Position Sizing

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Position Sizing

The way we structure the size of the trades at my hedge fund is by following the money management parameters we reviewed in yesterdayís blog.    The rules are:  no one trade can risk more than 2% of the capital, and in any month that you lose 6% the fund goes flat and stops trading for that month.

Letís assume the fund has $2MM under management.  Following the 2% at max risk means that we could risk up to $40K on one trade.  If we traded a RUT condor with 10 point wings spreads where condor uses $1K of margin (assuming reg-T) one would think that you could do 40 RUT condors.  That is 40 X $1K = $40K which is 2% of $2MM.    Actually, this is correct if you are assuming that you will let the condor lose the maximum it can.   In practice I use a smaller allowed loss before I pull the trade.   For example, in the RUT condor I might have a profit target of 15% of margin and an allowed loss of 20% of margin.  Hence, if one condor lost $200 (20% of $1K) I would exit the trade instead of letting it lose the maximum $1K.   If you are only allowing the trade to risk $200 then if you can risk $40K (2% of $2MM) per trade then you could trade up to 200 RUT condors.

In practice, at the fund we wouldnít normally go up to 200 condors to have a trade risk 2% of capital.  Usually we risk 0.5% to 1.5% of the capital per trade not the full 2%.  We would go up to a full 2% only if the thought the trade was in a very good trading environment and we it was time to pull out all the stops.  But, we never, ever, go above the 2% risk allowed per trade.   

A question that comes up a lot is that if the second rule doesnít allow you to lose more than 6% in a month do you only have 3 trades on at any time due to the 2% rule.  The answer is no.  I would have multiple trades on following the 2% rule, but remember not all the trades should go against you at the same time.  If they are you are choosing highly correlated trades which should not be done (subject for another time).    On average, I would have about 15 to 20 trades on at a time.   If you assume an 80% success rate we would have about 3 to 4 trades go against you on any given month.  So, hitting a 6% loss in a month should be unlikely because if you had 4 bad trades at 2% loss is 8% loss.  However, you have to count the contributions from the winning trades.   The winning trades would have to make less than 2% to give you a 6% loss for the month.   If we did lose 6% in the month we stop and re-asses our strategies.

I highly suggest that you follow strict position sizing based on your money management parameters.   These rules will keep your funds safe and you will avoid blowing up.    Iíve seen many accounts blow up due to poor money management and position sizing.

Good luck and happy trading.

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