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Position sizing based on volatility

Updated: Mar 17, 2023

Position sizing is an essential aspect of portfolio management that aims to optimize the allocation of capital among various investments while simultaneously minimizing the risk associated with each trade taken.

One popular approach to position sizing involves adjusting the position size according to the volatility of a financial instrument. This article explores the importance of volatility-based position sizing and provides a step-by-step guide on how to implement it in your trading strategy.

The Importance of Volatility-Based Position Sizing

Volatility is a measure of the fluctuation in the price of a financial instrument over time. High volatility implies large price swings, whereas low volatility indicates small price movements. By considering the volatility of an instrument, traders can better manage their risk exposure and avoid potential losses.

Volatility-based position sizing allows traders to:

  1. Adjust the size of their positions according to the risk associated with each instrument.

  2. Maintain a consistent risk profile across different assets and market conditions.

  3. Protect their portfolio from extreme price movements that could lead to substantial losses.

  4. Enhance the overall risk-adjusted performance of their portfolio.

Step-by-Step Guide to Volatility-Based Position Sizing

Step 1: Assess the Volatility of an Instrument

The first step in implementing volatility-based position sizing is to measure the volatility of a financial instrument. This can be done using various methods, such as calculating examining realized volatility, standard deviation of historical price returns or using the Average True Range (ATR) indicator.

Step 2: Determine Your Risk Tolerance

Next, establish your risk tolerance by deciding the percentage of your total trading capital that you are willing to risk on each trade. This percentage will vary depending on your individual risk appetite and trading objectives.

Step 3: Calculate the Position Size

To calculate the position size, divide the amount of risk you are willing to take on a trade by the instrument's volatility. This will give you the number of shares or contracts to trade. Keep in mind that the position size should be adjusted to ensure that the total dollar risk remains consistent across different trades and market conditions.

For example, if you have a $100,000 trading account and are willing to risk 1% of your capital on each trade, you would allocate $1,000 to each position. If the volatility of the instrument you are trading is on average 2% that means you may want to set a stop around 2.5%, which with a $100,000 account would give you a position size of $40,000. If a 2.5% loss was taken that would equate to $1,000 or 1% of the total account.

Step 4: Implement Stop-Loss Orders

Incorporate stop-loss orders into your trading strategy to manage your risk exposure. Stop-loss orders help limit potential losses by automatically closing a position when the price of an instrument reaches a predetermined level. I prefer to use a trailing stop based on (IV+RV)/29 for many swing trades. Other techniques are possible as well, such as using a prevailing moving average that interacts with the instrument. I often favor the EMA(8). Or looking at key levels. But the key is set the stop loss amount with the 1% total drawdown of the account and adjust your equation accordingly.

Step 5: Monitor and Adjust

Regularly review your positions and adjust the size of your trades based on the changing volatility of the instruments in your portfolio. This will ensure that you maintain a consistent risk profile and adapt to different market conditions.

In closing

Volatility-based position sizing is a valuable risk management technique that can help traders optimize their capital allocation and minimize potential losses. By adjusting the size of your trades according to the volatility of an instrument, you can maintain a consistent risk profile and enhance the overall risk-adjusted performance of your portfolio.

As with any trading strategy, it is crucial to monitor your positions and adjust your approach as market conditions evolve.

Want some one-on-one hands on help finding your edge? Reach out. I offer coaching focused on helping you determine what will work best to streamline your trading process, optimize your consistency, gain discipline, and identify entries as well as exits.

2 commentaires

Very good step by step article Mayhem. I was talking to someone about this very thing just a couple days ago.

Markets & Mayhem
Markets & Mayhem
18 mars 2023
En réponse à

Thank you so much! :)

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