Tuesday, May 07, 2019

Varying Position Size Still Doesn't Make Sense

Last year, I posted that increasing trading position size when volatility is lower didn't make sense for my trading system. When the volatility was low trades tended to lose more and win less. So, trading bigger because risk was supposedly lower didn't pay off.

Now I am using a more traditional trading system that wins by letting winners run and cutting losses short, without pretending to predict the direction of the market. Here, I have found that there is no correlation between the profit from trades and the maximum loss possible given the initial stop loss:

The chart shows all the trades in Bitcoin futures my system would have made in the last year The x-axis shows the maximum loss on the trade of one contract (assuming we can exit at the stop loss, i.e. no Black Swans). The y-axis shows the profit for the trade. There is a slightly positive correlation, though it is not statistically significant. On the other hand, you can see that realized losses do increase with increased initial risk. The system won 46% of the time with the average win 4.1 times bigger than the average loss. The average trade lasted 5 days.

If you adjust position size so that the initial risk of each trade is the same, returns do increase, but so does the maximum drawdown. If you scale back the average size of trades so that the maximum drawdown in percentage terms is the same as for trading with the same number of contracts each time, then returns turn out to be very similar for both strategies.

Bottom line is that varying position size increases returns but also drawdowns by a similar amount. If you care about drawdowns it doesn't help. So, I think I will focus on controlling drawdowns when choosing position size rather than equalizing initial risk.

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