Previously in this column, we discussed how to determine the size of your initial capital for trading derivatives. This week, we discuss how to position size each trade.
Profit factor
The following discussion will be meaningful if you have been trading for a while, as this would allow you to gather information on how your trades performed over time. Alternatively, it would be helpful if you are testing your (nondiscretionary) trading system and want to determine the optimal position size when you take the system live.
To determine the optimal position size, you need three inputs: total trading capital, profit factor and winning percentage. The profit factor is the ratio of total gains to total loss in your trading account. This would be based on actual returns on your past trades applying a chosen strategy. For this purpose, strategy could be either trend-following or price reversal strategies. If you engage in both strategies, your position size should be determined separately for each strategy. If you are back-testing to validate your trading system, then the profit factor would be the series of returns generated through an optimization process. The winning percentage is the winning trades as a proportion of the total trades.
The optimal position size is based on a formula: [percentage of winning trades x (1+profit factor) -1]/profit factor. You can check this formula on the Internet. It is referred to as Optimal f. This number, the output of the formula, must be multiplied by your total trading capital to determine the amount you can allocate to a trade. Suppose Optimal f is 40 per cent and your trading capital is ₹5 lakh, then you allocate ₹2 lakh to the trade you want to initiate. With futures or options, you require an additional step- you must divide the amount by the permitted lot size to determine how many contracts you can buy. Of course, you can choose to buy less than the number determined through its process. That said, you must be mindful of two issues. You should have implemented the strategy for a while or should be currently back-testing the robustness of a trading system. Optimal f does not consider the maximum drawdown. That is, it does consider the maximum potential loss on a trade, the price movement from the peak to the lowest for a position. It is, therefore, preferable to cap Optimal f at 25 per cent.
Optional reading
The Optimal f is based on the Kelly formula that was originally used to determine long distance telephone noise. The Kelly formula was later used by gamblers to determine the optimal betting size. A modified version of Optimal f that accounts for the maximum drawdown is Secure f. Note that there are many ways to position size your trades. For instance, you can simply decide not to risk more than two per cent on your total trading capital on any single position.
(The author offers training programmes for individuals for managing their personal investments)
The formula
The optimal position size is based on a formula: [percentage of winning trades x (1+profit factor) -1]/profit factor
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