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Thursday, March 10, 2011

Position sizing revisited (The risk scale)

Reference to our previous post on the importance of position sizing, this post dives deeper into how to put this in practice. Basically we would like to find answer to these situations:

1.- When a trend is identified and I want to open a position, how much should I trade?

2.- What happens if another pair is also showing signs of entering a trend, how much should I buy/sell in relation to the first trade?

The concept of volatility:

We all know the very traditional concept of volatility in finance http://en.wikipedia.org/wiki/Volatility_(finance) , but I'd prefer to look at volatility in chemistry terms: “a measure of the tendency of a substance to vaporize”, the substance being your account capital. Volatility is a must understand concept when dealing with these questions. As the source of risk/reward, it will define how much risk I take when entering a trade or if it is “safer” to enter at all.

The best tool in my opinion for volatility measure is ATR. The ATR (Average True Range) "gauges the average range from low to high of each candlestick during its respective period of time". Now, ATR is commonly used to set stops. It is very common to see stops set at 2xATR. I would challenge this as it has no logical background (what happens in the market when the price is against you 2xATR?) the answer is: no one knows, but the price is just against your position. Instead, our stops are placed following other rules (see nutcracker system/rolling stone system).

However, the ATR can help us to find correlation between currency pair volatilities. But how? In your trade station take the amount of units required to move $0,01/pip (the minimum move per trade). Secondly take a look at the ATR for 15 periods associated to that currency pair and use this value as a volatility indicator for a stop loss in your trading station. The result will be a dollar amount of the instant volatility for that currency pair. Now take 1% of your account and divide it by the instant volatility in dollars. Do this for all currency pairs and you will get results like the one shown below.

Notice that the normalized units to trade based on its own volatility can be grouped in three. Basically for each 9 units I buy/sell of EUR/CAD I should buy/sell 18 units of USD/JPY
In our approach to a new trend, we will open a position with the minimum number of units possible, as the trend continues, we would increase the amount of units. Should a second trade be needed, we would enter it by referencing to the first trade.  The pairs in green are most likely in a trending state or showing no interesting price movement. The color codes do not mean likelihood of profitability. It tell us how to approach our entries with a risk management mindset.