Why your returns are probably bullshit at best

Posted on | Tuesday, July 7, 2009 | No Comments

Dr. Van K. Tharp did an experiment which shows the importance position sizing. In his book "Trade Your Way to Financial Freedom" Van gives the results of his testing of four different position sizing models. He tested the models on the same trading system, so the only variable was the position sizing. The simulations were run with an initial equity of $1,000,000 and took 595 trades over a 5.5 year period. The models produced drastically different results:

  • The worst was the baseline model which just bought 100 shares of stock whenever a signal was given. That model returned $32,567 or 0.58% annualized.

  • Fixed-amount model: This method traded 100 shares per $100,000 in equity. It returned $237,457 or 5.75% annualized.

  • Equal leverage model: Each position in this model was 3% of the account equity. So at the start of the trial each position was $30,000. This method returned $231,121.

  • Percent risk model: According to this model positions were sized such that the initial risk exposure was 1% of the account equity. So with $1,000,000 equity the initial risk would be $10,000. So if the initial stop on a trade was $1 the system would trade 10,000 shares. For an initial stop of 50 cents the system would trade 20,000 shares, etc. This model returned $1,840,493 or 20.92% annualized.

  • Percent Volatility model: Positions were sized based on each stock's volatility -- the more volatile the stock the fewer shares are traded. For this trial positions were pegged at 0.5% volatility (initially $5,000 per position) -- so if a stock's average true range was $5 the system would trade 1,000 shares. This model returned $2,109,266 or 22.93% annualized.
If you are day trading you probably should be using the percent risk model. Percent volatility will be too slow to calculate on the fly. The percent risk model is the best bang for the time involved to figure out. All you need to do is some simple math. Figure out how much your max down draw per trade you want either as a percentage or a fixed dollar amount.

Example 1) I start the day with $87,000 in my trading account and I want to take no more than a 1% loss per trade. 87,000 * 0.01 = $570.00.

Example 2) I want to lose no more than 100 dollars per trade no matter what size my account is = $100.00.

Then figure out what percentage of a stop you are using. I use 1% stops*, some use 3 or 4%. Then do some math.

Example 1) I want to lose no more than 1% of my 87K account per trade and will use a 3% stop on all trades. 570.00 (from above) / 0.03 = 19,000. So you have $19,000 to use for every trade with a 3% stop to lose no more than $570.00 per trade. How many shares can I then HIT THE BID with? Take your 19,000 and divide by the current PPS. ie 19,000 / 12.43 = 1528 shares, or 19,000 / 6.18 = 3074 shares.

Example 2) I want to lose no more than $100.00 per trade with a 4% stop. 100/0.04 = $2,500 I can use per trade. How many shares can I then HIT THE BID with? Take your 2,500 and divide by the current PPS. ie 2,500 / 12.43 = 201 shares, or 2,500 / 6.18 = 404 shares.

If you use a broker such as Interactive Brokers, you can input the dollar amount you with to trade and it will calculate the share size automatically.

* Why do I use 1% stops? I'll actually exit before I take a 1% loss. Either the trade works in my favor right away or it doesn't. If it doesn't, either my judgement of the setup was wrong or my timing of the entry on the setup was wrong.


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