Position Sizing: The Profit Secret of Pro Day Traders

Many junior traders are keen on efficiency, data-backed retrospective study,or blindly pursuing a winning rate, etc. Actually, they have not yet started trading. They are weak hands. Because the first step in trading is to accept and control losses unemotionally.


1. Gambling Matters


Seniors have taught you that investment was investment, and gambling was not good. It seems that gambling is a dirty word, everyone is annoying, but I don’t think so. Speculation or investment is gambling.


Not only investment, in fact, since the day you were born, you have been a gambler. When you come to this world and survive, you bet your parents will not abandon you. You deposit money in the bank, you bet that the bank will not bankrupt. When you ride to work, you bet that your bike won’t be tire flattened. When you go upstairs, you bet that you won't get hurt by wearing high heels! In fact, you can go to this day, you have been betting.


However, why do few of us think we are gambling? That's probability. People tend to ignore small probability events and think that it is not gambling. Therefore, if your trading can also achieve a small probability of loss, you will win the bet, but this requirement is not as high as what is required in daily life. With reasonable position sizing management, sometimes the winning rate is greater than a certain value. Of course, this risk is still higher than the probability of wearing a skirt being disturbed by the wind, but we have a weather forecast, or wearing a tight skirt when it is windy is much less risky.



2. Why is Loss an Inevitable Part of Trading?


A small probability event cannot happen in one experiment-everyone knows this sentence, in fact, there is another sentence in probability theory: a small probability event must happen in many experiments. 

The fluctuation of stock prices is uncertain. Traders should insist on trading with high probability, yet "small" probability events will inevitably occur.


For example, if a trader judges that there is a 70% probability that the stock price will rise under certain circumstances, then he should buy. Assuming that his judgment is completely correct, and he does this 100 times, then there will be about 70 times that it will rise, and about 30 times it will not rise but fall. As long as he firmly stops the loss, he will make money. And those 30 losses does not mean that he did anything wrong. In fact, he did everything right, and the 30 losses are still inevitable because of probability.  


In addition, new trading forces may intervene in the stock market at any time, and existing trading forces may exit at any time. This change in buying and selling power may cause stock prices to suddenly change the current direction of movement, leading to traders losses. Anyway, if there is a reward, there must be risks. This is the law of the evolution of things. If there is an opportunity to make money, there must be the possibility of losing money. What's more, traders are also human beings. As long as they are human, they will make mistakes, and mistakes in judgment and operation are inevitable.


3. How Can We Accept the Loss Calmly?


First of all, intellectually and emotionally recognize that loss is an inevitable part of trading, and repeatedly remind yourself not to expect every trade profitable, as long as the money earned is more than the money lost, you can make money subsequently.   Secondly, realizing that loss does not mean mistake. Sometimes, losses are purely probabilistic, part of normal trading and not caused by errors.


Mistakes in our trading philosophy refer to violations of trading disciplines and strategies. In trading, not every time you make a mistake leads to losing money. The "conspiracy" of the stock market is often to make you make some money when you first make a mistake, and then let you lose big after your mistakes become a habit. Therefore, loss and error are two different things and should not be confused. Finally, we must develop the good habit of stop loss unconditionally, and remember the benefits of resolutely stop loss; and affirm, cultivate and persist in the valuable qualities of being able to remain calm and active after experiencing losses.  


In addition, regarding the loss as the cost of the business of "trading", the cost is unavoidable, but it can be controlled. If after the stop loss, the stock turns around and moves in the previously expected direction, you should understand that the previous stop loss was correct, the previous trade has ended, and now is the next turn. What you have to do is not to be annoyed, but to be brave. Get involved again.


4. Position Sizing is The Magic Weapon for Profit Traders


If position sizing is the higher realm of trading, I not only support it with both hands, but even reckon that position sizing is still the "highest state" of trading. Any trading strategy, no matter how good or bad it is, if matched with good position sizing, will get better performance.


When you encounter a stronger opponent, fight if you can win, or just run away if you cannot. In trading, it is to increase your position after gaining a profit, or even increase leverage.


In an article by my friend Joseph who lives in Hong Kong, he started from a trading strategy. Basically, this trading strategy is already very good. Over a period of 14 years, the assets have changed from 100,000 Hong Kong dollars to 2 million Hong Kong dollars, and this is in a fixed position. Under the premise, there is no position sizing (PS) tech.


Although Joseph emphasized that with the addition of PS, asset growth can be much faster, but I believe that if traders in the market can double 20 times within 14 years, they should be very satisfied (Even Hong Kong real estate speculation does not earn 20 times) , In order to emphasize the importance of winning and losing, I want to start from another perspective. I call it the random trader test, or RT test for short.


5. Random Trader Test: Different Positions, Different Gains and Losses.


RT test started trading on Feb. 02, 2018, trading at the moment of opening every day, random trading. It may be long or short. The probability of being long and short is 50%. This can be simulated from a Binomial Distribution, or it can be thought of as a fair-coin-tossing experiment before the market opens every day, heads appear to be long, and numbers appear to be short.


The following four strategies ABCD all open in random-trader-mode, and the difference is stop loss, take profit, and position sizing. The point is not whether these four strategies will make money, but the reaction to different position sizing, which will bring different results of profit and loss comparison.


Strategy A: Open 1 position randomly every day, non-stop loss, non-take profit , and close the position when the day market closes.


Strategy B: Open 1 position at random every day, stop loss at -20%, take profit at +20% , if daily volatility is less than 20%, close the position when the day market closes.


Strategy C: Open 1 position at random every day, stop loss at -20%, take profit at +30% , if daily volatility is less than -20% or +30%, close the position when the day market closes.


Strategy C has involved the concept of “cut losses and let profits run”. The profit is 10% larger than the loss. Theoretically, as long as the winning percentage is higher than 40%, this will be a profit trade.


Strategy D: Open 1 position at random every day with a stop loss of -20%. When the profit is +30%, double the position. And keep the position, reset the stop loss to the break-even point (The average price of the position). Hold the position until price pullback to the price of stop-lose or market closes.


Strategy D realizes the concept of “cut losses and let profits run”. No matter the strategy is good or bad, position sizing is a nostrum.


6. Results: How to Become a Pro Treader?


The results of the experiment prove that the strategy ABCD will not certainly make money, but after repeating the experiment many times, there is a high probability that it presents a situation.


We simulated the four strategies 10,000 times each, from the retrospect on Feb 02, 2018 to Aug 21, 2018, which took a total of 18,400 seconds (no parallel processing). The following is the statistical data: out of 10,000 times, there are 6779 times the performance ranking is Strategy A <Strategy B <Strategy C <Strategy D.


Let’s look at the percentage of performance champions for each strategy: out of 10,000 times, 9,565 times, strategy D has the best performance; 247 times, strategy C has the best performance; 35 times, strategy B has the best performance; 153 times , Strategy A performs best.


In other words, among these four strategies, strategy D significantly won. What's more amazing is that the best number of strategy A is slightly more than strategy B, but that may be a statistical sampling error. The average profit and loss of the four strategies is as follows, on average, strategy A gains <strategy B <strategy C <strategy D.


After deducting the commission fee, only Strategy D may make money finally. But on average, it may only earn 1% per day, so these four strategies are by no means tradable strategies.


Many people spend their entire lives specializing in the supreme martial arts, and many have spent their entire lives specializing in trading strategies that make money without losing money. They have exhausted their entire lives to find out the entry and exit points for trading, but they have neglected the simplest and direct principle of position sizing. It turned out to be nothing.


There is no certain thing in the world, everything has a probability, only betting according to the rate of odds is the way to win. This is position sizing.


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