A link to view and download my Position Sizing Tool Google Sheet can be found at the end of section #1: Measure Risk in R-Multiples.
One common trading hurdle that I see with several traders (even some who are highly followed on Twitter with booming subscription services and chat rooms) is their difficulty in scaling up trade size once they feel that they are in a position to do so. This is something that can be overcome fairly easily by making just three changes to your methodology:
#1: Measure Risk in R-Multiples
- Stop looking at Risk from a monetary perspective and instead approach Risk from an R-Multiples perspective.
One of the most powerful changes that you can make to your methodology to make scaling infinitely easier is to eliminate the monetary component to risk. If you’re looking at risk from a monetary perspective, then you are immediately putting yourself in a disadvantageous position when it comes to scaling up trade size down the road. If you get used to risking $1,000 per trade, then it’s going to be more mentally and emotionally challenging to increase that monetarily-measured risk in a meaningful way once your methodology has produced a statistically meaningful positive expectancy (statistically meaningful in the sense that you have 100+ trades to base your dataset on, positive expectancy meaning the expected return based on your statistically meaningful dataset; for more information on expectancy, read Van Tharp’s expectancy concept).
Some traders combat this by slowly scaling up their monetary risk per trade; however, if your system has already demonstrated a meaningful positive expectancy, then why wait what can take years to actually get to a trade size that allows you to truly capitalize on your profitable methodology? Some believe that it is necessary to slowly increase trade size over a longer period of time in order to minimize the mental and emotional hurdles that can challenge a trader who tries to increase trade size too quickly due to their conscious or subconscious discomfort with the meaningfully larger monetary risk per trade (something that happens all of the time, even to experienced traders as I mentioned in the opening paragraph of this post); however, though slowly increasing the monetary risk per trade tends to be more effective than increasing it quickly, I strongly disagree that this is the best approach to scaling up trade size. Moreover, I strongly believe that adopting an R-Multiples approach to measuring Risk is a far superior way to simplify the process of scaling up trade size.
If you’re not familiar with R-Multiples, then read Van Tharp’s Risk and R-Multiples concept. You can also purchase his book “Trade Your Way to Financial Freedom” which covers Risk and R-Multiples in greater detail.
With an R-Multiples approach to Risk, you essentially eliminate the monetary component of Risk when you put on a trade and set a mental or physical stop loss. Doing so allows you to focus on the market and not on how much you’re risking monetarily, which can be mentally and emotionally toxic for many traders. When you view risk in terms of R-Multiples, you’re always risking 1R per trade.
Prior to thinking in terms of R-Multiples, you must first define R (Risk). It’s common to see traders risk between .5% and 2% of their account value per trade. I personally risk 1% of my Initial Account Balance per trade (instead of risking 1% of whatever the balance is in my account prior to taking each trade and having a different monetary risk per trade, I fix my monetary risk for all of my trades based on the initial value of my account). So, with a $100,000 Initial Account Balance, my risk per trade will always be $1,000 (1% of $100,000) regardless of whether my account dips to $90,000 or increases to $110,000. Doing so allows me to not have to recalibrate R each time I take a trade, a task which would require me to think about how much capital I’m risking per trade. Remember, the whole point of using R-Multiples is to eliminate the monetary aspect of Risk from your mind. The only time that you should be associating capital with Risk is when you initially define R (as I just outlined).
Once the monetary value of R is defined (the amount of capital risked per trade), you can determine position size per trade. Position size will vary based entirely on where your stop loss is for each trade. For the following example, assume R is $1,000 (1% of $100,000 Initial Account Balance):
- AAPL is trading at $101.53.
- You identify a valid long trade setup based on your methodology.
- You identify an invalidation point at $100.34 (the point at which your trade idea would cease to be valid; in other words, the point at which you’d want to get the fuck on out of the way by exiting the trade via a stop loss).
- Your position size is determined based on the following equation:
- R ($1,000) / ($101.53 (the current price of AAPL) – $100.34 (the trade’s invalidation point/your stop loss) = 840.33 (rounded down to 840) shares of AAPL.
- $101.53 – $100.34 = $1.19. You are risking $1.19/per share of AAPL on this trade (R).
- Your position size would be 840 shares of AAPL at a cost basis of $101.53. If AAPL went to $100.34 and you were stopped out of the trade, then you would lose 1R (your initial risk of $1,000, or $1.19/per share of AAPL).
Few successful methodologies permit a trade to be taken when the potential reward is less than 2x the initial Risk of the trade. As a result, once your stop is defined (and subsequently your position size is defined), a valid target of at least 2x the initial Risk (2R) must be identified. Continuing with the AAPL example:
- AAPL’s nearest price resistance level is at 104.50.
- $104.50 – $101.53 (the price of AAPL where you’re looking to enter) = $2.97. $2.97 is your potential profit per share of AAPL based on the $104.50 target that you’ve identified.
- $2.97 / $1.19 (R, your Risk) = 2.49.
- Your potential reward for this trade is 2.49x your R or 2.49R.
As you start trading more using R-Multiples, you will find yourself thinking less and less about capital and more and more about R-Multiples. Instead of thinking, “My target is $3,000 on this trade and my risk is $1,000”, you’ll begin thinking, “My target is 3R on this trade, or 3x my Risk”. Which thought do you think has more potential to rouse your emotions? The monetary one, of course.
Once you get to the point where you have demonstrated a positive expectancy over 100+ trades, you might begin to think about increasing your capital risked per trade. This is where using an R-Multiples approach to Risk can really pay off.
Let’s pretend that you increased your account value to $150,000 (from the initial $100,000) and decided to deposit an additional $50,000 from one of your savings accounts. Let’s also assume that you’d still like to Risk 1% of your newly defined Initial Account Balance of $200,000. Your R per trade is $2,000 (1% of $200,000). However, 1R is still 1R, just as it was when you risked 1% of $100,000. Once you monetarily define R, your amount risked per trade should always be 1R. A trader looking at risk from a monetary perspective will always view their Risk per trade as $2,000. However, a trader looking at risk from an R-Multiples perspective will always view their Risk per trade as 1R. Whether R is $1,000 or $10,000 per trade, it’s always 1R. In addition, each trade’s profit target should continue to be viewed from an R-Multiples perspective (as illustrated by the AAPL example in this post).
An additional way to further simplify the position sizing process is to create a position sizing cheat sheet which allows you to associate incremental stop loss sizes with their associated position sizes based entirely on R. Lucky for you, I’ve created a Google Sheet which does exactly that:
- View the BreakingOutBad Position Sizing Tool Google Sheet
- View the BreakingOutBad Return on Risk Projection Tool Google Sheet
#2: Kick That P&L Bitch to the Curb
- Remove (or Hide) Profit and Loss from your trading platform.
Some find that having their broker’s Profit and Loss feature enabled while having open trades does not inhibit their ability to filter out the noise of their monetary P&L fluctuations. I have found, especially when scaling up trade size, that P&L does more harm than good. As a matter of fact, after going back and forth with and without trade P&L visible, I still struggle to find any meaningful reason to keep it visible.
When you’re trading with an R-Multiples approach to risk, you are going out of your way to significantly minimize your exposure to monetary variable stimuli. From converting your capital risked per trade to 1R, to setting profit targets based entirely in R-Multiples, to using a position sizing cheat sheet to automate your position size for any given trade, your exposure to monetary variables is significantly reduced. So, if your goal is to remove risked capital from your mind while trading, then watching your P&L in real time and seeing that risked capital fluctuate is highly counterintuitive and highly counterproductive. Do yourself a favor, and kick that P&L Bitch to the curb. Odds are that as you attempt to scale up your trade size, not having your P&L visible will make a big difference – both mentally and emotionally – in your trading.
#3: Discriminate Against Illiquidity
- Trade only highly liquid vehicles.
The third and final way that you can more effectively scale up your trade size is to trade only liquid vehicles. If you can specialize in a basket of (or if possible, one) highly liquid trading vehicle(s), then when the time comes to meaningfully increase your trade size, liquidity will not be an issue at all.
Think about it this way: Say you’ve spent a considerable amount of time developing, adjusting, and eventually, profitably executing your trading methodology. You know that after hundreds of trades, your expectancy is solid. The next logical step would be to…increase trade size. However, if after increasing trade size the vehicle(s) that you trade do not allow you to easily enter and exit without experiencing slippage, then that throws a monkey wrench into your methodology and brings into question the sustainability of your expectancy given the fact that you did not experience slippage with your previous trade size.
One of the reasons that I chose to focus exclusively on /ES is due to the fact that it is one of the most liquid trading vehicles available. Whether I’m trading 10 lots or 100 lots, I never have a problem getting in or out of a trade. If slippage were an issue, then it would significantly compromise my ability to scale up size in a meaningful way.
Set yourself and your methodology up for success and trade highly liquid vehicles. Whether you like low or high volatility, there are always liquid options available. Don’t let illiquidity and its bastard stepchild slippage hinder your potential as a trader.