I was listening to a podcast featuring John Bollinger and he mentioned that “volatility is the most important, least analysed and worst understood”. The importance of volatility in trading is indeed under emphasized as the limelight typically shines on entry and exit rules. I first came across usage of volatility in position sizing used by the Turtles and Richard Dennis and that definitely gave me one of those “Light bulb” moments.
In this article I will share a common way to position size your trades using volatility.
Firstly we need to decide how to measure volatility. For much of the investment community volatility is standard deviation. Another way to measure volatility is to measure the Average True Range of the time series.
True Range is the maximum of either:
Average True Range of past 100 periods is the average of True Range of the last 100 periods. The same method goes for any periods (e.g. 20 or 50 periods) of Average True Range.
When we trade different markets and instruments, the volatility profile of each would be different. For example, bonds would have very different volatility profile compared to stocks. Different stocks would also have different volatility profiles. We would like to take larger positions with less volatile instruments and smaller positions with more volatile instrument with the aim that the profit and loss generated per trade has roughly the same impact to the overall strategy regardless of the instrument traded.
We will illustrate using a simple example below:
We would like to risk 50 basis points per trade with a portfolio of $1 million in value. Thus the impact per trade would be 50 basis points * $1 million = $5000
We calculate the Average True Range of past 100 periods of 1 unit of stock to be $10.
No. of units of stock to be traded = $5000 / $10 = 500 units
We calculate the Average True Range of past 100 period of 1 unit of bond to be $1.
No. of units of bond to be traded = $5000 / $1 = 5000 units
While the example above is overly simplified, I’m sure you see the idea behind position sizing using volatility.
Next, if you have a stop-loss level based upon volatility, you would be able to size the trade such that the maximum amount that you lose is the risk percent you have chosen. For example, the stop loss can be 3 units of ATR above or below your entry price.
Again we will illustrate using a simple example below:
We would like to risk 50 basis points of capital per trade with a portfolio of $1 million in value. Thus we would like to calculate the size of the trade such that we will lose $5000 when stop loss level is triggered.
Suppose a stock is trading at $80 and our stop loss is at $70. Hence we would make a loss of $10 per unit of stock when stop loss level is triggered.
No. of units of stock to be traded = $5000 / $10 = 500 units
Suppose a stock is trading at $80 and our stop loss is at $75. Hence we would make a loss of $5 per unit of stock when stop loss level is triggered.
No. of units of stock to be traded = $5000 / $5 = 1000 units
Hence we can see that when stop loss is wide, the size is smaller and when stop loss is narrow, the size can be larger.
Position sizing is important in trading and it is important to place emphasis on it.
In this article I will share a common way to position size your trades using volatility.
Firstly we need to decide how to measure volatility. For much of the investment community volatility is standard deviation. Another way to measure volatility is to measure the Average True Range of the time series.
True Range is the maximum of either:
- Distance from today’s high to today’s low
- Distance from yesterday’s close to today’s high
- Distance from yesterday’s close to today’s low
Average True Range of past 100 periods is the average of True Range of the last 100 periods. The same method goes for any periods (e.g. 20 or 50 periods) of Average True Range.
When we trade different markets and instruments, the volatility profile of each would be different. For example, bonds would have very different volatility profile compared to stocks. Different stocks would also have different volatility profiles. We would like to take larger positions with less volatile instruments and smaller positions with more volatile instrument with the aim that the profit and loss generated per trade has roughly the same impact to the overall strategy regardless of the instrument traded.
We will illustrate using a simple example below:
We would like to risk 50 basis points per trade with a portfolio of $1 million in value. Thus the impact per trade would be 50 basis points * $1 million = $5000
We calculate the Average True Range of past 100 periods of 1 unit of stock to be $10.
No. of units of stock to be traded = $5000 / $10 = 500 units
We calculate the Average True Range of past 100 period of 1 unit of bond to be $1.
No. of units of bond to be traded = $5000 / $1 = 5000 units
While the example above is overly simplified, I’m sure you see the idea behind position sizing using volatility.
Next, if you have a stop-loss level based upon volatility, you would be able to size the trade such that the maximum amount that you lose is the risk percent you have chosen. For example, the stop loss can be 3 units of ATR above or below your entry price.
Again we will illustrate using a simple example below:
We would like to risk 50 basis points of capital per trade with a portfolio of $1 million in value. Thus we would like to calculate the size of the trade such that we will lose $5000 when stop loss level is triggered.
Suppose a stock is trading at $80 and our stop loss is at $70. Hence we would make a loss of $10 per unit of stock when stop loss level is triggered.
No. of units of stock to be traded = $5000 / $10 = 500 units
Suppose a stock is trading at $80 and our stop loss is at $75. Hence we would make a loss of $5 per unit of stock when stop loss level is triggered.
No. of units of stock to be traded = $5000 / $5 = 1000 units
Hence we can see that when stop loss is wide, the size is smaller and when stop loss is narrow, the size can be larger.
Position sizing is important in trading and it is important to place emphasis on it.
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Editors’ Picks
EUR/USD stays below 1.1850 after dismal German sentiment data
EUR/USD stays in negative territory below 1.1850 in the second half of the day on Tuesday. Renewed US Dollar strength, combined with a softer risk tone keep the pair undermined alongside downbeat German ZEW sentiment readings for February.
GBP/USD falls toward 1.3550, pressured by weak UK jobs report
GBP/USD remains under bearish pressure and extends its decline below 1.3600 on Tuesday. The United Kingdom employment data suggested worsening labor market conditions, bolstering bets for a BoE interest rate cut next month and making it difficult for Pound Sterling to stay resilient against its peers.
USD/JPY is looking for direction around 153.00 with key US data in focus
USD/JPY reversal from 153.70 has been contained above 152.70 on Tuesday. Major currencies are trading within narrow ranges amid thin trading volumes. Investors await the release of the US GDP and PCE Inflation figures to make decisions.
Editors’ Picks
EUR/USD stays below 1.1850 after dismal German sentiment data
EUR/USD stays in negative territory below 1.1850 in the second half of the day on Tuesday. Renewed US Dollar strength, combined with a softer risk tone keep the pair undermined alongside downbeat German ZEW sentiment readings for February.
GBP/USD falls toward 1.3550, pressured by weak UK jobs report
GBP/USD remains under bearish pressure and extends its decline below 1.3600 on Tuesday. The United Kingdom employment data suggested worsening labor market conditions, bolstering bets for a BoE interest rate cut next month and making it difficult for Pound Sterling to stay resilient against its peers.
Gold recovers modestly, stays deep in red below $4,950
Gold (XAU/USD) stages a rebound but remains deep in negative territory below $4,950 after touching its weakest level in over a week near $4,850 earlier in the day. Renewed US Dollar strength makes it difficult for XAU/USD to gather recovery momentum despite the risk-averse market atmosphere.
Canada CPI expected to show sticky inflation in January, still above BoC’s target
Economists see the headline CPI rising by 2.4% in a year to January, still above the BoC’s target and matching December’s increase. On a monthly basis, prices are expected to rise by 0.1%.
UK jobs market weakens, bolstering rate cut hopes
In the UK, the latest jobs report made for difficult reading. Nonetheless, this represents yet another reminder for the Bank of England that they need to act swiftly given the collapse in inflation expected over the coming months.
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