Position Sizing: How to start trading a new system and scale up
We’ve all been there. You get your hands on a new system, it seems to check out, and you want to dive right in and start making money. But…
Before you do leap in, it’s worth doing a little thinking about the characteristics of the system and what is the most likely thing that will occur when you first start trading. It’s worth doing this to preserve your trading capital.
What type of system is it?
Systems come in 2 basic varieties:
- Lose small but more often
- Win small but often, lose big but less often
If your system is Type-1, then the most likely thing that will happen to your first few trades is that they will be losers. Statistically this is unavoidable. If you start with a large position size, then – probably – you’ll end up falling into drawdown.
If your system is Type-2, then it’s more likely to win the first few trades – but still not guaranteed.
I think the most important thing to have when you start trading a new system is confidence in the system. You’ll obviously gain confidence if your early trades are winners, and you’ll lose confidence if they are losers.
So how do you gain confidence in a new system?
Confidence in a system is about more than just early wins. It’s important to validate that the system is performing within the expectations of the system. Early wins may result in over-confidence.
Let’s look at an example.A hypothetical system has the following performance characteristics:
Average size of win
Average size of loss
Average consecutive loss
# trades per week
This is over-simplified, but if a system wins 30% of the time, then 7 out of 10 trades will be losers. If we ignore winning and losing streaks, then we’d expect to see 2-3 losers for every winner on average. If the results obeyed probability, the equity curve might look like this:
A well-tested system will have other statistical information that can be used. Testing of the system may report an Average Consecutive Losses of 7.5. This means that on average, we could expect to see 7 or 8 losses before a win. Combining this information in the previous paragraph, this implies that System A tends to run in winning and losing streaks i.e. a losing streak would be following by a short winning streak.
The first step to gaining confidence in this system would be to keep position size small through a few of these cycles to check that the prevailing market is allowing the system to perform to its expectations. Three things may happen in this initial period:
If the market is:
When choosing a starting position size, I tend to start VERY small e.g. R=$10. Sometimes though, this prevents a full and therefore balanced portfolio. If the portfolio contains an instrument where the minimum position size is several times greater than the minimum on other instruments (e.g. IG Markets NAS100 vs EURUSD), and you trade those instruments at their minimum position size, then the cash losses and wins will be disproportionately large for them.
I would choose a starting position size that lets you avoid these instruments, so long as you are not excluding a large proportion of the portfolio. Once the system shows it’s in a favourable market and you scale up, you can include those instruments.
Getting from starting size to proper size
For this example, we’ll use an account size of $10,000.
Your initial trial at R=$10 has run for 4 weeks and your account is sitting at $10,070 (up 0.7%).
You decide it’s time to scale up your position size. Based on your account size and system performance characteristics, you’ve decided that your position size should be R=$50.
If you jump your position size straight from $10 to $50, you face a similar situation to the one you faced when first starting: It’s most likely that the next few trades will be losers. You have a small profit based on the wins at R=$10 and you’ll most likely clobber those gains with some losses at $50.
It will only take 2 losses to wipe out the profits that took 4 weeks to accumulate.
If you hit an average-length losing streak (7.5 trades) then that will knock $375 off your balance and take you to a draw-down of over 3%. Of course, you might get lucky if the market good, but statistically this is unlikely - and don’t forget the losing streak could be longer than average.
Much better then, to scale up as quickly as possible, but gradually.
I don’t like to over complicate this, because I doubt there’s an optimal approach. But here’s what I do and why I do it:
Since this hypothetical system typically trades about 10 times per week - that’s more than enough to represent the average losing streak and get us a win or two if the market is allowing the system to do its thing.
I would increase my position size by $5 each week off the minimum, until the position size reaches $30. From then I would increase it by 20% each week until it reaches by desired position size.
My reasoning is that I could expect that each week, the maximum possible drawdown would only increase by 20% (or by $37.50 while I’m increasing by $5). Psychologically I can deal with this - my losses would not feel a LOT larger than they did the previous week – and this would not erode my confidence in the system.
My wins would be increasing by the same proportion (with a slight lag because wins usually take longer to close than losses).
If the market dished out a couple of below-par weeks in a row I may wait before increasing position size further.
Assuming the market was friendly, here’s what the position sizes would look like over the following weeks. Stopping at week 7 of course, since that’s the target level:
Increase R by
Value of R ($)
Note: The first 4 weeks I’d increase at $5 per week, because a smaller jump probably wouldn’t allow more contracts to be traded.
After 7 weeks I’m at the desired position size, while managing my risk of drawdown.
I’m being conservative here – you need to increase within your own comfort levels.
Keep in mind: Trading is a marathon - not a sprint.
Keeping position size aligned to the account size
Depending on your strategy, you may wish to keep your position size constant or you may wish to vary it.
If, for example, you are trading for income you may have set your position size based on an expected average* income. If this is the case, you’d hold your position size constant and regularly withdraw funds to keep your account balance at $10,000.
* Since it’s an average expected income, some months you’d draw more than the expected amount and some months you’d draw less.
By contrast, if you were trading to accumulate, you’d probably want to accumulate your gains in the account and keep the position size aligned to the size of your account.
If your account grew from $10,000 to $12,000 then you’d keep increasing your position as the account grew (again – each week or at least regularly so the changes are small). Likewise, if you hit a long draw-down you’d reduce your position size so your position size never exceeded 0.5% of your account. Ie maintaining your position size to a fixed % of your account balance.
If your position size is a small percentage of your account size (e.g. < 1%), then margin won’t generally be a significant factor. If, however, you keep an absolute minimum in your IG account and your position size is a large percentage of your account size, then you will be prevented from taking trades once you have a few positions open.
This in turn will mean that you are not able to trade the full portfolio, and your result will therefore not reflect what the system would do on a full portfolio.
You need to keep enough funds in your account to ensure you cover margin for the number of trades that the system is likely to open. The easiest way to do this is to ensure your position size is a small percentage of your account balance.
If you are using a VPS (highly recommended for automated trading) then you need to consider the costs of doing so. For IG Markets/BEEKS, this is $50/month if your account falls below $10,000 within a month. Therefore, you need to keep a balance that is enough above 10,000 to allow for draw-downs or you’ll pay $50 in the months where the balance dips below $10,000.
Note that there are other VPS providers out there that offer cheaper charges, but don’t have a minimum-balance deal with IG markets. So if you choose one of them you’ll pay month-in, month-out – but the cost will be lower.
Let’s have a quick look at what BEEKS cost equates to – should you pay it. If you have R=$50 and your account balance is below $10,000, then the BEEKS service is costing you 1R on those months. If your R=$25, then it costs you 2R on those months. If your system only returns 1R on average per month, you need to avoid that fee.
The benefit of a VPS though is that you reduce or remove the risk of missing trades. For a Type-1 system, missing a win has a significant impact on the equity curve.
Where to keep your trading funds
You may consider keeping the IG account small and holding the balance of your trading funds in another account somewhere. But consider: That $50 fee per month (saving) on $10,000 equates to 6% per year.
It’s unlikely that you would get 6% return on cash elsewhere in this low interest environment, so there’s a reasonable argument to keep at least $10,000 in your IG account.
If your IG account was $20,000 the $50 cost saving would equate to 3% return, so there’s probably a sweet spot somewhere above $10,000 that would depend on your personal circumstances. Don’t forget to consider margin requirements.
In this post I’ve shared some considerations on account size and using a hypothetical system and provided some ideas on how to decide your position size and your account size.
The key points of this post are:
I've spoken with a few members about position size over these last few weeks, I hope these thoughts help. If you have any questions or thoughts, please do leave a comment.