Adapting to Volatility: Strategic Position Sizing for Algorithmic Traders

I’m going to show you how to turn a good system into an amazing system with just a few lines of code! Adding these few lines of code could make you an additional $10k, $25K or even $50K in profits instantly.

Today we’re going to take my Better Breakout Strategy, which is a day trading strategy and dramatically improve it’s ability to generate profit. The simple technique I’m going to show you can easily be applied to any of your trading systems allowing you to generate 10s of thousands of more dollars quickly.

Let’s start with a thought experiment.

Explain This Mystery?

Say we have two traders who are each given identical trading systems to execute on the NASDAQ futures market (@NQ).  Because both systems are identical copies of an automated trading system, both trading systems generate the same buy/sell signals, use identical stop loss and trailing stop parameters.

These two traders are also going to start trading on the same day, with the same starting account size.  In essence let’s pretend we have two traders that have identical trading circumstances. Let's give these two traders 12 months to trade.  At the end of the trading period, we would expect them to have the same account balance, right?

But at the end of the trading period, reality has made fools of us. One trader generated more net profit. How can this be?

Reviewing the trading results for both traders you can see both traders took the same signals. Both traders have the same win/loss ratio and even the same number of stop-out trades. But there is one difference.

One trader used a simple mathematical formula to determine how many shares to buy and thus, his account grew at a faster rate.

What is Position Sizing

Position sizing is a critical component of both systematic and discretionary trading, addressing the pivotal question: How many shares or contracts should I purchase?

Far too often, the answer is derived from nothing more than a well-informed guess. A common misstep among traders is to size their trades without considering risk, potentially undermining their results, their trading systems, and, in some cases, their careers as algorithmic traders!

By anchoring your trade size to a risk metric, you adopt a defensive stance against the unpredictability of the market. Risk management should be paramount for any trader aiming for long-term success. Therefore, employing a risk-based metric to mathematically size your trades is not just recommended; it's essential. Despite this, the common practice involves using a fixed number of shares or allocating a fixed dollar amount per trade. Let's pause to consider the implications.

Imagine your trading system signals a new buy opportunity. You could, theoretically, risk your entire cash balance on this single signal. A win might double your money swiftly, but a loss could deplete your account entirely. It's evident that staking your whole account on one trade is a gamble far too risky for any prudent investor. This extreme example illustrates a fundamental truth: risking your entire trading capital on a single trade is recklessly imprudent.

So, what's the prudent amount to wager? Maybe 90% of your account? Or perhaps you decide on purchasing 100 shares. Many system developers overlook how trade size influences the risk-reward dynamic of a trade.

As the risk increases, so does the potential reward. Yet, overextend your risk, and a few losing trades could decimate your account. Theoretically, there's an optimal balance between risk and reward specific to each trading system.

Your mission is to identify a nearly optimal level that aligns with your comfort as a trader. While delving into the intricacies of finding an optimal position sizing strategy for a specific trading system is beyond the scope of this discussion, I will illustrate the difference between employing a risk-based position sizing algorithm and simply buying a fixed number of shares—the latter being a common practice that neglects risk metrics, thereby failing to adjust trade sizes according to market conditions.

Does a risk-based approach truly offer an advantage? Let's delve into the evidence.

Our Day Trading Algorithm

We will be using a simple intraday breakout model called, Better Breakout which was discussed in thie article, A Modern Approach To Breakout Trading. Please review that article for the strategy rules. The code is available for all EasyLanguage Mastery subscribers.

Let's load the strategy on a NASDAQ Futures (@NQ) chart.

• Historical data January 1, 2012 through October 31, 2024
• Trades are executed on a 5-minute bar
• All trades are closed at the end of the day
• A dynamic stop loss based upon the volatility of the market. See the code for details.
• All trades are long only.
• We assumed a starting capital of $100,000
• $15 for slippage and commissions deducted for each round trip.

Below is an example of the strategy trading on the daily chart of @NQ. We can see the trade entering early on the 9:05 AM bar on a big gap up from the previous day. The trade closed at 15:00 PM the same day.

Fixed Contract Position Sizing

The fixed-share method is a non-risk-based method. In this case we simply buy the same number of contracts (1) for each signal. I use this technique all the time when developing a strategy. But it's probably not the best way to trade something live.

Contracts = 1

Percent Risk Position Sizing

The percent-risk method is a strategy grounded in risk management. In this approach, we allocate a fixed percentage of our equity—2% in this example—to risk on each trading signal. The choice of 2% is guided by a widely accepted principle in trading that suggests risking anywhere from 0.5% to 2% of your account balance on any single trade. This strategy aims to mitigate the impact of a series of losses, preventing them from significantly damaging your trading account. We then use this predetermined risk percentage to calculate the specific dollar amount you're willing to risk on an individual trade.

Example:

Contracts  = (2% of Account Equity) / ( Stop Loss Per Contract)
Contracts  = (2% * $100,000)/ $500
Contracts = $2,000 / $500
Contracts = 4

In the example provided, we have the methodology to calculate the number of contracts to purchase while maintaining a consistent risk level of 2% of the account size per trade. As mentioned, the stop-loss value for the 'Better Breakout' strategy adjusts based on recent market volatility, as detailed in the original article.

This adaptive approach means that if market volatility increases, our stop-loss threshold will widen. Consequently, to adhere to our 2% risk per trade guideline, we might find ourselves buying fewer contracts. Conversely, in periods of reduced volatility, our stop-loss tightens, allowing us to purchase more contracts without breaching the 2% risk rule.

The essence of this strategy is that we never risk more than 2% of our account on a single trade. This flexibility enables us to adjust the number of contracts traded in response to the volatility of the market, effectively normalizing our risk exposure relative to market conditions.

But what implications does this have for our trading outcomes?

Performance Comparison

In our analysis, we observed an increase in profits while maintaining the same number of trades (almost, there is one extra trade), without escalating our maximum intraday drawdown. We also increased every other metric!. 

This is a clear win. More profit. Identical risk. 

It's important to note that in our Percent Risk model, we are not reinvesting profits. We started trading with an account balance of $100,000 which remains constant for the purpose of calculating position sizes.

Why adopt this approach?

The goal was to evaluate the impact of scaling trades based on market volatility and to compare its performance with that of the Fixed Model. Incorporating profits into our calculations would undoubtedly enhance our returns further. However, I preferred to avoid complicating the analysis with additional variables. This decision was made to provide a clearer comparison and to focus solely on the influence of the position sizing model.

Pitfalls To Avoid

Don't Using Position Sizing To Improve A Poor System

First, let’s tackle a common misconception: thinking position sizing can turn a mediocre system into a winner.

Here’s the truth – position sizing isn’t a magic fix. If your trading system doesn’t have a solid foundation, even the best position sizing approach won’t make it profitable in the long run.

Imagine trying to fix a car with no engine by just repainting it; it might look better, but it’s still not going anywhere. You should always start with a positive expectancy system, meaning it’s capable of generating returns based on the market behavior it was designed to exploit.

Think of position sizing as the tool that can amplify or protect your returns, not create them from scratch. So, before diving into advanced sizing techniques, ensure your system is already well-tuned and thoroughly backtested. Only then can you expect position sizing to help elevate your results.

Don’t Risk Too Much Per Trade

Now, here’s a mistake that every beginner should be wary of risking too much per trade. It’s easy to think that a higher risk per trade means faster growth, but the opposite is true – the more you risk, the faster you can blow up your account.

In professional trading, a common rule is to keep risk per trade around 1-2% of your account. Why? Because this allows you to survive the inevitable losing streaks. Even the best trading systems will experience losses, sometimes back-to-back.

If you’re risking 5%, 10%, or more on a single trade, it won’t take long for a few bad trades to wipe out a significant portion of your capital. Here’s the bottom line: keeping your risk per trade at around 2% or lower gives you the breathing room to recover from losses and make adjustments if needed. It’s all about protecting your account so you can stay in the game for the long haul.

Remember, in trading, slow and steady does win the race.

Conclusion

Alright, let’s recap the main points.

We started with the concept of position sizing and why it’s essential for traders who want consistent, long-term results. We saw how adjusting trade size based on a percent-risk approach – rather than a fixed contract method – can help align your trades with market conditions, providing flexibility and stability in a volatile environment.

We also dug into the two common pitfalls to avoid: first, don’t rely on position sizing to make up for a weak system. Build a solid foundation with a proven strategy, and then let position sizing enhance it. Second, keep your risk per trade at a reasonable level, around 2%, to avoid those devastating losses that can sideline even the most promising traders.

Key takeaway? Strategic position sizing is a powerful tool when used with a robust trading system and disciplined risk management. It’s about managing your exposure, protecting your capital, and allowing your account to grow consistently.

Good luck with your trading.