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We are going to trade Nifty futures which are available in increments of one lot with each
lot representing 75 Nifty Indices (lot size). At a price of approximately 8000 on the spot Nifty
the value of one lot of Nifty futures is Rs.600,000. The initial margin required to take position
in one lot of the Nifty will be approximately Rs.60,000.
Thus, a move against the position will by 8 points will lead to a loss of 8 x 7,425 = Rs. 59,400
The optimum number here is 54 lots of the Nifty which would use up Rs32.4 lac in initial
margins (54 lots x Rs.60,000 initial margin per lot) and still leave a buffer Rs27.6 lacs to take
be used up if the stop loss gets hit.
Thus, a move against the position will by 663 points will lead to a loss of 663 x 4,050 = Rs.
26,85,150
Hence the maximum number of Nifty lots that can be shorted when the stop loss is 663
index points and trading capital is Rs.60 lacs is 54 lots. Just because our capital allows us
to take a 50 lot Nifty position does it mean that 50 lots is the correct position size for our
trade? If the stop loss on the trade really gets hit we will have blown away almost 50% of
the capital on the first trade. At this rate if each of our first seven trades continuously hit
the stop loss we would have blown away more than 98% of our capital.
Clearly optimising our size in order to take the maximum number of lots for each trade
using our starting capital is clearly not a viable strategy. One point to always remember is
that it is impossible to predict which trade will be a winner and which one will be a loser. In
a sequence of 10 trades It is possible to have a string of 9 losing trade followed by one
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winner or a string of 9 winning trades followed by one loser. The key to optimising the
position size of a trade is to keep placing small enough bets that allows us to survive a
long string of losers until we arrive at the winning jackpot. The key goal is to have enough
capital to keep playing until we reach the end of the rainbow to our pot of gold.
The greatest experts in trading and investing have suggested that position sizing should
be such that each trade risks no more than 1% or at best 2% of capital. In extreme high
conviction cases one may risk 5% of capital but that’s stretching it to the very limit of a
prudent position sizing strategy ( a string of 20 losers will vaporise the entire capital). This is
true irrespective of the trading or investing strategy used. Be it fundamental, technical,
trend following, financial astro any strategy implemented should not risk more than 1% to
2% of capital on a single trade or investment.
We have calculated the loss per lot if the stop loss of the Tom Basso system is hit to be
Rs.60,000.
If we are going to risk 1% of capital (i.e. 1% of Rs.60 lacs = Rs60,000) then our position size
should be one lot. If we are going to risk 2% of capital then our position size should be two
lots and if we have high conviction on the trade then at best we will take a position of 5
lots risking 5% of our capital. Go figure. In this example the highest prudent position sizing
will be just 10% of the maximum possible 50 lots position.
To complete the example let us compute our winnings based on a 1%, 2% & 5% risk position
sizing. The total profit earned was 491 index points using the LearnApp modified Tom Basso
system.
SEBI is progressively pushing the exchanges to increase the lot size of the futures in the
mistaken belief that large lot sizes will deter small investors from speculating in futures.
They have forced the withdrawal of mini-index futures and have raised the lot size limit
from Rs.2 lac. to Rs. 5 lac. We believe that such measure will not deter speculation among
investors who want to speculate, rather, it will push them into the arms of unscrupulous
brokers operating a grey market in speculation. Anyhow, increasing lot sizes implies that a
greater amount of capital is required to adhere to the position sizing rules that we have
discussed above. For example if risk management throws up a notional value of Rs 6 lac.
as the ideal position size for a given amount of capital what will the investor do when the
lot size of 40 on bank Nifty makes one lot of Bank Nifty worth more than Rs.10 lacs.
Conclusion
A systematic trading strategy takes away most of the discretion that exists in a
fundamental or technical investing or trading strategy. LearnApp modified Tom Basso
Trading System is an excellent example of a systematic trading strategy. It can also be
used by fundamental investors as an excellent risk management tool. Traders using a
systematic approach should be very cautious with regards to position sizing and maintain
a balance between profitability and long term survival.