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

Copyright 2002 Breakout Futures

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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

Copyright 2002 Breakout Futures

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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

Copyright 2002 Breakout Futures

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Methods that Don’t 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”).
Copyright 2002 Breakout Futures 5

The odds of the next trade being a win are not related to whether the last trade was a win or a loss.Why They Don’t Work • Martingale and equity curve methods assume • dependency between trades. Copyright 2002 Breakout Futures 6 • . you can’t determine the likelihood of the next trade being a win or a loss based on the previous trade. If trades are independent. trades are independent of each other. In most cases.

Attributable to Larry Williams. see The Definitive Guide to Futures Trading.5 plus the margin requirement. Add another contract only when the closed profits are equal to drawdown * 1. Volume II.Margin Plus Drawdown Sizing • The equity to trade one contract is the • • maximum historical drawdown multiplied by 1. Copyright 2002 Breakout Futures 7 .5 plus margin.

so drawdowns can be large. Theoretically safe but doesn’t reduce contracts in a drawdown.) • You always have enough money to handle the • • worst historical drawdown plus 50%. Doesn’t take the risk of each trade into account. • Copyright 2002 Breakout Futures 8 .Margin Plus Drawdown (cont. Designed so you only increase the number of contracts. never reduce.

) 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 9 .Margin Plus Drawdown (cont.

. Trade Risk = possible loss on trade ($) Copyright 2002 Breakout Futures 10 . Equity = account equity ($).Fixed Fractional Position Sizing • Risk the same fraction (“fixed fraction”) of the • account equity on each trade. 5%. Number of contracts: N = ff * Equity/|Trade Risk| where ff = fixed fraction.g. e.

Copyright 2002 Breakout Futures 11 . • Using a money management (mm) stop to define the trade risk may produce greater risk-adjusted returns than using the largest loss. largest historical loss.) • Trade risk may come from: – Estimate. Examples: n standard deviations of the trade distribution. – Size of money management stop.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 Copyright 2002 Breakout Futures .Fixed Fractional (cont.

more on that later… Copyright 2002 Breakout Futures 13 . • 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. regardless of the number of contracts.Observations on Fixed Fractional • As a percentage of account equity. the risk of each trade is the same.

) 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 Copyright 2002 Breakout Futures 14 .Fixed Fractional (cont.

delta: the profit per contract needed to increase the number of contracts by 1. 1999. regardless of account equity. Copyright 2002 Breakout Futures 15 .Fixed Ratio Position Sizing • Developed by Ryan Jones. John Wiley. see The • Based on a fixed parameter called the Trading Game. • Each contract contributes the same profit towards increasing the number of contracts.

) • Number of contracts: N = ½ *[ 1 + (1 + 8 * Profit/delta) ] where Profit = total closed trade profit ($). 1/2 Copyright 2002 Breakout Futures 16 . delta = profit/contract to increase by 1 contract ($).Fixed Ratio (cont.

Contracts 15 Fix Frac Fix Ratio 10 5 0 0 5 10 15 Trade 20 25 30 Copyright 2002 Breakout Futures 17 .Fixed Ratio (cont.) 25 20 No.

Fixed Ratio (cont. Contracts 15 Fixed Frac Fixed Ratio 10 5 0 0 30.) 25 20 No.000 Profit Copyright 2002 Breakout Futures 18 90.000 .000 60.000 120.

account size. It becomes more conservative as the account size increases. i. • Doesn’t directly depend on trade risk. Copyright 2002 Breakout Futures 19 ..Observations on Fixed Ratio • Performance depends on total accumulated profits.e.

m >= 0. m • With m = ½. N: N = ½ *[ 1 + (1 + 8 * Profit/delta) ] where Profit = total closed trade profit ($). we get the fixed ratio equation. delta = fixed ratio parameter ($).A More Generalized Approach • Consider the following equation for the number of contracts. Copyright 2002 Breakout Futures 20 .

Copyright 2002 Breakout Futures 21 .e.) • Consider m = 0: N = ½ *[ 1 + (1 + 8 * Profit/delta) ] = 1/2 * [1 + 1] =1 0 i.A Generalized Approach (cont.. we get fixed contract trading (N = 1).

the equation for fixed fractional trading) Copyright 2002 Breakout Futures 22 1 .) • Consider m = 1: N = ½ *[ 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.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..g. m > 1  N increases faster as equity grows..A Generalized Approach (cont. Copyright 2002 Breakout Futures 23 .g. m < 1  N increases more slowly as equity grows. e. fixed fraction. e. fixed ratio.

A Generalized Approach (cont.5 Copyright 2002 Breakout Futures 24 .5 m=1.0 m=1.) 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 Copyright 2002 Breakout Futures 25 .A Generalized Approach (cont.0 m=1.) 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.

However. there is probably an optimal value of m. For any sequence of trades. m >= 1 works best when biggest run-up comes late.Conclusions From Generalized Approach • m < 1 works best when worst drawdowns come • • late. (Monte Carlo analysis to find the best m?) Copyright 2002 Breakout Futures 26 . the sequence of trades and drawdowns/run-ups is unknown.

• “Optimal f”: Ralph Vince. July. 1998. February. e. TASC. Copyright 2002 Breakout Futures 27 ..Finding the Best Fixed Fraction • Ad hoc. TASC. • “Secure f”: Leo Zamansky & David Stendahl. 2% rule. 1990.g. Portfolio Management Formulas. 2001. • Monte Carlo simulation: Bryant.

) Optimal f: • f value that mathematically maximizes the compounded rate of return. • Doesn’t take the drawdown into account.Best Fixed Fraction (cont. Copyright 2002 Breakout Futures 28 . • Theoretically sound but not practical to trade. • Typically results in very large – and dangerous – f values.

.) Secure f: • f value that maximizes the compounded rate of return subject to a limit on the maximum drawdown.g. e. “what f value gives the greatest rate of return without exceeding 30% drawdown?” • Improvement on optimal f. Copyright 2002 Breakout Futures 29 .Best Fixed Fraction (cont. • Only problem: the drawdown calculated from the historical sequence of trades is not very reliable.

Best Fixed Fraction (cont.3% 45000 35000 25000 15000 12/31/97 12/31/98 12/31/99 12/30/00 12/30/01 30 Copyright 2002 Breakout Futures .) 85000 75000 65000 Equity 55000 DD=9.

) 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.

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=25.

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 .) 85000 75000 65000 Equity 55000 DD=37.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.

2% Copyright 2002 Breakout Futures 35 .6% DD=46.3% Equity 55000 45000 35000 25000 15000 12/31/97 12/31/98 12/31/99 12/30/00 12/30/01 DD=16.Best Fixed Fraction (cont.6% DD=37.) 85000 75000 65000 DD=9.7% DD=25.

• Find the fixed fraction that maximizes the RoR of the historical sequence with no more than 30% drawdown  f = 8.Best Fixed Fraction (cont. One result: max drawdown = 76%! Copyright 2002 Breakout Futures 36 .2% on some randomized sequences of the original trades.2% • Try f=8.) • Historical sequence: 14% max drawdown on 2 contracts. starting with $50k.

) 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 Copyright 2002 Breakout Futures 37 .Best Fixed Fraction (cont.

• Output of simulation is a distribution. • Can be used to find the “best” fixed fraction by replacing the trade with the distribution of trades. • Distributions are randomly sampled many times. Copyright 2002 Breakout Futures 38 .Best Fixed Fraction (cont.) Monte Carlo Simulation: • Replaces random variables in a simulation with their probability distributions.

) Distribution of Profit/Loss 25 20 15 10 5 0 0 10 00 20 00 30 00 40 00 50 00 -3 00 0 -2 00 0 -1 00 0 Trade P/L Copyright 2002 Breakout Futures 39 60 00 .Best Fixed Fraction (cont.

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.) Applying Monte Carlo to Fixed Fractional Trading: • Randomize the sequence of trades. and. Copyright 2002 Breakout Futures 40 . • Find the f value that maximizes the return at 95% confidence while keeping the drawdown at 95% confidence below your drawdown limit. • The return at 95% confidence is the return such that 95% of sequences return at least that much.Best Fixed Fraction (cont.

1 200 0 0.04 0.Best Fixed Fraction (cont.08 0.) 120 100 1600 1400 1200 1000 800 600 400 20 0 0 0.12 60 40 Fixed Fraction Copyright 2002 Breakout Futures Ave RoR (%) P (40% DD) 80 41 .06 0.02 0.

) 4000 3500 100 3000 120 RoR at P=95% 2000 60 1500 1000 500 20 0 -500 0 0.2 Fixed Fraction Copyright 2002 Breakout Futures 40 0 0.4 DD at P=95% 2500 80 42 .1 0.3 0.Best Fixed Fraction (cont.

which enables more precise position sizing. • How do we choose the size of the money management stop? One approach: volatility.Money Management Stops • Lesson from fixed fractional trading: a money management stop defines the trade risk. Copyright 2002 Breakout Futures 43 .

) ATR Volatility .Money Management Stops (cont.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 44 Copyright 2002 Breakout Futures 10-day ATR .

Money Management Stops (cont. 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 Copyright 2002 Breakout Futures 45 .) Distribution of ATR.

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 Copyright 2002 Breakout Futures 52 46 .) Cumulative ATR Distr .Money Management Stops (cont.

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 .) ATR Volatility .Money Management Stops (cont.

Money Management Stops (cont.) Distribution of ATR. E-mini Nasdaq 60 50 40 30 20 10 0 5 5 5 5 5 5 0 0 28 35 55 75 95 11 13 15 17 19 21 24 Average True Range Copyright 2002 Breakout Futures 48 32 0 .

Trailing Stops Some ideas for trailing stops: • Try basing the size of the stop on volatility. • Try tightening the stop sharply after a big move in your favor (but not before). as suggested for money management stops. but use a smaller value. wait until the market has moved in your favor by some multiple of the ATR before applying the trailing stop. Copyright 2002 Breakout Futures 49 . • If the trailing stop is tighter than the mm stop.

how does this affect performance measurements? • Short answer: Don’t rely on the TradeStation performance summary.Performance Measures • Problem: If you simulate trading with position sizing. Copyright 2002 Breakout Futures 50 .

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 Copyright 2002 Breakout Futures 51 .) If given in dollars.Performance Measures (cont.

• Consider my FixedRisk and MonteCarlo EasyLanguage user functions… Copyright 2002 Breakout Futures 52 .) • 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.Performance Measures (cont.

00% PERFORMANCE RESULTS: Error Code: 0 Total Net Profit: $119572.) * MM ANALYSIS: PERFORMANCE OF HISTORICAL SEQUENCE * NQ_0_V0B.60 Final Account Equity: $169572.Performance Measures (cont. 4/19/2002 TRADING PARAMETERS: Initial Account Equity: $50000.00 Position Sizing Method: Fixed Fractional Risk Percentage (fixed fraction): 4.CSV (Daily Data).00 Profit Factor: 1.00 Gross Loss: $-199430.00 Gross Profit: $319002.00 Copyright 2002 Breakout Futures 53 .

00) Largest Losing Trade ($): $-12805.19 Max # Consecutive Losses: 5 Copyright 2002 Breakout Futures 54 .77%) Average Losing Trade (%): -3.94 Max # Consecutive Wins: 5 Largest Losing Trade (%): -6.00 (14.00 (-6.10% Average Losing Trade ($): $-3835.) Number of Trades: 103 Number Winning Trades: 51 Number Losing Trades: 52 Number Skipped Trades (# contracts=0): 0 Percent Profitable: 49.02% ($9400.Performance Measures (cont.77% ($-12805.54%) Average Winning Trade (%): 5.85% Average Winning Trade ($): $6254.51% Largest Winning Trade (%): 16.00) Largest Winning Trade ($): $24400.

90 Max # Contracts: 18 Avg # Contracts: 5 Max Closed Trade % Drawdown: 21.13%) Date of Max $ Drawdown: 4/1/2002 Return on Starting Equity: 239.33% Average $ Trade: $1160.14% Copyright 2002 Breakout Futures 55 .) Ratio Avg Win(%)/Avg Loss(%): 1.13% ($43351.Performance Measures (cont.40) Date of Max % Drawdown: 4/1/2002 Max Closed Trade $ Drawdown: $43351.63 Average % Trade: 1.40 (21.89 Ratio Avg Win($)/Avg Loss($): 1.

) * MM ANALYSIS: MONTE CARLO ANALYSIS * INPUT DATA: Initial Account Equity: $50000.Performance Measures (cont.00% Drawdown Goal: 30.00 Risk Percentage (fixed fraction): 4.00% Number of Trades: 103 Rate of Return Goal: 100.00% Probability Goal: 95.00% Number of Random Sequences: 1000 Copyright 2002 Breakout Futures 56 .

48% Average Final Account Equity: $174741.00% Probability of Reaching Drawdown Goal: 85.31% Drawdown at 95.) OUTPUT/RESULTS: Error Code: 0 Average Rate of Return: 249.10% Rate of Return at 95.00% Probability: 195.00% Probability: 35.Performance Measures (cont.10% Probability of Reaching Return and Drawdown Together: 85.00 Probability of Reaching Return Goal: 100.16% Copyright 2002 Breakout Futures 57 .