounce back. A 50% loss (double that) however requires a return three times that – basically your job now is to double your money just to get back to break/even. Scary! And that does not even account for slippage, exchange/brokerage fees, data fees, etc.

Now you may understand why we rats are extremely disciplined when it comes to when, where, and how we execute our trades. Of course not all traders face the same success rate (or reliability as Van Tharp calls it in Trade Your Way to Financial Freedom). Short-term traders normally achieve higher success rates, while long-term traders generally achieve greater risk-reward ratios.

Success Rate (Reliability)

Your success rate is the number of winning trades expressed as a percentage of your total number of trades:

Success rate = winning trades / (winning trades + losing trades) * 100%

Risk-Reward Ratios

When it comes to assessing basic profitability of automated trading systems Van Tharp uses a similar formula:

Expectancy = (Success rate * average win) / (Failure rate * average loss)

Let’s say you executed 100 ES scalping trades – 60 were winners and 40 losers. The average win is around $5 ticks (i.e. $125)- the average loss based on your system is 8 ticks (i.e. $200). Thus your total wins are $7,500.- but your total losses outweigh at $8,000. Although your average hit rate is above 50% your system has an expectancy of 0.94, which means your system is expected to be losing money on average. You will have to find a smaller stop or find a way to ride out those winners.

Alright, that should keep you guys busy for a while. Let’s move on to my weekly perspectives – please step into my evil lair:
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Charts and commentary below for anyone donning a secret decoder ring. If you are interested in becoming a Gold member then don’t waste time and sign up here. And if you are a Zero or Geronimo subscriber it includes access to all Gold posts, so you actually get double the bang for your buck.
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I pointed out my CPCE Deluxe chart last week expecting some type of breach either way. Well, the line that gave way turned out to be the sell line, which may good timing in regards to seasonality – no matter which way you count the weeks – grumble mumble…. 😉

As the put/call ratio seems to be dropping (i.e. bullish sentiment is on the increase) it’s probably good to take a peek at our volatility indicators:

You probably recall my VXV:VIX chart (VXV representing three month volatility as opposed to front month only as expressed by the VIX). That steep push outside the upper Bollinger did lead to a small correction, which frankly was a bit weaker than I expected. All in all pretty bullish as we now have a rising and expanding BB bubble with plenty of upside potential.

Yes, I have been a busy bee and even spent some time updating my historical SKEW-VIX delta chart. Thus far I am not seeing any divergences plus we barely pushed into the neutral zone. No worries – it’s completely devoid of Romulans – but they seem to have a habit of becoming uncloaked when we start pushing into the red areas highlighted on the chart. But at the current time we are still lightyears away from that.

Since we’re on the topic I decided to go all the way and share with you a little side note on vanilla volatility as shown on the VIX. The orange box frames what I consider a ‘disturbance in the force’ (last sci-fi reference for the day) – a clear market dislocation and volatility literally went apeshit in a matter of days. You can basically hear millions of bulls scream in terror and then suddenly fall silent.

After that we continued to bounce around and that is to be expected as large moves in volatility usually cause reverberations. Now we just may (notice the weasel talk) enter a period of normalization, which however cannot be confirmed until we close back below the 100-day SMA, which not so coincidentally also ranges around the 30 mark right now. In case you are new or do not recall – the 30 mark has always been my bear/bull separation trend delineation mark.

Another positive sign on the horizon is observable on my SPXA200R chart (i.e. percentage of SPX symbols above their 200-day SMA). As you can see we peaked above the 30 mark, which is an important clue of potentially better times ahead. Of course it is possible that we push above and then drop below again, just like we did in 2008. That would be a pretty bearish event and it is something the longs need to fight tooth and nail to avoid from happening. I’m sure the Bernank will do his part.

Let’s poke around a bit more. Here I’m correlating JNK/TLT with the SPX – usually credit market traders are the ones to follow as they represent much larger assets and thus are on average better advised than those lowly equity traders (many of whom are retail schmucks like you and I). So we are looking out for divergences and I’m not seeing any at the current time.

Quick peek at the Dollar, which has been reversing quite hard in the past month. You may recall that I was wondering about a repeat of 2008 when we were forming that wedge on the very bottom. Thus far that analogy seems to be breaking down as the Dollar ramped without much of a downside response on the equity side. Based on the 2008 pattern we should be dropping hard by now and although seasonality does permit a late October dislocation the odds are now starting to firmly support the bullish camp.

Finally, the one ointment in my soup – let’s hope the spider on my bread will soon get it. Copper has been taking a few hard hits as of late and is not supporting the recent rally on the equity side. What gives? Frankly, I’m not sure but it’s making me a bit nervous. I would very much enjoy seeing it catch a bid in the near term future – let’s keep an eye on the 3.00 mark, which is rather crucial psychologically.
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Public Service Announcement:

I completed the refactoring of my TrendAlert indicator and it’s now working on a tick basis just as the Convict Down Under wanted it (actually it’s a 1-sec interval as that’s the market snapshot my data provider produces – it gets complicated). However, when manually comparing my 90-min window- 1-min – 75% treshold setting to Scott’s 45-min- 1-tick – 90% threshold setting mine seemed to do a bit better – at least in the past 30 days. So, to not to fall prey to recency bias I decided to turn it into a simple trading strategy later this week so that I can do some thorough back testing. I’ll report back once the results are in.

In the interim the TrendDay indicator will however run via Scott’s rules as they are obviously more conservative and every once in a while I try to act responsibly. I’ll test it on myself overnight and if everything works according to plan I’ll switch it on for all the subs on Tuesday or Wednesday.

Cheers,


About The Author
The Mole
Mole created Evil Speculator amidst the chaos of the financial crisis in early August of 2008. His vision for Evil Speculator is a refuge of reason, hands-on trading knowledge, and inspiration for traders of all ages and stripes. You can follow him and his nefarious schemes at various social media waterholes below.
  • Anonymous

    Great post as always

    I was infact reading Van Tharpe this weekend, and was a little confused confused c/o position size & position risk.
    For my simple mind, are we saying you should never place a trade with an capital outlay more than 2% or total account, or are we saying never with a risk (i.e. if stop-loss hit) of 2% total capital loss (i.e. trade outlay might be greater than 2% but tight stop so loss never more than 2% total account). And ‘R’=2% effectively

  • http://evilspeculator.com molecool

    If you read my post properly the example should answer this:

    “Which means that if 666 shares move 3 points against you then you will lose $3 per handle which is a haircut of roughly $2,000 (i.e. 2% of your capital). Or in other words – if you buy 666 shares @ $124 (the current quote) you pay $82,584 which is a good portion of your capital. Now if it drops to $121 per share next week (those 3 bucks you set as your stop) then your position is now worth $80,586 – a delta of $2000. Got it?”

    This is one of the most confused concepts when it comes to capital commitment guidelines. The 2% rule is NOT based on your capital, otherwise you would only be able to buy 16 shares of SPY (i.e. $124 * 16).

    Of course you CAN trade many more positions by using small percentages of your assets and then for instance use much more generous stops. For instance you may decide to reserve ‘unit’ to one particular market segment (e.g. commodities, bonds, stock, etc.). Also, using a 1% or 0.5% position size (relative to your max loss – not your capital) with much larger stops may work better for trend traders.

    Does this answer your question?

  • Anonymous

    Thanks. Hope my question helps others (or may be im the only one in remedial class!)

  • http://evilspeculator.com molecool

    Please reload – I just added a few thoughts.

  • http://twitter.com/nogreedorfear nogreedorfear

    put simply  – your loss per trade should always be restricted a maximum of to 2% of your account.

  • http://twitter.com/nogreedorfear nogreedorfear

    yes, i will keep it in mind going forward I think..

  • http://twitter.com/nogreedorfear nogreedorfear

    futures seem to be buy buy for short term..

  • http://evilspeculator.com molecool

    Exactly – I think the best way to put it is that the rules do NOT state that you should only devote 2% of your assets to one position – they state that you should not risk more than 2% of your assets with each position.

  • Anonymous

    Thanks – cant see any difference yet , may be server lag!

    p.s. in the spy examle above, there is the assumption that you can buy 666 shares within $100,000 – another stock might cost more than $100,000 for 666 shares, even though your theoretical risk might still be 2% of 100,000 based on stops. (I suppose one has to choose trades as that fit with the total account size!)

  • http://twitter.com/nogreedorfear nogreedorfear

    one question still remains – How big one’s account be? what %age of one’s current net worth? 

    :)

  • Anonymous

    Futures down, Europe is melting, the world is ending (ok just kidding!)

  • http://twitter.com/nogreedorfear nogreedorfear

    2% of assets- I see. makes it quite clear now.

    thanks

  • Anonymous

    whatever you can afford to lose. i look at it as what i could afford to lose on an advertising investment for my business.

  • http://twitter.com/nogreedorfear nogreedorfear

    thats too subjective – and someone can screw up in thinking easily..

    so better to have figures ..

  • Anonymous

    well, staying under the SIPC insurance limit would probably be a good idea.

  • http://twitter.com/nogreedorfear nogreedorfear

    googling – SIPC insurance limit. 

  • Marcus Troyka

    The only problem I can see with that is that at smaller capital outlays, commissions become disproportionate to returns. So even if you make a modest gain you might still end up making a loss.

    For example: 10,000 *.02 = 200
    Given $10 commission, you would have to make a minimum of 5% on your position just to break even.

    Another strategy, outlined by the guy who coined the term “black swan”, involves using options and the fact that ‘black swan’ events occur in economics much more often than they do in physical statistics.

    He just buys up OTM calls and puts on a handful of things every month, and waits. Eventually the market will make a violent swing one way or the other and he banks a fortune exercising them. The tradeoff here is that you have to tolerate slowly bleeding to death in the interim.

  • http://evilspeculator.com molecool

    NOOOO! LOL :-)

  • http://evilspeculator.com molecool

    Yeah and since that book everyone continues to lose money betting on a recurrance.

  • Anonymous

    Interesting that /ES filled the gap and Euro has not been able to do so;)

  • http://twitter.com/nogreedorfear nogreedorfear

    Do you guys rely and check historical index charts? dow/spx -from 1900 ?

  • Anonymous

    Nice post! My two cents, if I may. For those that trade some weird stocks you may also want to factor in potential gap-ups or gap-downs. You would hate to see your losses as multiples of Rs! Hence, I trade futures (mostly emini) and I do not hold over the weekend. Unless, of course, it is a longer term trade, which are very rare for me. 

  • http://practicalt.blogspot.com/ Gold_Gerb

    AMC…GBP T completed.

    http://i54.tinypic.com/2lauiy1.png

    .8686

  • Anonymous

    Thank you very much I was trying myself later part of the day clicked and saved…

  • http://practicalt.blogspot.com/ Gold_Gerb

    Currencies….(sign me up)

    EUR/USD

    http://i55.tinypic.com/9766h3.jpg

  • Anonymous

    Been counting too?;)

  • http://practicalt.blogspot.com/ Gold_Gerb

    I don’t count waves.
    LOL.

  • Anonymous

    Counting that 1.39 resistance level;)

  • http://practicalt.blogspot.com/ Gold_Gerb

    1.3901 – can it slip any closer?

  • Anonymous

    Not much, lol……………did you notice it did not fill the gap from open as /ES did?

  • http://practicalt.blogspot.com/ Gold_Gerb

    no I did not.  any significance?
    my simple thought is it should close that gap.
    but last few hours are zagging up hill, similar to when Carrot called out the drop.

  • Anonymous

    Mole – thanks for the updates on all the charts.  Much appreciated.

  • Anonymous

    interesting 500 point squeeze in 1 minute on HKG33.

  • Anonymous

    Could be, ya here you go;)

  • http://twitter.com/nogreedorfear nogreedorfear

    buying orgy before next turn…

  • Anonymous

    you seem really biased toward the upside.

  • Anonymous

    ZFX looks to be down.

  • http://twitter.com/nogreedorfear nogreedorfear

    u cud have waited 25 mins and seen..:)

    just kidding…but yeah it’s up for a day or two…but i am not trading it…

  • Anonymous

    why not? always money to be made.

  • http://practicalt.blogspot.com/ Gold_Gerb

    AUD/JPY – we have liftoff out of the triangle pattern.

  • http://twitter.com/nogreedorfear nogreedorfear

    personal commitments..

  • http://practicalt.blogspot.com/ Gold_Gerb

    oh, one more thing.
    High Pole MOle Reversal Warning on AAPL P&F chart from the 19th.

    Support Around $260

    Ciao.

  • http://evilspeculator.com molecool

    I would disagree….

  • http://twitter.com/nogreedorfear nogreedorfear

    whats ur blog? 

  • Anonymous

    noticed some people on other blogs going crazy with AAPL calls lately. :)

  • Anonymous

    just give me some god damn 750-775 Russell so I can fucking dose up on the bearoin already, and I pinky swear it won’t be 2%

  • Anonymous

    NQ isn’t following ES, which isn’t following YM…

  • http://twitter.com/nogreedorfear nogreedorfear

    ..

  • http://profiles.yahoo.com/u/6NFOSGRXKB4LMGOAXV3ZY6IWZA Grainman

    Action picking up….selling 2 ES 1239 for a ride lower

  • Anonymous

    Just klick on name:)

  • http://twitter.com/nogreedorfear nogreedorfear

    oh thx!

  • Anonymous

    those are all hippy children who will smoke up, puke on the floor, & then drag their hairy asses off the floor, get in line, and obey,, as soon as papa Russell cuts off their allowance. Also Dr.C says long. until she doesn’t.

  • Anonymous

    yea, russell lagging all of the above.

  • http://profiles.yahoo.com/u/6NFOSGRXKB4LMGOAXV3ZY6IWZA Grainman

    buying 1 @1237 and 1239 stop on other

  • Anonymous

    http://content.screencast.com/users/AMCabrera/folders/Jing/media/3d940bc6-ee98-4ae2-abcb-88f7094213df/2011-10-24_0515.png
    ok im going to start off with this because it puts me in a good mood but hope no falls for this. Zeroedge and many other places state what hedge fund managers say. HEDGE FUND MANAGERS! Ok lets put it this way would you trust this guy with your wife/kids….

  • volar

    very good point. gaps are a big difference btwn actual risk and expected risk

  • Anonymous

    http://content.screencast.com/users/AMCabrera/folders/Jing/media/32131f86-ef88-4dd8-a772-115ca78cc7ca/2011-10-24_0822.png
    . So ill just wait nice and patiently and not be a liquidity provider, aka ultra short term trades. Nice volatility for those who like surfing but Im scared of the great whites in the water. 😉

  • http://practicalt.blogspot.com/ Gold_Gerb
  • Anonymous

    If you reach for the stars, then the stars can be yours. Long or short??
    Futures have broken above aug 31st high

  • Schwerepunkt

    Euro going the other way for last 30-min. Non-confirm?

  • http://practicalt.blogspot.com/ Gold_Gerb

    long to 1260, but I’m not playing.

    http://screencast.com/t/kqutUeLwmJv

  • Anonymous

    These things seem to go up & down!

  • Anonymous

    Im long DOWchem & a UK bank, need to be careful might take profits

  • Schwerepunkt

    CAD toying with parity again. Probably a good pair to watch for risk-on/off signals, along with AUD, of course.

  • http://practicalt.blogspot.com/ Gold_Gerb

    SPX – 1245
    the faster and sharper this rise today – the better chance it’s an end-of-a-T time frame.
    (no guarantees of a reversal, but better probability)

  • Anonymous

    Pulling the trigger as Zero has pointed out! Picked up some SPY puts for the day;)

  • Anonymous

    Copper going up finally

  • Anonymous

    While EURUSD going down. Going all in short now.

  • Anonymous

    lol not nearly as good looking as me. but it could be said it was the way I was setup on August 3….

  • http://twitter.com/nogreedorfear nogreedorfear

    equity put/call after 30 mins of open – 0.38!

  • http://twitter.com/nogreedorfear nogreedorfear

  • Anonymous

    hahahaha

  • Anonymous
  • Anonymous
  • http://twitter.com/nogreedorfear nogreedorfear

    whats that?

  • Anonymous

    Think we still have a B class divergence;)

  • http://practicalt.blogspot.com/ Gold_Gerb
  • Anonymous

    B Class?

  • Anonymous

    Without divulging sub info, can anyone say trend day by $tick analysis?
    Anyway, stopped out of longs – they always seem to know where my stops are, before the market moves even more favourably!

  • volar

    nice

  • Anonymous

    Looking at the Zero you have equal positve spikes as prices rise;)

  • Anonymous

    Thanks. 

  • Anonymous

    Some sort of Battle of the Bulge at 1250spx. Who will win?

  • Anonymous

    You bet!

  • volar

    NEW POST

  • http://twitter.com/nogreedorfear nogreedorfear

    of course they know – market makers job..

  • Anonymous

    yea, looks like Russell & drC had the last laugh,, as usual. YWIA