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.
Editors’ Picks
EUR/USD climbs to daily highs near 1.1820
EUR/USD now picks up pace and advances to the area of daily peaks north of the 1.1800 barrier at the end of the week. The pair’s decent move higher comes against the backdrop of a generalised lack of direction in the FX galaxy and the mild offered stance in the US Dollar.
GBP/USD trims losses, retests 1.3460
After briefly challenging its key 200-day SMA near 1.3440, GBP/USD now manages to regain some balance and revisit the 1.3460 zone on Friday. Cable’s pullback comes as the selling pressure on the Greenback gathers traction, reigniting some recovery in the risk-linked space.
Japanese Yen gives back half of early gains against USD ahead of US PPI data
The Japanese Yen (JPY) surrenders half of its early gains against the US Dollar (USD) during the European trading session on Friday. The USD/JPY pair rebounds to near 155.90 as the JPY falls back, but is still 0.15% down.
Editors’ Picks
EUR/USD: Fed calm, ECB steady, but the Dollar still leads Premium
EUR/USD is still struggling to find real traction. The pair has tried to stabilise, but momentum keeps fading, leaving the door open to further weakness.
Gold: Falling US yields, geopolitics help XAU/USD hold ground Premium
Gold (XAU/USD) gained traction and climbed above $5,200, ending the fourth consecutive week in positive territory. The next round of US-Iran talks and crucial macroeconomic data releases from the US will be watched closely by market participants in the short term.
GBP/USD: Will Pound Sterling defend key 1.3450 support ahead of US jobs data? Premium
The Pound Sterling (GBP) entered a bearish consolidation phase against the US Dollar (USD), after having tested critical support near the 1.3450 level on several occasions.
Bitcoin: Another month of losses, and it’s been five
Bitcoin (BTC) price is stabilizing around $68,000 at the time of writing on Friday, but the Crypto King is poised to close February on a fragile footing, marking its fifth consecutive month of losses since October and a rare start to the year with back-to-back monthly corrections.
US Dollar: At a crossroads; Fed steady, tariffs in flux Premium
The US Dollar’s (USD) upward momentum from the previous week seems to have encountered a tough nut to crack in the 98.00 region, as measured by the US Dollar Index (DXY).
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