Position sizing is the least talked about and most important factor that determines investment success. In his book, “Trade Your Way to Financial Freedom,” Dr. Van K. Tharp uses the term “position sizing” in preference to the more widely used term, “money management.” He says that money management means different things to different people, but position sizing is clear. It’s the answer to the question of “how much?” The number shares or contracts that should be bought or sold.
In his book, Tharp researches four position sizing models: one unit per fixed amount of money, equal value units for stock traders, percent risk, and percent volatility.
Testing a simple breakout system and assuming a million dollar stock portfolio with a 0.5% cost of trading and taking 595 trades over a 5.5 year period, the system had 273 winning trades and 322 losing trades. So only 45.9% of the trades were profitable. Here are the results of Tharp’s tests as applied to all four position sizing models:
One Unit Per Fixed Amount of Money: This model buys takes a one unit position per so much equity. It’s commonly used by futures traders. For his tests, Tharp used 100 shares of stock per $100,000 in equity. It made $237,457 for an annual compounded rate of return of 5.75%. It had a maximum drawdown of equity of 7.13%.
Equal Value Units for Stock Traders: Stock investors use this one a lot. For this model, Tharp allocated 3% of his equity for each position. So for a million dollar portfolio, no position would be larger than $30,000. In other words, you would buy 1,000 shares of a $30 stock and 300 shares of a $100 stock. It made $231,121 over the period for an annual compounded rate of return of 3.86%. It had a maximum drawdown of 3.72%.
Percent Risk: For this model, Tharp sized his positions at a 1% risk. Since 1% of a million dollars is $10,000, the initial risk could be no more than $10,000 for each position. So if you bought a $30 stock with a stop loss at $24 (20% below the entry price), you would risk 0.5 percent of the portfolio (.01/.20). With a million dollar portfolio, you would buy $50,000 worth of stock. $50,000 divided by the $30 stock price means that you would buy 1,666 shares.
It made $1,840,493 for an annual compounded rate of return of 20.92%. It had a maximum drawdown of 14.44%.
Percent Volatility: For this model, Tharp used the average true range of the stock over the last 10 days. In other words, he factored in the volatility of the stock. He used a 0.5% volatility, which means that he wanted to limit his market volatility exposure to 0.5% per positon, or $5,000 in a million dollar portfolio. So if the average true range for a stock was $5, he would buy 1,000 shares ($5,000/5). If the average true range was $2, he would buy 2,500 shares ($5,000/2).
It made $2,109,266 for an annual compounded rate of return of 22.93%. It had a maximum drawdown of 16.61%.
Think about it. The exact same system was used for each model, producing the exact same entry and exit points and the exact same win/loss percentage. But the last two models made well over 700% more money than the first two. And the only difference among the models was position sizing.
Tharp said that the percent volatility model was probably best for “traders who use tight stops” and the percent risk model was probably best for “long-term trend followers.” Since most of what we do is closer to long-term trend following, we are using the percent risk model.
Larry Holmes
