Position sizing is the act of determining HOW MANY contracts to trade when a trading system gets a signal. It is one of the strongest concepts available to traders and yet often the least accepted. Position sizing should manage risk, reinforce returns, and improve robustness through market normalization. Position sizing can finish up being rather more significant than where a trader buys or sells! However , most trading systems and testing platforms either ignore position sizing or use it illogically.

A big problem with many trading systems is they risk far too much of a trader's equity on each trade. Most pros agree that a trader should never risk more than 1% to 3% of his equity on any specific trade. This same idea applies to the total risk for each sector. For example, if a trader is risking two percent of his equity on each trade in some highly linked markets such as 2 year bonds, 5 year bonds, 10 year bonds, and 30 year bonds, this is essentially the same as risking 8% in the same trade. Although over trading in this way can produce phenomenal looking results with returns of 100% or even more, this is generally just a case of using too much leverage, taking too large a proportion of risk on each trade ( or sector ), and / or "cherry picking" the best starting date ( for instance, right before a sequence of winning trades ).

When running a study of the worst-case eventuality at those high-risk levels, it becomes clear that the danger of ruin climbs dangerously high. A collection of losing trades, or just beginning on the incorrect day, could cause an investor to lose everything ( or as a minimum have an enormous drawdown ).

The bottom line is that when putting on a trade, a trader should know what percentage of his equity he is going to lose if he is wrong. This should really only be a small part of his available trading capital. This also means that he has to know the risk he is taking on when entering a trade. Some trading systems, moving average systems, for example, do not even know how much risk they are taking. This is as the trading system doesn't know how far the market needs to go to trigger an exit. We think it is dangerous to trade this way and do not suggest it.

Another huge problem is the lack of market normalization ( such as single contract based results ) in trading systems. We don't think it is logical, as an example, to trade one contract of natural gas with an average daily volatility of around $2,000 for one Eurodollar contract with a typical daily volatility of about $150. To do this would indicate that the natural gas market is more significants than the Eurodollar market. If the Eurodollar market trends, we would like to give it just as much weight as the natural gas market ( or any other market ). In the prior example, a trader could simply take away the Eurodollar from the equation and get virtually the same performance. In essence, the results are unintentionally biased ( curve fitted ) toward natural gas. A $150 average winning trade in the Eurodollar isn't going to nullify a $2000 average losing trade in natural gas!

We endorse trading a basket of commodities for diversification, but if traders don't normalize the info and most of their profits and losses arise from just a few of the markets in their portfolio, that's clearly not diversification. The issue is that as time goes forward, traders are going to be dependent on that tiny handful of markets to perform. It is far better knowing that all markets have the capability to perform at an equal level rather than being dependent on just a few of the markets in the portfolio.

Most programs design work on a one contract basis. It is ( likely ) because of this that most trading systems ignore position sizing or use it illogically. Of the many back testing products for sale for sale ; we are only conscious of 2 software programs that may properly perform position sizing and cash management testing. Though there are numerous products which claim to do it, we've found that most all these products are not able to perform position sizing and money management properly ( there are several reasons for this, please be at liberty to talk to us for details ). We use Bob Spears' state-of-the-art testing software Mechanica for most position sizing based research and testing ( it sells for $25,000 a copy ).

Other issues include vendors that only report smaller drawdown numbers like "closed trade" drawdowns or "average yearly" drawdowns. There also are problems with position sizing ideas like "optimal F" or "Fixed Ratio." We feel that both these concepts are just a threatening form of hindsight biased curve fitting.

Another common misconception asserts that traders should find their "best" single contract based trading system FIRST and THEN apply position sizing to it. This is not the right approach. Position sizing can change the risk-to-reward profiles of any single contract based trading system, a trading system that could have looked terrific, with a smooth equity curve when on an one contract basis, can look much less engaging when all markets are equally weighted for robustness.

For all of the reasons cited above, we here at DH Trading Systems develop trading systems with correct position sizing logic. We believe this not only raises the robustness and importance of the testing results, but can also help to circumvent the inadvertent optimizing that will happen with other sorts of position sizing / money management based testing software.

Commodity trading carries risks and is not suitable for all investors. Past performance is not indicative of future performance.