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 clings to daily gains above 1.0650
EUR/USD gained traction and turned positive on the day above 1.0650. The improvement seen in risk mood following the earlier flight to safety weighs on the US Dollar ahead of the weekend and helps the pair push higher.
GBP/USD recovers toward 1.2450 after UK Retail Sales data
GBP/USD reversed its direction and advanced to the 1.2450 area after touching a fresh multi-month low below 1.2400 in the Asian session. The positive shift seen in risk mood on easing fears over a deepening Iran-Israel conflict supports the pair.
Gold holds steady at around $2,380 following earlier spike
Gold stabilized near $2,380 after spiking above $2,400 with the immediate reaction to reports of Israel striking Iran. Meanwhile, the pullback seen in the US Treasury bond yields helps XAU/USD hold its ground.
Bitcoin Weekly Forecast: BTC post-halving rally could be partially priced in Premium
Bitcoin price shows no signs of directional bias while it holds above $60,000. The fourth BTC halving is partially priced in, according to Deutsche Bank’s research.
Week ahead – US GDP and BoJ decision on top of next week’s agenda
US GDP, core PCE and PMIs the next tests for the Dollar. Investors await BoJ for guidance about next rate hike. EU and UK PMIs, as well as Australian CPIs also on tap.
RECOMMENDED LESSONS
Making money in forex is easy if you know how the bankers trade!
Discover how to make money in forex is easy if you know how the bankers trade!
5 Forex News Events You Need To Know
In the fast moving world of currency markets, it is extremely important for new traders to know the list of important forex news...
Top 10 Chart Patterns Every Trader Should Know
Chart patterns are one of the most effective trading tools for a trader. They are pure price-action, and form on the basis of underlying buying and...
7 Ways to Avoid Forex Scams
The forex industry is recently seeing more and more scams. Here are 7 ways to avoid losing your money in such scams: Forex scams are becoming frequent. Michael Greenberg reports on luxurious expenses, including a submarine bought from the money taken from forex traders. Here’s another report of a forex fraud. So, how can we avoid falling in such forex scams?
What Are the 10 Fatal Mistakes Traders Make
Trading is exciting. Trading is hard. Trading is extremely hard. Some say that it takes more than 10,000 hours to master. Others believe that trading is the way to quick riches. They might be both wrong. What is important to know that no matter how experienced you are, mistakes will be part of the trading process.