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**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

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**Why They Don’t Work
**

• Martingale and equity curve methods assume

dependency between trades. • In most cases, trades are independent of each other. The odds of the next trade being a win are not related to whether the last trade was a win or a loss. • If trades are independent, you can’t determine the likelihood of the next trade being a win or a loss based on the previous trade.

Copyright ©2002 Breakout Futures

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**Margin Plus Drawdown Sizing
**

• The equity to trade one contract is the

maximum historical drawdown multiplied by 1.5 plus the margin requirement. • Add another contract only when the closed profits are equal to drawdown * 1.5 plus margin. • Attributable to Larry Williams; see The Definitive Guide to Futures Trading, Volume II.

Copyright ©2002 Breakout Futures 7

**Margin Plus Drawdown (cont.)
**

• You always have enough money to handle

the worst historical drawdown plus 50%. • Designed so you only increase the number of contracts, never reduce. • Theoretically safe but doesn’t reduce contracts in a drawdown, so drawdowns can be large. • Doesn’t take the risk of each trade into account.

Copyright ©2002 Breakout Futures 8

**Margin Plus Drawdown (cont.)
**

140000 120000 100000 Equity 80000 60000 40000 20000 0 12/31/97

1-Con Marg+DD

12/31/98

12/31/99

12/30/00

12/30/01

9

Copyright ©2002 Breakout Futures

**Fixed Fractional Position Sizing
**

• Risk the same fraction (“fixed fraction”) of

the account equity on each trade; e.g., 5%. • Number of contracts:

N = ff * Equity/|Trade Risk| where ff = fixed fraction, Equity = account equity ($), Trade Risk = possible loss on trade ($)

Copyright ©2002 Breakout Futures

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**Fixed Fractional (cont.)
**

• Trade risk may come from:

– Estimate. Examples: n standard deviations of the trade distribution; largest historical loss. – Size of money management stop.

• Using a money management (mm) stop

to define the trade risk may produce greater risk-adjusted returns than using the largest loss.

Copyright ©2002 Breakout Futures 11

**Fixed Fractional (cont.)
**

300000 250000 200000 150000 100000 50000 1/1/98 1/1/99 1/1/00 12/31/00 12/31/01

12

Equity

MM Stop Max Loss

Copyright ©2002 Breakout Futures

**Observations on Fixed Fractional
**

• As a percentage of account equity, the risk of

each trade is the same, regardless of the number of contracts. • 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; more on that later…

Copyright ©2002 Breakout Futures

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**Fixed Fractional (cont.)
**

140000 120000 100000 Equity 80000 60000 40000 20000 0 12/31/97 1-Con Marg+DD Fix Frac

12/31/98

12/31/99

12/30/00

12/30/01

14

Copyright ©2002 Breakout Futures

**Fixed Ratio Position Sizing
**

• Developed by Ryan Jones; see The Trading

Game, John Wiley, 1999. • Based on a fixed parameter called the delta: the profit per contract needed to increase the number of contracts by 1. • Each contract contributes the same profit towards increasing the number of contracts, regardless of account equity.

Copyright ©2002 Breakout Futures

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**Fixed Ratio (cont.)
**

• Number of contracts:

N = ½ *[ 1 + (1 + 8 * Profit/delta) ] where Profit = total closed trade profit ($), delta = profit/contract to increase by 1 contract ($).

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1 /2

**Fixed Ratio (cont.)
**

25 20 No. Contracts

15 Fix Frac Fix Ratio 10

5

0 0 5 10 15 Trade 20 25 30

Copyright ©2002 Breakout Futures

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**Fixed Ratio (cont.)
**

25 20 No. Contracts

15 Fixed Frac Fixed Ratio 10

5

**0 0 30,000 60,000 Profit
**

Copyright ©2002 Breakout Futures 18

90,000

120,000

**Observations on Fixed Ratio
**

• Performance depends on total

accumulated profits; i.e., account size. It becomes more conservative as the account size increases. • Doesn’t directly depend on trade risk.

Copyright ©2002 Breakout Futures

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**A More Generalized Approach
**

• Consider the following equation for the number

of contracts, N:

N = ½ *[ 1 + (1 + 8 * Profit/delta)m ] where Profit = total closed trade profit ($), delta = fixed ratio parameter ($), m >= 0.

m

**• With m = ½, we get the fixed ratio equation.
**

Copyright ©2002 Breakout Futures 20

**A Generalized Approach (cont.)
**

• Consider m = 0:

N = ½ *[ 1 + (1 + 8 * Profit/delta) ] = 1/2 * [1 + 1] =1 i.e., we get fixed contract trading (N = 1).

Copyright ©2002 Breakout Futures 21

0

**A Generalized Approach (cont.)
**

• Consider m = 1:

N = ½ *[ 1 + (1 + 8 * Profit/delta) 1 ] = 1 + 4 * Profit/delta Let delta = 4 * Risk/ff and Equity0 = Risk/ff. Then, N = (Equity0 + Profit) * ff/Risk (i.e., the equation for fixed fractional trading)

1

Copyright ©2002 Breakout Futures

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**A Generalized Approach (cont.)
**

• Rate of Change of N with Profit:

∂N/∂(Profit) = 4*m/delta * (1 + 8 * Profit/delta)m-1 N/ m = 1 ROC of N independent of profit; e.g., fixed fraction. m > 1 N increases faster as equity grows. m < 1 N increases more slowly as equity grows; e.g., fixed ratio.

Copyright ©2002 Breakout Futures 23

**A Generalized Approach (cont.)
**

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 m=1.0 m=1.5

Copyright ©2002 Breakout Futures

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**A Generalized Approach (cont.)
**

500000 425000 350000 Equity 275000 200000 125000 50000 12/31/98 12/31/99 12/30/00 12/30/01

m=0.5 m=1.0 m=1.5

Copyright ©2002 Breakout Futures

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**Conclusions From Generalized Approach
**

• m < 1 works best when worst drawdowns

come late. • m >= 1 works best when biggest run-up comes late. • For any sequence of trades, there is probably an optimal value of m. However, the sequence of trades and drawdowns/run-ups is unknown. (Monte Carlo analysis to find the best m?)

Copyright ©2002 Breakout Futures 26

**Finding the Best Fixed Fraction
**

• Ad hoc; e.g., 2% rule. • “Optimal f”: Ralph Vince, Portfolio

Management Formulas, 1990. • “Secure f”: Leo Zamansky & David Stendahl, TASC, July, 1998. • Monte Carlo simulation: Bryant, TASC, February, 2001.

Copyright ©2002 Breakout Futures 27

**Best Fixed Fraction (cont.)
**

Optimal f: • f value that mathematically maximizes the compounded rate of return. • Doesn’t take the drawdown into account. • Typically results in very large – and dangerous – f values. • Theoretically sound but not practical to trade.

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**Best Fixed Fraction (cont.)
**

Secure f: • f value that maximizes the compounded rate of return subject to a limit on the maximum drawdown; e.g., “what f value gives the greatest rate of return without exceeding 30% drawdown?” • Improvement on optimal f. • Only problem: the drawdown calculated from the historical sequence of trades is not very reliable.

Copyright ©2002 Breakout Futures 29

**Best Fixed Fraction (cont.)
**

85000 75000 65000 Equity 55000 DD=9.3% 45000 35000 25000 15000 12/31/97

12/31/98

12/31/99

12/30/00

12/30/01

30

Copyright ©2002 Breakout Futures

**Best Fixed Fraction (cont.)
**

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.)
**

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

32

Copyright ©2002 Breakout Futures

**Best Fixed Fraction (cont.)
**

85000 75000 65000 Equity 55000 DD=37.6% 45000 35000 25000 15000 12/31/97

12/31/98

12/31/99

12/30/00

12/30/01

33

Copyright ©2002 Breakout Futures

**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.)
**

85000 75000 65000 Equity 55000 45000 35000 25000 15000 12/31/97 DD=9.3% DD=16.7% DD=25.6% DD=37.6% DD=46.2%

12/31/98

12/31/99

12/30/00

12/30/01

35

Copyright ©2002 Breakout Futures

**Best Fixed Fraction (cont.)
**

• Historical sequence: 14% max drawdown

on 2 contracts, starting with $50k. • Find the fixed fraction that maximizes the RoR of the historical sequence with no more than 30% drawdown f = 8.2% • Try f=8.2% on some randomized sequences of the original trades. One result: max drawdown = 76%!

Copyright ©2002 Breakout Futures

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**Best Fixed Fraction (cont.)
**

800000 700000 600000 Equity 500000 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

Original Optimized Randomized

**Best Fixed Fraction (cont.)
**

Monte Carlo Simulation: • Replaces random variables in a simulation with their probability distributions. • Distributions are randomly sampled many times. • Output of simulation is a distribution. • Can be used to find the “best” fixed fraction by replacing the trade with the distribution of trades.

Copyright ©2002 Breakout Futures 38

**Best Fixed Fraction (cont.)
**

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 60 00

Trade P/L

Copyright ©2002 Breakout Futures 39

**Best Fixed Fraction (cont.)
**

Applying Monte Carlo to Fixed Fractional Trading: • Randomize the sequence of trades, and, 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. • The return at 95% confidence is the return such that 95% of sequences return at least that much. • Find the f value that maximizes the return at 95% confidence while keeping the drawdown at 95% confidence below your drawdown limit.

Copyright ©2002 Breakout Futures 40

**Best Fixed Fraction (cont.)
**

120 100 P (40% DD) 80 60 40 20 0 0 0.02 0.04 0.06 0.08 0.1 Fixed Fraction 1600 1400 1200 1000 800 600 400 200 0 0.12 Ave RoR (%)

Copyright ©2002 Breakout Futures

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**Best Fixed Fraction (cont.)
**

4000 3500 3000 RoR at P=95% 2500 2000 1500 1000 500 0 -500 0 0.1 0.2 Fixed Fraction

Copyright ©2002 Breakout Futures 42

120 100 DD at P=95% 80 60 40 20 0 0.3 0.4

**Money Management Stops
**

• Lesson from fixed fractional trading:

a money management stop defines the trade risk, which enables more precise position sizing. • How do we choose the size of the money management stop? One approach: volatility.

Copyright ©2002 Breakout Futures

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**Money Management Stops (cont.)
**

ATR Volatility - 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.)
**

Distribution of ATR, 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

**Money Management Stops (cont.)
**

Cumulative ATR Distr - ES 100 90 80 70 % of Total 60 50 40 30 20 10 0

12 16 20 24 28 32 36 40 44 48 52

10-day ATR Copyright ©2002 Breakout Futures 46

**Money Management Stops (cont.)
**

ATR Volatility - 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

**Money Management Stops (cont.)
**

60 50 40 30 20 10 0

5 5 5 5 5 0 5 35 55 75 95 11 13 15 17 19 21 24 28 0 32 0

Distribution of ATR, E-mini Nasdaq

**Average True Range
**

Copyright ©2002 Breakout Futures 48

Trailing Stops

Some ideas for trailing stops: • Try basing the size of the stop on volatility, as suggested for money management stops, but use a smaller value. • Try tightening the stop sharply after a big move in your favor (but not before). • If the trailing stop is tighter than the mm stop, 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

Performance Measures

• Problem: If you simulate trading with

position sizing, how does this affect performance measurements? • Short answer: Don’t rely on the TradeStation performance summary.

Copyright ©2002 Breakout Futures

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**Performance Measures (cont.)
**

If given in dollars, some performance statistics could be skewed by the higher equity and larger number of contracts at the end of the equity curve:

• Average Trade • Largest Win • Largest Loss

**• Win/Loss ratio • Max Drawdown
**

51

Copyright ©2002 Breakout Futures

**Performance Measures (cont.)
**

• 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. • Consider my FixedRisk and MonteCarlo EasyLanguage user functions…

Copyright ©2002 Breakout Futures

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**Performance Measures (cont.)
**

* MM ANALYSIS: PERFORMANCE OF HISTORICAL SEQUENCE * NQ_0_V0B.CSV (Daily Data), 4/19/2002 TRADING PARAMETERS: Initial Account Equity: $50000.00 Position Sizing Method: Fixed Fractional Risk Percentage (fixed fraction): 4.00% PERFORMANCE RESULTS: Error Code: 0 Total Net Profit: $119572.00 Gross Profit: $319002.00 Gross Loss: $-199430.00 Profit Factor: 1.60 Final Account Equity: $169572.00

Copyright ©2002 Breakout Futures 53

**Performance Measures (cont.) 103 Number of Trades:
**

Number Winning Trades: 51 Number Losing Trades: 52 Number Skipped Trades (# contracts=0): 0 Percent Profitable: 49.51% Largest Winning Trade (%): 16.02% ($9400.00) Largest Winning Trade ($): $24400.00 (14.54%) Average Winning Trade (%): 5.85% Average Winning Trade ($): $6254.94 Max # Consecutive Wins: 5 Largest Losing Trade (%): -6.77% ($-12805.00) Largest Losing Trade ($): $-12805.00 (-6.77%) Average Losing Trade (%): -3.10% Average Losing Trade ($): $-3835.19 Max # Consecutive Losses: 5

Copyright ©2002 Breakout Futures 54

**Performance Measures (cont.)
**

Ratio Avg Win(%)/Avg Loss(%): 1.89 Ratio Avg Win($)/Avg Loss($): 1.63 Average % Trade: 1.33% Average $ Trade: $1160.90 Max # Contracts: 18 Avg # Contracts: 5 Max Closed Trade % Drawdown: 21.13% ($43351.40) Date of Max % Drawdown: 4/1/2002 Max Closed Trade $ Drawdown: $43351.40 (21.13%) Date of Max $ Drawdown: 4/1/2002 Return on Starting Equity: 239.14%

Copyright ©2002 Breakout Futures

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**Performance Measures (cont.)
**

* MM ANALYSIS: MONTE CARLO ANALYSIS * INPUT DATA: Initial Account Equity: $50000.00 Risk Percentage (fixed fraction): 4.00% Number of Trades: 103 Rate of Return Goal: 100.00% Drawdown Goal: 30.00% Probability Goal: 95.00% Number of Random Sequences: 1000

Copyright ©2002 Breakout Futures

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**Performance Measures (cont.)
**

OUTPUT/RESULTS: Error Code: 0 Average Rate of Return: 249.48% Average Final Account Equity: $174741.00 Probability of Reaching Return Goal: 100.00% Probability of Reaching Drawdown Goal: 85.10% Probability of Reaching Return and Drawdown Together: 85.10% Rate of Return at 95.00% Probability: 195.31% Drawdown at 95.00% Probability: 35.16%

Copyright ©2002 Breakout Futures

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