Size Matters: Matching Quantity to Quality

This article will focus on a simple technique to help you think about position size. The main concept in this article is very rudimentary, but my hope is to challenge your thinking no matter if you’re a beginner or an experienced trader.

Before we begin, take a moment to ponder this question:

How do you determine your position sizing?

Based on the simple questions above, there’s obviously many different styles of determining position sizing prior to entering a trade. In this article I’ll share a very simple technique I use to help anchor sizing to quality.

What do I mean by quality?

Not all trading setups are created equal and everyone has their own preferences for conditions they’d like to see before placing a trade. Examining setup quality forces us to think about what works best for your trading style depending on the current market conditions. If you’re struggling to take your trading to the next level, I’d encourage you to consider dynamic position sizing based on the backtested quality of the setup.

In day trading, there are specific setups I prefer when the market is in a structural uptrend and specific setups I prefer when it’s in a downtrend. My goal is to increase my position sizing on setups that I know have the best odds of success based on past performance. In the next section I’ll be using day trading examples, but you can also apply these principles to swing trading and investing.
 
 I like to use the 30min Opening Range when day trading S&P500 Futures (ES). One of my “go-to” trade setups involves a breakout from the Opening Range Highs or Lows. Over time I’ve realized that the success rate for Opening Range breakouts changes depending on the overall market. For example, an Opening Range High breakout is more likely to “have legs” and lead to a Trend Day during an uptrend (measured from a daily chart) versus an Opening Range High breakout during a downtrend.
 
 Market context (or situational awareness) is critically important to day traders. Let’s look at some examples together.

How To Determine the Current Trend

There are many different ways to do this. My goal is not to tell you how to determine a trend because that’s going to be different for everyone. When assessing a daily trend, what we’re really trying to determine is if the buyers or sellers are currently in control. Some people use trendlines for this, or moving averages, or oscillators, etc. etc. etc. You’ll learn what works best for you with time and experience…I try to keep trend identification as simple as possible. The purpose of this article is to help simplify your trading, not make it more complicated.

Here's a very basic trend analysis chart, looking at daily candlesticks:

The daily SPX chart above is looking for 2 simple factors:

If so, we’ll call that a structural uptrend. If not, it’s a downtrend.
 

Is it perfect? No, but nothing in trading is. However, it's simple and effective.

Here’s another example using Heikin Ashi daily candlesticks. Thanks to the smoothing properties of Heikin Ashi, this chart produces almost the same results without the use of any indicators.

These are just a couple basic examples, but it’s important to match your trend analysis with your preferred trading timeframe. The above examples work for me as a day trader, but if you’re a long-term swing trader or investor you might use something like the 200DMA instead of the 50DMA. No matter what you choose, the principle remains the same: Find a way to identify the overall trend of the market to the best of your ability.

After we know which way the market is trending we can start to think about which trading setups produce the best results for that trend. Feel free to start with your favorite setups, but I’d encourage you to eventually rank them based on backtested results rather than personal preference. What we like doesn't matter; what works matters.

Here’s an example of 3 different day trading setups I like to take in an uptrend, ranked by my experience of their effectiveness:

(If you’re unfamiliar with the setup names above, there’s charts at the end of this article explaining them.)

As we can see from the simple table above, my position sizing changes based on the quality of the setup (I'm using number of futures contracts in this case, but it could be number of shares or % of total account if you’re a swing trader). Each of these setups produce better than 50/50 results for me, so they each have an edge and are better than random; however, as you can see I do not use the same size for each setup because some are more reliable than others or tend to produce larger price moves. So to achieve the best results I can over time, I need to hit the highest quality trades with the most size.

The table above is just an example and not exhaustive. In reality, most traders that have taken the time to identify specific setups probably have multiple setups they could list for the A, B, and C categories. I kept the example as simple as possible for the purposes of learning, but I would encourage you to spend some time thinking about all the setups you look for and make a complete list. Trust me, there's a hidden benefit from completing this exercise: If a setup is not on your list, then you shouldn't be taking it! Trading for the sake of trading is not sustainable. Good trading requires thought, discipline, and patience. As you discover new trading setups, simply add them to your list and rank them based on effectiveness. This will help you avoid low quality trade setups because it will force you to think "Should I really be taking this trade? What's the thesis? What is my edge in this trade?"

Now let’s look at a ranked example of day trading setups for when the market is in a downtrend:

As we can see from this table, one of the trade setups is the same setup from uptrend table but the number of contracts traded has decreased in a downtrend because it’s not as reliable of a trade when the market is trending down.

The number of contracts specific to each setup is not particularly quantitative in this example and your sizing may differ. However, the point is to get you thinking about Risk vs Quality. In my experience, the most common thing traders struggle with (especially new traders) is overtrading. This is especially true for day traders; there’s often an innate desire to be in a position at all times in order for traders to feel like they are, well, actually trading. I personally think that’s a flawed way of viewing things—sometimes the best trades are the ones we avoid taking because it’s not a high quality setup.

One of my hopes for this simple article is that it gets you thinking more methodically about your trading decisions in order to avoid less-than-ideal trades. If you can identify a handful of setups that work well for you in both an uptrend and a downtrend you’re more likely to avoid overtrading and wait for quality. Plus, when the time comes to place the trade you won’t have to think as much about position sizing if you’ve done the thinking in advance. If you’ve backtested your favorite setups, you’ll be better prepared to take the trade with appropriate size when it presents itself. For example, your brain will say “Ok here’s an ‘A’ Setup that has a 75% win rate, I’m taking this trade.” Theoretically, this should free up brain processing time to think more about things like stoploss placement because you won’t have to think about whether or not you want to take the trade and what kind of size you’ll use. As ridiculous as it sounds, I strive to take as much thinking out of trading as possible…but that’s only possible with proper preparation.

Let the market force you to trade by producing one of your highest quality setups. If you’ve done your homework and have a basic idea of the success rate for a specific setup then there will be less internal debate and hesitation. For example, if you know a specific setup has a 75% win rate in an uptrending market, you should be taking that setup every time with appropriate size. Sure, you’re going to get stopped out 1 out of every 4 times, but trading is all about probabilities and if we can take better quality trades with suitable size we will be more likely to see long term success and avoid overtrading suboptimal setups out of boredom, ignorance, or addiction. If you’re a day trader, taking 1 high quality trade with larger size is far better than 10 low quality setups with the same size each time. Every trade we take is an opportunity for error.
 
 If you already employ this simple dynamic sizing technique then I'd argue you’re ahead of the curve. Many day traders set up brackets through their broker and use the same size for every trade. Why? Because it’s easy and simple to execute. If that’s you and you’re struggling or plateauing, I’d challenge you to rethink that approach and consider tying your position size to the quality of the setup. Some of the best traders I’ve met have very poor win rates, but they are very disciplined at hitting the highest quality setups with more size. Again, trading is all about probabilities in the long run…we press when the odds are in our favor and run away from low quality “suckers bets” that entice many retail traders.
 

 Capitalize on Quality,
 

 Horse

Long Trade Setups Referenced Above:

A. Opening Range Low to Mid (Long)

B. Opening Range High Breakout Trade (Long)

C. Offsides Delta at the Lows (Long)