# Selectively Increasing Position Size for Optimum Performance

System traders as well as
discretionary traders tend to trade similar position sizes from one trade to
the next. For example, if a system trader usually has a finite amount of
capital, he might trade three contracts
per signal over the course of one year.
If his capital increases, he might increase style=”mso-spacerun: yes”> his size to five contracts after his capital
increases by 50% or more. This is
because the capital amount does not vary usually by more than 5% or 10% from
one trade to the next unless the trader is highly leveraged. However, most
successful traders do not use excessive leverage (usually leverage of over
10-to-1 is too high for most systems).

As a result of contract sizes, traders usually have to wait until their
capital increases by at least 50% before they increase the number of contracts
they trade. For example, one S&P 500 futures contract is worth \$361,250 as
of this writing (\$1445 x 250). If the
trader wants to increase his system to two contracts per signal, that would
increase his position size to \$722,500 (\$361,250 x 2). style=”mso-spacerun: yes”> That is a considerable increase for most
let his capital increase by at least \$200,000 before adding one more contract
so that his leverage would not increase so dramatically. Let me elaborate,
suppose the system is capitalized with
\$75,000 to trade one S&P 500 futures contract. His leverage ratio is 4.81
(\$361,250/\$75,000). Now suppose the
capital increases to \$125,000 and the trader adds one more contract per
signal. Now the leverage ratio is 5.78 (\$722,500/\$125,000). style=”mso-spacerun: yes”> The increase in leverage is about 17% even
though the capital in the trade has increased by 66%. style=”mso-spacerun: yes”>

Luckily there are some solutions to
alleviate this problem (trading mini S&P 500 contracts) but we are
illustrating this example to remind you of the basic concept here. You must be
very careful about how you increase your position size. I have seen many
traders have initial success in the markets, increase their position sizes and
consequently lose all of their profits and more. In the end, they go through
intolerable drawdowns because of their bigger position sizes and shut down
because of bad position size management. />

size=2>Solutions

The scenario above almost seems like a
dilemma but there are strategies for dealing with it. style=”mso-spacerun: yes”> I will illustrate one with an example using
a system to trade S&P 500 futures.

When I first came across this problem
I asked myself if there was a way to heed the lesson described above, but only
selectively increasing the position size.
This way I would not have to wait long periods of time for my capital
to increase before increasing my position size. I found one such
approach.

size=2>Background

I started with a typical volatility
breakout system I had seen. The rules
were the following:

style=”MARGIN-LEFT: 0.25in; TEXT-INDENT: -0.25in; mso-list: l0 level1 lfo1; tab-stops: list .25in”> face=”arial, helvetica” size=2>1. style=”FONT-STYLE: normal; FONT-VARIANT: normal; FONT-WEIGHT: normal”>
Measure the average true range of the last four days.

style=”MARGIN-LEFT: 0.25in; TEXT-INDENT: -0.25in; mso-list: l0 level1 lfo1; tab-stops: list .25in”> face=”arial, helvetica” size=2>2. style=”FONT-STYLE: normal; FONT-VARIANT: normal; FONT-WEIGHT: normal”>
Buy today at yesterday’s close plus the number you get in
#1.

style=”MARGIN-LEFT: 0.25in; TEXT-INDENT: -0.25in; mso-list: l0 level1 lfo1; tab-stops: list .25in”> face=”arial, helvetica” size=2>3. style=”FONT-STYLE: normal; FONT-VARIANT: normal; FONT-WEIGHT: normal”>
Exit four days later or the next bar where you have a profitable
open.

4. style=”mso-spacerun: yes”> style=”mso-spacerun: yes”>Vice versa for shorts.

I want to point out that this system
is a typical breakout system and there are many out there that you can buy or
make yourself. The system itself is not
important here. What is critical is the way we are going to manage the
position size. You can apply this to
any system.

size=2>Rational

Next, I asked myself the question: How could I selectively increase position size based on a known market principle
that makes sense? I came up with
the principle of volatility. It is a
known fact that volatility is cyclical in nature. style=”mso-spacerun: yes”> It increases and then decreases when all
market participants have acted on their intentions. style=”mso-spacerun: yes”> One can look at a chart of the VIX index and
see this cycle in the stock market.
Assuming this principle, I then reasoned that big stock market moves
would be accompanied by high-volatility periods. If the big moves were in high
volatility conditions then it would be reasonable to expect that before the
move there was a low-volatility condition since volatility is cyclical in
nature. So why not double your position
size in those instances where volatility is unusually low, thereby possibly
giving the system a profit that’s twice
normal? The rest of the time when volatility was normal, meaning it was
neither too high nor too low we would trade regular position size.

I have summarized the results for this
below

Trade dates: April 21, 1982 to Jan.
10, 2000

System A trades one contract
constant

System B trades one contract and two
contracts when the average true range as of today drops to a 10-day
low

style=”mso-spacerun: yes”>
Net Profit style=”mso-spacerun: yes”>
Max
Drawdown

System A style=”mso-spacerun: yes”> \$83,
472 style=”mso-spacerun: yes”>
\$25,519

System B style=”mso-spacerun: yes”>
\$140,522 style=”mso-spacerun: yes”>
\$30,355

%change from

System A to B style=”mso-spacerun: yes”>
%68.34 style=”mso-spacerun: yes”>
%18.95

As we can see, profits went up by
68.34% and drawdown went up by only 18.95%. This is a 3.60 ratio. style=”mso-spacerun: yes”> That is a favorable outcome and
signifies that there are times when it does pay to take on extra risk. style=”mso-spacerun: yes”> The important thing to realize is that the
trader must be very selective and realize that extraordinary profit
opportunities do not come around
often.