I’ve been thinking about position sizing a lot recently…
If you’ve been reading my stuff for a while you’ve probably seen me refer to the five essential parts of a well-rounded trading strategy:
What to trade, when to enter a trade, when to exit a winning trade, when to exit a losing trade, and finally, the bit we’re interested in today – how much to trade.
How much to trade just means how much of your overall trading account you’ll be allocating against the trade.
Depending on the market you’re trading you might measure it by the number of shares bought, the number of futures contract bought, or when it comes to Forex spread betting, how much cash to stake against each pip of movement in the market.
Here’s why I’ve been giving this some serious thought…
Firstly, I’ve been writing about money management and risk control ready for the Trader’s Academy section of the new website (it’s not far off being ready now so do keep your eyes peeled for access information coming soon).
Secondly, I’ve been helping some newer traders get their head around the concept of position size. I’ve been explaining why they shouldn’t compare their trades in different markets solely on pips achieved. And how instead they need to create a standard ‘unit’ of risk across all their trades and base it on the size of the stop loss – and therefore cash risk – involved.
And just when I needed a good analogy to illustrate my point to them, the third reason for me thinking about position sizing arrived in the nick of time!
Position sizing – medieval style
The other night I was watching a program on TV about medieval building methods. You might have seen it too. It’s about a team of craftsmen in France building a medieval castle using authentic techniques from the time.
I find this kind of stuff fascinating. I built some sandstone walls in my garden a few summers ago and thoroughly enjoyed it! (I must have been a stonemason in a former life or something.)
So anyway, in this program they explained how each medieval site had a head mason. And it was the width of the top man’s thumb that became the standard unit of measurement for that entire building site. It remained so until the project was complete.
They even scratched the measurement into a stone block so if (heaven forbid) he fell off some rickety scaffolding and plunged from the castle battlements they’d still have the size of his thumb to work with.
They called the measurement a ‘pouce’. It’s French for ‘thumb’. And it’s also French for ‘inch’ – that’s where we get the imperial measurement from. I never knew that! So I rushed off to find a tape measure to size-up the width of my own thumb. Sure enough, an inch. (Is it just me that gets a kick out of learning this kind of thing? Should I be getting worried?)
OK, back to trading…
A standard unit of risk using the ‘Frenchman’s Thumb’ method
So I used the ‘pouce’ example to explain to these new traders the importance of standardising the size of risk on each Forex trade…
When the medieval site foreman ordered some clay floor tiles to be cut and fired he might specify them to be six ‘pouce’ square. He didn’t just say “make me a hundred floor tiles”. Each tile was cut and formed by hand so he’d get all sorts of odd shapes and sizes arriving on site!
No, the tile makers knew exactly what the size needed to be on each and every piece they turned out. And they were held accountable too. Each man had his own little mark he made in the edge of the clay tile, kind of a signature, so the boss knew who needed a ‘talking to’ should the size of the tiles start getting a bit freehand.
And that’s exactly how you need to think about the size of your trades. You can’t just fire off 50 pip risk trades here, 20 pip risk trades there, and anything in between too, all risking a level stake of £1 per pip, and still expect to see smooth growth in your equity.
There’d be no standard unit of risk. Some trades are risking twice as much as others and everything is out of balance. Do this and your account is likely to topple given time.
So you need to come up with your own ‘pouce’. You need your own standard unit of risk to apply to each of your trades.
How much of your trading bank should you allocate against each trade?
Common trading wisdom suggests placing a maximum risk of 2% of your total trading bank against any one trade and I think that’s a good benchmark.
But there are always exceptions to the rule…
If you’re trading a particularly large account you might have a more conservative outlook. You might be willing to risk only 0.5% of your account per trade because of the economies of scale involved.
You can still make big money… each one of your trades might have a potential cash return of £1,000.00 so you might decide the 0.5% risk profile fits your trading goals perfectly.
One or two of those trades a week should keep the wolf from the door!
And it means even a string of losing trades will hardly scratch the surface of your overall account.
If you’re trading a small account on the other hand, you might decide to risk more on each trade in order to grow your account more quickly. Again, that might be the right thing to do when you look at things in terms of cash…
A 4% risk on your micro-account might convert to £15.00 in cash – it may well be a sum you feel comfortable risking in order to enjoy that faster growth to your equity. And don’t forget, you can always scale things back to risk 2% on each trade as your cash account grows.
So the key here is to do a quick reality-check whenever you’re planning a trading campaign.
It’s easy to get tangled up thinking purely in terms of percentages but I think you need to add-in a ‘real world’ cash factor too.
And next time you’re about to fire off a trade, take a good look down at that thumb gripping the side of your mouse. It’s your new prompt to check you’ve measured up the trade before pulling the trigger. It’s your very own trader’s ‘pouce’!
Be Prepared: Market Moving Data Coming This Week (London Time)
Wednesday 17/12/14:
09:30 GBP Average Earnings Index
09:30 GBP MPC meeting minutes
10:00 EUR CPI
13:30 USD CPI
19:00 USD FOMC Statement
Thursday 18/12/14:
09:00 EUR German IFO Business Climate Index
09:30 GBP Retail Sales
15:00 USD Philly fed
Friday 19/12/14:
– no big reports
Monday 22/12/14:
15:00 USD Existing Home Sales
Tuesday 23/12/14:
09:30 GBP Gross Domestic Product
13:30 USD Core durable goods
13:30 USD Gross Domestic Product
15:00 USD New Home Sales
I hope you enjoyed our look at trade position sizing today (with a bit of medieval technology thrown in for good measure!). Have a great week and I’ll catch up with you again very soon.
