Position Sizing™ and your personal psychology are the two most important aspects of trading and they are probably the two most neglected topics. Chapter 14 of the second edition of Trade Your Way to Financial Freedom, is all about helping you understand the importance of position sizing.
Before we discuss this topic, let me give you some important background information. I tend to think of trading systems by the distribution of R-multiples that they generate. And the average R (or mean R) of the system's R-multiple distribution is the expectancy of the system. It tells you what to expect from the average trade.
So let me give you a simple trading system, one that is probably much simpler than any you'd trade. Twenty percent of the trades are 10R winners and the rest of the trades are losers - 70% are 1R losers and the remaining 10% are 5R losers. Is this a good system? Well, if you want a lot of winners, then it certainly isn't - it only has 20% winners. But if you look at the average R for the system it's 0.8R. That means on the average, you'd make 0.8R per trade over many trades. Thus, when it's phrased in terms of expectancy, it's a winning system.
Let's say that you made 80 trades with this system in a year. On the average you'd end up making 64R - which is excellent. If you allowed R to represent 1% of your equity (which is one way to do position sizing), then you'd be up about 64% at the end of the year.
I frequently play a marble game with this R-multiple distribution to teach people about trading. The R-multiple distribution is represented by marbles in a bag. The marbles are draw out one at a time and replaced. The audience is given 100,000 to play with and they all get the same trades.
So let's say we do 30 trades, and they come out as shown in the table:
| R-Multiples Draw In A Game | ||
| -1R | -5R | -1R |
| -1R | -1R | -1R |
| -1R | -1R | +10R |
| -5R | -1R | -1R |
| -1R | -1R | +10R |
| +10R | -1R | -1R |
| -1R | -1R | -1R |
| -1R | -1R | -5R |
| -1R | -1R | +10R |
| +10R | -1R | +10R |
| +8R | -14R | +30R |
If you look at the bottom row, you see the total R-multiple distribution after each ten trades. After the first 10 we were up +8R, we then had 12 losers in a row and were down 14R after the next 10 trades. And finally we had a good run on the last 10 trades, with four winners, getting 30R for the ten trades. Over the 30 trades we were up 24R. And if you divide 24R by 20 trades is gives us a sample expectancy of 0.8R. Thus, our sample expectancy was exactly the same as the expectancy of the marble bag. That doesn't happen often, but it does happen.
Now let's say that you are playing the game and your only job is to decide how much to risk on each trade or how to position size the game. How much money do you think you'd make or lose? Well, in a typical game like this, 1/3 of the audience will go bankrupt (i.e., they won't survive the first five losers or the streak of 12 losses in a row); another 1/3 of the audience will lose money; and the last third will typically have made a huge amount of money - sometimes over a million dollars. And in an audience of say 100 people, except for the 33 or so who are at zero, I'll probably have 67 different equity levels.
That shows you the power of position sizing. Everyone in the audience got the same trades, those shown in the table. Thus, the only variable working was how much they bet or their position sizing. And through that one variable we had final equities than ranged from zero to over a million dollars. That's how important position sizing is. And by the way, I've played this game hundreds of times, getting similar results each time.
Position sizing is that important and I'd suggest that you take a look at chapter 14 of my book because many people have told me that it turned their trading around, making them winners instead of losers. Next week, I'll tell you a lot more about position sizing - how to do it and what its purpose is.
Dr. Van K Tharp
TradingEducation.com
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