by Tyler Craig | November 4, 2011 10:27 am
Position sizing is a subject that many traders ignore at their own peril, especially when it comes to establishing an options position, given the incredible power of leverage that comes with it.
When you are examining your wins and losses, don’t forget to take into account the size of the trades in question and, well, leverage them accordingly in your analysis.
The views toward position sizing largely fall into two schools of thought. You might risk a fixed percentage or dollar amount in each trade, regardless of circumstance. Or, you might adopt more of a variable approach by adjusting the amount of money at risk based on your conviction levels about a trade’s potential success.
In the event that market conditions are favorable, if you’re in the latter camp you may up the ante and allocate more to a position in hopes of better exploiting the trade setup. When bipolar conditions arise and the difficulty level heightens, you may dial back by risking less per trade.
Both methods have their own individual merits, but let’s make the case for the former approach.
First, we must acknowledge the random nature of outcomes. Over the course of your next 50 trades, there will be a random distribution between winners and losers.
While you may be confident that your trading approach should produce a 60% win rate, you never know beforehand which trades will end up being the winners and which will be the losers. And, if you did, well then you’d have a 100% win rate, wouldn’t you?
Generating consistent results, then, necessitates that you risk a similar amount per position … and not make bigger bets than you’d normally be comfortable making.
Allowing conviction to enter the equation can threaten the consistency of your results. Upsetting the consistency cart then puts into question the effectiveness of your overall plan.
Suppose you normally risk $100 per trade, but you afford yourself the discretion to increase the risk to $200 when conviction levels are high and to decrease your risk to $50 per trade when conviction levels are low.
In the event your forecasting skills fall woefully short, you may end up losing on the trades with more risk while winning on the trades with less risk. Thus, though you may still win 60% as expected, your results will be much less profitable than expected.
Welcome to the slippery slope of the variable approach!
While I don’t discount the fact that there are assuredly some traders who have success with regularly modifying position sizing in correlation with conviction, so far it’s not for me.
Though my stealth is usually sufficient to steal one or maybe two cookies from the cookie jar, as soon as greed sets in and I go for five, I undoubtedly get caught.
Accept the randomness, trust your edge over time, and don’t convince yourself this one’s a sure thing.
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