One question we get asked a lot at Forex Trading-Pips is “how much risk to allocate to trades?”
A feature common to all robust trading systems is that they go through ‘hot’ and ‘cold’ periods. When a system is ‘in sync’ with the market we make money and life feels good. When systems go ‘out of sync’ we experience losses and trading becomes less enjoyable.
Many traders risk a percentage of their equity on each trade. In practice this means that risk is increased after a series of winning trades and reduced after a series of losing trades. The problem with this approach is that you are often trading largest at hot streak peaks and at reduced size after cold periods, leading to larger drawdowns and slower recovery.
This raises an important question: is it a viable approach to reduce size after a series of wins (run up in equity) and increase size after a series of losing trades (drawdown in equity), in essence employing a ‘counter trend’ position sizing strategy to our equity curve?
Ed Thorp addresses this question in his recent interview in Hedge Fund Market Wizards. Ed Thorp’s original fund, Princeton Newport Partners, achieved a track record of average annualized compounded gross return of 19.1% consisting of 227 winning months and only 3 losing months (all under one percent). When a trader posts 98.7 percent winning months over such an extended period it pays to listen!
Jack Schwager: ‘Do you think reducing your exposure on drawdowns was a good idea?’
Ed Thorp: “It all depends on how confident you are about your edge. If you have a really strong conviction about your edge, then the best thing to do is sit there and take your lumps. If, however, you believe there is a reasonable chance that you might not have an edge, then you better have a safety mechanism that constrains your losses on drawdowns.”
At Forex Trading-Pips we are confident in our edge as validated by our robust and enduring performance through widely varying market conditions and we employ counter trend position sizing to all of our trading as follows:
1. We employ fractional position sizing to our trading at all times, risking a small percentage of our trading capital on each trade.
2. We employ counter trend bet sizing at equity extremes: increasing size after a string of losses (equity oversold), reducing size after a string of wins (equity overbought).
Our results show significant improvement over fixed fractional position sizing: drawdown, account volatility and recovery period to new highs are all significantly reduced.
Risk management (position sizing) is an integral component of the Forex Trading Pips Signals Program and we make advanced position sizing technology available to all of our clients.
