Trade Risk Talk

Trading the Risk
Position Sizing and Exit Stops
Michael R. Bryant, Ph.D.

Breakout Futures
www.BreakoutFutures.com
Copyright 2002 Breakout Futures
Scope of Talk
• Short to intermediate-term trading

• Rational methods of position sizing
and stop selection; mostly
quantitative
• Oriented towards futures but also
applicable to stocks
• One market-system at a time
Copyright 2002 Breakout Futures 2

What is Position Sizing?
• Selecting the number of contracts or

shares of stock for the next trade
• A way to reinvest profits
• The way traders compound their
returns

Methods of Position Sizing
• Ad hoc: trade no larger than lets you

sleep at night
• Margin plus drawdown
• Fixed Fractional
• Fixed Ratio
• Hybrid fixed fractional/fixed ratio

Methods that Don’t Work
• Martingale methods: increase position size

after a loss; decrease it after a win.
• Equity curve methods: increase size when
your equity curve falls below its moving
average (“reversion to mean”), or
increase size when you cross above the
moving average (“trade the trend in
equity curve”).

Why They Don’t Work
• Martingale and equity curve methods assume
dependency between trades.
• In most cases, trades are independent of each
other. The odds of the next trade being a win
are not related to whether the last trade was a
win or a loss.
• If trades are independent, you can’t determine
the likelihood of the next trade being a win or a
loss based on the previous trade.

Margin Plus Drawdown
Sizing
• The equity to trade one contract is the
maximum historical drawdown multiplied
by 1.5 plus the margin requirement.
• Add another contract only when the closed
profits are equal to drawdown * 1.5 plus
margin.
• Attributable to Larry Williams; see The
Definitive Guide to Futures Trading,
Volume II.

(cont.)
• You always have enough money to handle
the worst historical drawdown plus 50%.
• Designed so you only increase the number
of contracts, never reduce.
• Theoretically safe but doesn’t reduce
contracts in a drawdown, so drawdowns can
be large.
• Doesn’t take the risk of each trade into
account.

(cont.)
140000
120000
100000
80000
Equity
1-Con
Marg+DD
60000
40000
20000
0
12/31/97 12/31/98 12/31/99 12/30/00 12/30/01

Fixed Fractional Position
Sizing
• Risk the same fraction (“fixed fraction”) of
the account equity on each trade; e.g., 5%.
• Number of contracts:
N = ff * Equity/|Trade Risk|
where ff = fixed fraction,

Equity = account equity ($),
Trade Risk = possible loss on trade ($)

Fixed Fractional (cont.)
• Trade risk may come from:

– Estimate. Examples: n standard deviations of
the trade distribution; largest historical loss.
– Size of money management stop.
• Using a money management (mm) stop
to define the trade risk may produce
greater risk-adjusted returns than using
the largest loss.

300000
250000
200000
Equity
MM Stop
Max Loss
150000
100000
50000
1/1/98 1/1/99 1/1/00 12/31/00 12/31/01

Observations on Fixed
Fractional
• As a percentage of account equity, the risk of
each trade is the same, regardless of the
number of contracts.
• Takes advantage of trade risk.
• Responsive to changes in equity (unlike margin
plus drawdown method).
• The trick is determining the best value of the
fixed fraction; more on that later…

140000
120000
100000
80000 1-Con
Equity
Marg+DD
60000 Fix Frac
40000
20000
0
12/31/97 12/31/98 12/31/99 12/30/00 12/30/01

Fixed Ratio Position Sizing
• Developed by Ryan Jones; see The Trading
Game, John Wiley, 1999.
• Based on a fixed parameter called the
delta: the profit per contract needed to
increase the number of contracts by 1.
• Each contract contributes the same profit
towards increasing the number of
contracts, regardless of account equity.

Fixed Ratio (cont.)
• Number of contracts:
1/2
N = ½ *[ 1 + (1 + 8 * Profit/delta) ]
where Profit = total closed trade

profit ($),
delta = profit/contract to increase by 1
contract ($).

Fixed Ratio (cont.)
25
20
No. Contracts
15
Fix Frac
Fix Ratio
10
0
0 5 10 15 20 25 30
Trade

Fixed Ratio (cont.)
25
20
No. Contracts
15
Fixed Frac
Fixed Ratio
10
0
0 30,000 60,000 90,000 120,000
Profit

Observations on Fixed Ratio
• Performance depends on total

accumulated profits; i.e., account
size. It becomes more conservative
as the account size increases.
• Doesn’t directly depend on trade
risk.

A More Generalized
Approach
• Consider the following equation for the number
of contracts, N:
m
N = ½ *[ 1 + (1 + 8 * Profit/delta)m ]
where Profit = total closed trade profit ($),

delta = fixed ratio parameter ($),
m >= 0.
• With m = ½, we get the fixed ratio equation.

A Generalized Approach
(cont.)
• Consider m = 0:
0
N = ½ *[ 1 + (1 + 8 * Profit/delta) ]
= 1/2 * [1 + 1]
=1
i.e., we get fixed contract trading (N =
1).

(cont.)
• Consider m = 1:
1
N = ½ *[ 1 + (1 + 8 * Profit/delta) 1 ]
= 1 + 4 * Profit/delta
Let delta = 4 * Risk/ff and Equity0 = Risk/ff.

Then, N = (Equity0 + Profit) * ff/Risk
(i.e., the equation for fixed fractional trading)

(cont.)
• Rate of Change of N with Profit:
m-1
∂N/∂
N/ (Profit) = 4*m/delta * (1 + 8 * Profit/delta)
m = 1  ROC of N independent of profit; e.g.,

fixed fraction.
m > 1  N increases faster as equity grows.
m < 1  N increases more slowly as equity
grows; e.g., fixed ratio.

(cont.)
450000
400000
350000
300000
250000 m=0.5
Equity
m=1.0
200000
m=1.5
150000
100000
50000
0
12/31/97 12/31/98 12/31/99 12/30/00 12/30/01

(cont.)
500000
425000
350000
m=0.5
Equity
275000 m=1.0
m=1.5
200000
125000
50000
12/31/98 12/31/99 12/30/00 12/30/01

Conclusions From Generalized
Approach
• m < 1 works best when worst drawdowns

come late.
• m >= 1 works best when biggest run-up
comes late.
• For any sequence of trades, there is
probably an optimal value of m. However,
the sequence of trades and
drawdowns/run-ups is unknown. (Monte
Carlo analysis to find the best m?)

Finding the Best Fixed
Fraction
• Ad hoc; e.g., 2% rule.
• “Optimal f”: Ralph Vince, Portfolio
Management Formulas, 1990.
• “Secure f”: Leo Zamansky & David
Stendahl, TASC, July, 1998.
• Monte Carlo simulation: Bryant,
TASC, February, 2001.

Best Fixed Fraction (cont.)
Optimal f:
• f value that mathematically maximizes the
compounded rate of return.
• Doesn’t take the drawdown into account.
• Typically results in very large – and
dangerous – f values.
• Theoretically sound but not practical to trade.

Secure f:
• f value that maximizes the compounded
rate of return subject to a limit on the
maximum drawdown; e.g., “what f value
gives the greatest rate of return without
exceeding 30% drawdown?”
• Improvement on optimal f.
• Only problem: the drawdown calculated
from the historical sequence of trades is
not very reliable.

85000
75000
65000
55000
Equity
DD=9.3%
45000
35000
25000
15000
12/31/97 12/31/98 12/31/99 12/30/00 12/30/01

85000
75000
65000
55000
Equity
DD=16.7%
45000
35000
25000
15000
12/31/97 12/31/98 12/31/99 12/30/00 12/30/01

85000
75000
65000
55000
Equity
DD=25.6%
45000
35000
25000
15000
12/31/97 12/31/98 12/31/99 12/30/00 12/30/01

85000
75000
65000
55000
Equity
DD=37.6%
45000
35000
25000
15000
12/31/97 12/31/98 12/31/99 12/30/00 12/30/01

85000
75000
65000
55000
Equity
DD=46.2%
45000
35000
25000
15000
12/31/97 12/31/98 12/31/99 12/30/00 12/30/01

85000
75000
65000
DD=9.3%
55000 DD=16.7%
Equity
DD=25.6%
45000 DD=37.6%
DD=46.2%
35000
25000
15000
12/31/97 12/31/98 12/31/99 12/30/00 12/30/01

• Historical sequence: 14% max drawdown
on 2 contracts, starting with $50k.
• Find the fixed fraction that maximizes the
RoR of the historical sequence with no
more than 30% drawdown  f = 8.2%
• Try f=8.2% on some randomized
sequences of the original trades. One
result: max drawdown = 76%!

800000
700000
600000
500000
Original
Equity
400000 Optimized
Randomized
300000
200000
100000
0
12/31/97 12/31/98 12/31/99 12/30/00 12/30/01

Monte Carlo Simulation:
• Replaces random variables in a simulation
with their probability distributions.
• Distributions are randomly sampled many
times.
• Output of simulation is a distribution.
• Can be used to find the “best” fixed fraction
by replacing the trade with the distribution
of trades.

Distribution of Profit/Loss
25
20
15
10
0
0
00
00
00
00
00
00
0
0
00
00
00
20
50
10
30
40
60
-2
-3
-1
Trade P/L
Applying Monte Carlo to Fixed Fractional Trading:
• Randomize the sequence of trades, and, for each
sequence, calculate the return and max drawdown
using a given value of f.
• The drawdown at 95% confidence is the drawdown
such that 95% of sequences have drawdowns less
than that.
• The return at 95% confidence is the return such that
95% of sequences return at least that much.
• Find the f value that maximizes the return at 95%
confidence while keeping the drawdown at 95%
confidence below your drawdown limit.

120 1600
1400
100
1200
80
Ave RoR (%)

P (40% DD)
1000
60 800
600
40
400
20
200
0 0
0 0.02 0.04 0.06 0.08 0.1 0.12
Fixed Fraction

4000 120
3500
100
3000
2500 80
RoR at P=95%
DD at P=95%
2000
60
1500
1000 40
500
20
0
-500 0
0 0.1 0.2 0.3 0.4
Fixed Fraction

Money Management Stops
• Lesson from fixed fractional trading:

a money management stop defines
the trade risk, which enables more
precise position sizing.
• How do we choose the size of the
money management stop? One
approach: volatility.

(cont.)
ATR Volatility - E-mini S&P 500
60
50
40
10-day ATR
30
20
10
0
9/1/97 9/1/98 9/1/99 8/31/00 8/31/01
(cont.)
Distribution of ATR, E-mini S&P
200
180
160
140
120
100
80
60
40
20
0
12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54
10-day ATR
(cont.)
Cumulative ATR Distr - ES
100
90
80
70
% of Total
60
50
40
30
20
10
0
12
16
20
24
28
32
36
40
44
48
52
10-day ATR
(cont.)
ATR Volatility - E-mini Nasdaq
400
350
300
10-day ATR
250
200
150
100
50
0
6/30/99 12/30/99 6/30/00 12/30/00 7/1/01 12/31/01
(cont.)
Distribution of ATR, E-mini Nasdaq
60
50
40
30
20
10
0
5
0
5
0
35
55
75
95
11
13
15
17
19
21
24
28
32
Average True Range
Trailing Stops
Some ideas for trailing stops:
• Try basing the size of the stop on volatility,
as suggested for money management
stops, but use a smaller value.
• Try tightening the stop sharply after a big
move in your favor (but not before).
• If the trailing stop is tighter than the mm
stop, wait until the market has moved in
your favor by some multiple of the ATR
before applying the trailing stop.

Performance Measures
• Problem: If you simulate trading with

position sizing, how does this affect
performance measurements?
• Short answer: Don’t rely on the
TradeStation performance summary.

(cont.)
If given in dollars, some performance statistics
could be skewed by the higher equity and
larger number of contracts at the end of the
equity curve:
• Average Trade • Win/Loss ratio

• Largest Win • Max Drawdown
• Largest Loss
(cont.)
• Solution: Calculate equity-dependent
performance statistics by recording
the trade profit/loss as a percentage
of the equity at the time the trade is
entered.
• Consider my FixedRisk and
MonteCarlo EasyLanguage user
functions…
(cont.)
* MM ANALYSIS: PERFORMANCE OF HISTORICAL SEQUENCE *
NQ_0_V0B.CSV (Daily Data), 4/19/2002
TRADING PARAMETERS:
Initial Account Equity: $50000.00
Position Sizing Method: Fixed Fractional
Risk Percentage (fixed fraction): 4.00%
PERFORMANCE RESULTS:
Error Code: 0
Total Net Profit: $119572.00
Gross Profit: $319002.00
Gross Loss: $-199430.00
Profit Factor: 1.60
Final Account Equity: $169572.00

(cont.)
Number of Trades: 103
Number Winning Trades: 51
Number Losing Trades: 52
Number Skipped Trades (# contracts=0): 0
Percent Profitable: 49.51%
Largest Winning Trade (%): 16.02% ($9400.00)

Largest Winning Trade ($): $24400.00 (14.54%)
Average Winning Trade (%): 5.85%
Average Winning Trade ($): $6254.94
Max # Consecutive Wins: 5
Largest Losing Trade (%): -6.77% ($-12805.00)

Largest Losing Trade ($): $-12805.00 (-6.77%)
Average Losing Trade (%): -3.10%
Average Losing Trade ($): $-3835.19
Max # Consecutive Losses: 5

(cont.)
Ratio Avg Win(%)/Avg Loss(%): 1.89
Ratio Avg Win($)/Avg Loss($): 1.63
Average % Trade: 1.33%
Average $ Trade: $1160.90
Max # Contracts: 18
Avg # Contracts: 5
Max Closed Trade % Drawdown: 21.13% ($43351.40)

Date of Max % Drawdown: 4/1/2002
Max Closed Trade $ Drawdown: $43351.40 (21.13%)
Date of Max $ Drawdown: 4/1/2002
Return on Starting Equity: 239.14%

(cont.)
* MM ANALYSIS: MONTE CARLO ANALYSIS *
INPUT DATA:
Initial Account Equity: $50000.00
Risk Percentage (fixed fraction): 4.00%
Number of Trades: 103
Rate of Return Goal: 100.00%
Drawdown Goal: 30.00%
Probability Goal: 95.00%
Number of Random Sequences: 1000

(cont.)
OUTPUT/RESULTS:
Error Code: 0
Average Rate of Return: 249.48%
Average Final Account Equity: $174741.00
Probability of Reaching Return Goal: 100.00%
Probability of Reaching Drawdown Goal: 85.10%
Probability of Reaching Return and Drawdown Together:
85.10%
Rate of Return at 95.00% Probability: 195.31%
Drawdown at 95.00% Probability: 35.16%

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Trading the Risk

Position Sizing and Exit Stops

Michael R. Bryant, Ph.D.

• Short to intermediate-term trading

Copyright 2002 Breakout Futures 2

• Selecting the number of contracts or

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• Ad hoc: trade no larger than lets you

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• Martingale methods: increase position size

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where ff = fixed fraction,

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• Trade risk may come from:

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where Profit = total closed trade

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• Performance depends on total

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where Profit = total closed trade profit ($),

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Let delta = 4 * Risk/ff and Equity0 = Risk/ff.

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m = 1  ROC of N independent of profit; e.g.,

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• m < 1 works best when worst drawdowns

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Ave RoR (%)

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• Lesson from fixed fractional trading:

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• Problem: If you simulate trading with

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• Average Trade • Win/Loss ratio

Copyright 2002 Breakout Futures 53