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Rule of thumb for position sizing
- Thread starter Ghost of Cutten
- Start date
Quote from Ghost of Cutten:
And for safety you need to keep drawdowns within acceptable limits. I.e. the whole subject I was discussing and basing my rules of thumb on.
I'm willing to tolerate a bigger drawdown for excellent trades that have great payouts(3-1, 4-1) but might not be for others without(1-1) even though they both have the same win rate. So I would have to incorporate that factor in
The fact is that a DD in excess of your risk tolerance is a hard limit. Whereas being somewhat less profitable than you hoped is not. You will not drop out of the game or go bust because you only made 15% instead of 25%. You will drop out or go bust because you dropped 50% on some aggressively sized leverage bet, or a particularly long losing streak, instead of the 20% you had bargained for as a worst case.
Do some simulated trading runs with sizing based on Kelly or Optimal F, you will see that the recommended sizes result in catastrophic drawdowns eventually. Big losing streaks are out there. Furthermore, neither formula accounts for system degradation, or (for discretionary traders) misjudgement of the trade odds. So, in the real world where systems degrade, and discretion is sometimes totally wrong, even a sensibly sized bet which assumes accurate assessment of the trade odds, is too big. You have to trade even smaller than what the odds would suggest is a conservative size. And this is before we even account for the psychological impact of serious drawdowns, which are demonstrable and very real for all traders (albeit to varying degrees).
It's no coincidence that traders with experience, who've witnessed several market cycles, trade smaller than those with less time in the trenches. Similarly for those who have looked into the odds of losing streaks, who've studied the blowups of professional traders, who've debated with systems traders about the degradation of returns. Very few traders overestimate risk, almost all of them underestimate it.
Do some simulated trading runs with sizing based on Kelly or Optimal F, you will see that the recommended sizes result in catastrophic drawdowns eventually. Big losing streaks are out there. Furthermore, neither formula accounts for system degradation, or (for discretionary traders) misjudgement of the trade odds. So, in the real world where systems degrade, and discretion is sometimes totally wrong, even a sensibly sized bet which assumes accurate assessment of the trade odds, is too big. You have to trade even smaller than what the odds would suggest is a conservative size. And this is before we even account for the psychological impact of serious drawdowns, which are demonstrable and very real for all traders (albeit to varying degrees).
It's no coincidence that traders with experience, who've witnessed several market cycles, trade smaller than those with less time in the trenches. Similarly for those who have looked into the odds of losing streaks, who've studied the blowups of professional traders, who've debated with systems traders about the degradation of returns. Very few traders overestimate risk, almost all of them underestimate it.
Quote from Ghost of Cutten:
The fact is that a DD in excess of your risk tolerance is a hard limit. Whereas being somewhat less profitable than you hoped is not. You will not drop out of the game or go bust because you only made 15% instead of 25%. You will drop out or go bust because you dropped 50% on some aggressively sized leverage bet, or a particularly long losing streak, instead of the 20% you had bargained for as a worst case.
Do some simulated trading runs with sizing based on Kelly or Optimal F, you will see that the recommended sizes result in catastrophic drawdowns eventually. Big losing streaks are out there. Furthermore, neither formula accounts for system degradation, or (for discretionary traders) misjudgement of the trade odds. So, in the real world where systems degrade, and discretion is sometimes totally wrong, even a sensibly sized bet which assumes accurate assessment of the trade odds, is too big. You have to trade even smaller than what the odds would suggest is a conservative size. And this is before we even account for the psychological impact of serious drawdowns, which are demonstrable and very real for all traders (albeit to varying degrees).
It's no coincidence that traders with experience, who've witnessed several market cycles, trade smaller than those with less time in the trenches. Similarly for those who have looked into the odds of losing streaks, who've studied the blowups of professional traders, who've debated with systems traders about the degradation of returns. Very few traders overestimate risk, almost all of them underestimate it.
There is no disagreement here, those formulas are not adequate due the ludic fallacy. They are just the baseline. I'd note that the large drawdowns they produce are not relevant in terms of expectation, people like to say 'if you lose 50% you must make 100% to get back to even' but it doesn't matter because those formulas will get the growth of the capital to be the fastest as possible so its pretty like you WILL get back to even, even though its a big return
I simple refuse to have the same drawdown tolerance in a 30-1 bet(say HKD revaluation) as in a 1-1 bet(say shorting US stocks with stops and profit taking exits). I don't think its mathematically sound
Quote from Daal:
I'm willing to tolerate a bigger drawdown for excellent trades that have great payouts(3-1, 4-1) but might not be for others without(1-1) even though they both have the same win rate. So I would have to incorporate that factor in
I incorporated that by having size bounds (e.g. 0.5-1% for low win rates, or 2-4% for high win rate strategies). Doubling size from 0.5% to 1%, or from 2% to 4%, will double your drawdown, so that is a pretty healthy level of leeway on bet size.
Quote from Ghost of Cutten:
Thanks for the link & comments.
I agree that risk tolerance is subjective, but I don't agree that treating unrealised and realised gains radically differently is at all rational. There is no difference between 'initial' capital and 'profit', at least not on closed positions. Dollar for dollar they are exactly the same thing, and treating them differently for psychological reasons is no more rational than -EV loss aversion, gambling on -EV games like roulette, or other behavioural finance oddities. So, I will call a spade a spade and say that this makes no sense.
If the goal of trading is to maximise risk-adjusted return for a given drawdown tolerance, then anything other than treating all dollars the same is going to be an inferior approach. Being reckless with 'open profit', and very cautious with 'initial capital' will result in excessive drawdowns when ahead, and inferior profitability when 'behind', or both. The optimal approach is to take the right amount of risk at all times. Not to mention, after a certain point in a profitable traders career, almost all their capital will be 'open profit'. Or, for people who use calendar years to reset their 'open'/'initial' distinction - why is a trade worth risking 3% on 31st December, and only 1% on Jan 1st? It makes no sense.
If a trader's emotions are such that they are tempted to inferior or irrational behaviour, then the trader needs to master their emotions, just like they would do when buying a market panic, or selling a super-profitable stock that everyone is bullish on.
Well I tend to agree with you. I am not advocating doing those methods,...just trying to point out there ae many ways to skin a cat. Reasons a trade may be "worth" different amounts on different days of the year is largely coming from the understanding that some people will manage other peoples money. The statements do not go out until the quarter or month or whatever is over. So If on Jan 1 you risk 1% per trade with 6% max and by the end of the month you are UP 10% by Jan 16 for example....as a money manager you may say "I'm off to a good start. Even if I lose 20% of this profit people will still be happy with 8% in 1 month" In that case you may risk a portion of the "profit". Again, some of the "profit" may still be paper profit if they are open positions. So account values will fluctuate until its "booked". Once its "booked" as profit you may change your stance and risk as you are saying. Again, not trying to convince you. Just trying to explain methods of maximizing returns with less risk.
N54_Fan
When I looked at position sizing, my calculations showed that following Kelly would result in trading approximately 5 to 10 times as much as the prudent maximum size.