Money management and position sizing is an area that does not usually receive a lot of attention. Traders generally prefer to look for new indicators or try different entry methods and neglect other areas of their trading. It takes most traders months, and sometimes even years, before they turn towards money management and advanced position sizing techniques.
However, for a well-rounded and advanced trading approach, having a thought-out position sizing strategy is very important. Flexible position sizing is used by some of the most successful traders; even in the book series of the Market Wizards, some traders utilize this approach.
What is dynamic position sizing?
Flexible, or dynamic, position sizing describes an approach where the trader adjusts his position size based on the quality of the trade and based on his historic winrate.
For example, a trader would risk a smaller percentage amount on a setup with a historic winrate of 45% than on a setup with a historic winrate of 65%. This approach has been used in many other areas where the concept of chance applies; and it is common sense that most people would bet more when they have a higher likelihood of winning.
The goals of flexible position sizing
The goal of flexible position sizing is that, although it sounds very obvious, a setup with a lower winrate encounters more and more frequent losses. Thus, if a trader trades multiple setups in the same account, using the same amount of risk on each trade does not account for the variance that will exist.
If you trade two setups – one with a winrate of 45% and the other one with a winrate of 65% – the frequent losses of the setup with 45% will eat up your profits from the setup with the higher winrate if you don’t adjust the risk.
Tip: You have to take the concept of R-multiple into account as well. The size of your winners plays a large role in position sizing. A trading system with a low winrate that also has a relatively low R-multiple on winning trades should consider an even smaller position size.
Pros of flexible position sizing
- It can reduce the account volatility and allows for a more stable account growth
- You give more weight to “better” trades which can, potentially, lead to a faster account growth
- Although different methods might be profitable over the long term, a system with a lower winrate can be mentally challenging because of frequent and larger drawdwons. Using a smaller position size can counter such an effect.
- Reducing account swings can reduce emotionally caused problems
Cons
- Determining the quality of a setup can be challenging for inexperienced traders
- It requires a large enough sample size before being able to estimate the historical winrate
- The concept of R-multiple and the ratio between losing and winning trades has to be taken into consideration as well which can pose challenges for new traders
- A trader has to make sure not to confuse subjective conviction with accurately calculated winrate when evaluating the quality of a trade and setup
- Don’t let emotions influence your decisions. Increasing the position size to make up for losses has to be avoided
Conclusion: the ideal tool for the advanced trader
Although the cons do mostly describe problems that arise when a trader does not have enough experience, it has to be said that dynamic position sizing is an approach that is more appropriate for the advanced trader. However, a good understanding of how winrate and the ratio between winners and loser impact the account volatility can also help new traders understand their trading performance better.
There is a substantial risk of loss in futures trading. Past performance is not indicative of future results.
