WB 2239 WavAdv Position Sizing Choices Tradeoffs

Position sizing
Choices and tradeoffs
5 May 2015
Adam Grimes, CIO, Waverly Advisors
Outline
 Why does position sizing matter?
 Understand our decisions
– Why we make them
– What effect they have
 Common position sizing plans
– What are they?
– Are some better than others?
– Understand the tradeoffs
© 2015 Waverly Advisors, LLC. All rights reserved. This material may not be reproduced, stored, displayed, modified or distributed
without the express prior written permission of the copyright holder. For permission, contact adamhgrimes@gmail.com.
Position Sizing
 Answers the “how much to trade”
question.
 Trading systems usually tell us:
– Where to get in
– Where to get out
– What to do while in the trade
 But how much we trade (on each
position) matters.
Decisions
 Every decision we make adds degrees of
freedom
– This makes it harder to evaluate results
 Consistency matters, so must have a plan
and follow that plan.
– (Have we heard that before?)
 Generally speaking, we want to know
what we’re going to do before the
situation arises
Position Sizing Plans
 No plan
 Intuitive sizing
 Portfolio allocation
 Fixed unit / fixed dollar
 Fixed dollar risk
 Fixed fractional risk
 Volatility-aware methods
We’ll come back to these
 No plan
 Intuitive plan
Portfolio Theory
 Most of the finance world thinks in terms
of portfolio allocation, so we should start
here.
 Basic problem is this:
– Given a combination of assets, how do we
maximize return for a given amount of risk?
– Some assumptions are needed:
 Risk = standard deviation of returns
 Assumptions regarding returns and correlations are also needed
Modern Portfolio Theory
 Assume that we will be building portfolios from
various assets.
 Different combinations of assets will produce
different portfolio returns and standard deviations.
 Given the assumptions used as inputs, the only
thing the allocator needs to worry about is the
percentage of the portfolio in each asset.
 Therefore, most of the world thinks in terms of a
% of capital allocated to each position.
Efficient Frontier
Source: Wikipedia commons
Portfolio-style Allocation
Pros Cons
 Well-documented and  Relies on assumptions, which
accepted by practitioners may or may not be good
 Math is well-defined and  Not designed for active trading
known  Does not assume you will be
getting in and out of positions
 For traders, the percentage
invested in each position may
be misleading
– Risk and volatility
– Style decisions
Fixed unit size
 Always trade same number of units
(shares, contracts) on each trade.
 Can be adjusted for different markets.
– Perhaps based on some assessment of risk?
 Often used by active traders
– Convenient
 Often used by beginning futures traders
– Contracts are large, so just trade one
– Are you undercapitalized?
Fixed Unit Plans
Pros Cons
 It’s simple  Prices and volatility can
vary greatly across assets.
 One unit may be vastly
different risks.
 Have to make decisions
about when to change sizes.
Fixed Dollar Plans
 Make a distinction between fixed dollar
invested and fixed dollar risk plans.
 Dollars invested is not that important
(maybe), but adjusts for contract size.
– I.e., you won’t trade one contract of copper and
also one of sugar.
 Discussion from here on concerns fixed
dollar risk.
Fixed Dollar Risk Plans
 Risk a fixed dollar amount on each trade
– Risk does not necessarily relate to amount invested
– Risk can be distance to stop or volatility measure
Model Trading System
 Wins 50% of the time
 Loses 50% of the time
 Wins are always 1.2 times the size of the
losses
 Wins and losses are always the same size
– No mistakes
– No slippage
– No surprises
 No frictions or costs or mistakes
 Is your system this predictable?
Model System Expectancy
 Expectancy:
Size of wins * win% + size of losses * loss%
(1.2 * 50%) + (-1 * 50%) = +0.1
 What does this mean?

– For every dollar risked, we win $0.10 (plus the
original dollar is returned).
 So what does this look like in practice?
Trading Example
 Start with $100,000
 Risk $2,000 per trade
 Execute 250 trades drawn from the
system
 We expect to end up with $150,000
Expected value * per trade risk * # of trades = ending
P&L
0.1 * $2000 * 250 = $50,000 profit
Hint: This is not how it works
Maybe like this
Or this
Or this?
50 Traders…
Stats for $2,000 Risk
from: The Art and Science of Technical Analysis (Wiley 2012), Grimes
Changing Risk Levels
 Because this is a simulation, we can
control what changes.
 Holding everything else the same, change
only the amount risked per trade.
– Will draw the same sequence of wins and losses
for each example, for each of 1,000 traders (graphs
show 50).
Stats for Different Risks
Aggressive Risk Levels
50 Traders: Different Risks
Fixed Dollar Risk
Pros Cons
 “Normalizes” each trade for  A static model, and you
risk have to make some
 Allows thinking in R- decisions about when to
multiples change.
– Are you trading $10,000 or
 Allows consistent (linear)
$1MM or $100MM?
equity growth
 Big jumps in trading size
can cause psychological
challenges
Fixed Fractional Risk Sizing
 The risk on each trade is set to a consistent
percentage of the portfolio
 Risk for each trade must be known in
advance
– Could this be adapted for fundamental methodologies?
– What if multiple entries?
 Define portfolio
– Closed trades?
– Net liquidating value?
Fixed Dollar vs. Fixed Fractional
Different Fixed Fractionals
“You Can’t ‘Go Broke’”?
 One of the (incorrect) arguments in favor
of fixed fractional approaches is that you
cannot lose all your money.
 You are risking less as you have less, so
you can’t get to zero.
 Theoretically true, but 99.999%
drawdowns are possible.
Fixed Fractional Risks
Fixed Fractional Risks
Pros Cons
 Allows for geometric  Can be disconnects between
account growth theory and psychology
 Allows for easy switching reality
between different size  Requires discipline
accounts
– There are psychological issues
 Easy to calculate and
implement
 Consistent
 Mathematically sound
Optimized Plans
 There are formulas that will tell you how
to maximize ending value (wealth) given
the characteristics of a trading system.
 Essentially, will give the fixed fraction to
risk, to maximize ending value.
 Note that these are optimized approaches,
and tend to be quite aggressive. (They
care where you end up, not the path you
take to get there!)
Kelly Criterion
Optimized Approaches (Cheat Sheet)
 All of these models come with important
assumptions. E.g.:
– Trade returns are independent of each other
– Future will look like the past
– There is not a larger loss in the future than in the
backtest
 If any of these assumptions are violated,
bad things may happen.
– They are violated frequently in real market data!
Optimized Approaches
 Kelly gives the “knife’s edge” maximum
amount to risk.
– The idea is that taking more risk increases chance of
both good and bad things happening.
– Risk more than Kelly, and you dramatically increase
the chance of bad things happening.
– Risk less, and you give up volatility faster than you
give up return.
 E.g., risking 50% (Half Kelly) reduces
volatility by 50% but growth by only 25%.
Kelly Risk Amount
Optimized Approaches
Pros Cons
 Mathematically sound  Optimized means you are at
– But understand assumptions the very edge of what is
 Gives the optimal amount to advisable
risk  Dangerous if assumptions
 Can be adapted to reduce don’t hold.
volatility  Too volatile in practice for
most traders
Volatility-aware Approaches
 Several ways to do this, but the core idea
is you take larger positions in less volatile
markets.
 Modern portfolio theory is one
implementation of this idea.
 Be clear on these two distinctions:
– Setting stops according to volatility
– Sizing positions (in portfolio) according to
volatility
Volatility-aware sizing
 Seeks to normalize the daily contribution
of each market to the portfolio’s P&L.
 Example:
– Calculate average true range (ATR) for each
market
– DollarVolatility = ATR * Dollars per point
(futures)
– Size = % of account / DollarVolatility
– How many units to make average daily swing = a
percentage of account equity?
Possible Issues
 Volatility changes
– How often to recalculate?
– Volatility compression can be dangerous
 Taking large positions just as volatility ready to explode
 Are we using a range measure to create a

close to close calculation?
 Correlations can be dangerous.
– And correlations change
 Can be used without a stop
The Biggest Issue
 Understand what you are trying to do
with any of these measures, and only mix
if it makes sense.
 Daily volatility may or may not equal
trade risk.
– Using volatility sizing with stops might not make
sense.
Changing Sizes
 Many traders trade more on some trades than
other trades.
– Does this make sense?
– Might the best behavioral answer be different than the
optimal mathematical answer?
– If you do this, you need proof that your changes are
helping!
 Intuitive sizing probably also reflects
volatility and risk in some way.
– Humans may understand risk in ways models do not.
Position Sizing Plans
 No plan
 Intuitive sizing
 Portfolio allocation
 Fixed unit
 Fixed dollar risk
 Fixed fractional risk
 Volatility-aware methods
An Important Misconception
 Money management is not an edge.
 Money management can not turn a negative
expectancy system into a positive expectancy
system.
 At best, money management will help you
lose money more slowly.
 To make money in the market, you must have
an edge.
 Money management is not an edge!
Summary
 Answering “how much” is as important as
the “when” and “how” questions of trading.
 Consistency and discipline matter.
 The market is noisy and maybe less
predictable than we think.
– Be careful of assumptions.
 Most active traders find value in a fixed
fractional risk approach.
 Must be tailored to your own situation and
psychology.
My Blog
http://adamhgrimes.com/blog/
© 2014 by Waverly Advisors, LLC. All rights reserved. No part of this document may be reproduced or transmitted in any form or
by any means without the express written consent of Waverly Advisors.
Waverly Advisors’ Research
 Specific systems, broad tendencies, and
actionable ideas in major liquid markets.
– Futures
– Currencies
– Stocks (indexes and individual names)
 Both trend-following and counter-trend
 Applicable to traders working on all
timeframes.
Waverly Advisors, LLC:
Research Products
Tactical Playbook – Available on Interactive Brokers
– Written for the active trader on the daily/weekly
timeframes
Tactical Portfolio Outlook – Available on Interactive
Brokers
– Written for the longer-term manager
Options Market Outlook – Contact Waverly Directly
– Proprietary, quantitative analysis of options market
– Incorporates both volatility and directional analysis
Adam Grimes
Managing Partner, Chief Investment Officer
grimes@waverlyadvisors.com
Chris Noye
Managing Partner
noye@waverlyadvisors.com
Waverly Advisors
5607 Pittsford-Palmyra Rd. 1034
Pittsford, NY 14534
(607) 684-5300
www.waverlyadvisors.com
info@waverlyadvisors.com

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Position sizing

Choices and tradeoffs

Source: Wikipedia commons

 What does this mean?

 Are we using a range measure to create a

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