Choosing a position size is the part of your trading approach that tells you "how much". It's not attractive. It does not give you the impression of your control over the market, as the entry methods do. It simply tells you what you risk in a given trade. You have already learned from the balloon game that many people lose 60% of their money in the system just because of a bad choice of position size. And the wide variation of results in this game depends entirely on how much they are at risk. And all this can become your best helper in the market. So why the competent choice of position size is such a problem?
Problem 1: Gambler's error.
How can you lose 60% of your money in the system at one-to-one bets? In a 60% system, you probably won seven or eight consecutive losses over 1,000 attempts. But you could easily get five losses in a row in 50 attempts in such a system.
For example, let's say that you've adopted a betting strategy of 10% of your capital. For the sake of simplicity, let us add that this capital is $1,000 at the beginning of the losing streak. You start with a 10% stake or $100, and you get the first loss. Now you have $900 left. You decide to bet $90, and you get the second loss. The balance is $810. Now you decide to bet $81 and get the third loss in a row. Now you've got $719 left. At this point, your thoughts may be as follows: "I got three losses in a row and now the odds of winning are high. After all, this is a 60% system. I think it's worth taking a $300 risk." Now you have four losses in a row and only $419 in the balance. You're feeling desperate. You lost almost 60% in just four rounds. You think "victory is now imminent," and you decide to risk another $300. The number of losses rises to five, and the capital falls to $119. You will now have to earn about 900% just to cover losses from the last five games, but your chances are very, very ghostly.
Some of you may think that you should have waited up to five consecutive losses and then bet $300. If that's the case, then you have the same problem. It's called a gambler's mistake. Your actual chance of losing in any given round is 40%. It doesn't depend on what's happened in the past. When you make a gambler's mistake and bet $300, you may well get the sixth loss in a row.
Problem 2: Difficulty in choosing the size of the position
The science of choosing the position size is a task as complex as the art of market entry. In addition, since only a few people are interested (or clearly understand) in the size of the position, software developers ignore it or completely ignore the problem. As a result, if you want to practice position sizing in today's computer world, you will have to do it yourself, in a table.
From my research and other sources, I know how a number of "market wizards" work. They have good systems with strong positive expectations. But these systems are not very different from those that an average trader can get. The difference between luck on the markets, which most of them have achieved, and the average yield only in determining the size of the position. Great traders apply clear rules of position size to good systems and have the discipline to follow them. Just read the Market Wizards, as well as Jack Schwager. They all talk about the importance of position size in their interviews.
Most traders find that the easiest solution when choosing the size of a position is just to trade one contract. This solution for small capital traders (i.e. for most traders) means not choosing the size of the position because they will have to at least double their capital before they can increase risk.
Problem 3: Most traders do not have enough capital
At the same conference, Ed Seykota said that he risked more than three percent of the capital in a separate deal to joke with fire. Your risk in this transaction is the difference between your entry price and your stop level. For example, if you open a position in gold at $400 with a stop at $390, then $10 stop is $1,000 risk. If you have an account of $25,000, then your risk on one contract is four percent. You'd be called a gambler with fire.
Most traders come to markets with accounts of $10,000 or less. They trade all at once and all their trades are very risky because the account size is too small. Of course, you can trade in some agricultural markets and with $10,000 in your account. In fact, you can also trade in many other markets if your stops are close and your system is designed for close stops. But most people who come to markets simply do not have enough capital to do what they are trying to do.
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