A position sizing rule determines the
number of contracts or shares that are committed to each trade.

It is very easy to see the impact of
position sizing at either extreme.

If we trade a position size that is too
small—for example, one S&P con- tract per $1,000,000—our
trading equity is not being used at optimal levels. Conversely, a
position size that is too large—for example, 100 S&P per
$100,000—for our capital can increase our risk of ruin to
certainty.

Only the most naive and inexperienced
of traders will be ensnared by either of these extremes. It is in the
area between these two opposite ends of the spectrum, however, where
a sizing rule will have the most impact on strategy performance,
whether positive or negative.

The best and most efficient sizing
principle will be the one that applies our trading capital in an
optimal manner so as to achieve maximum returns with an affordable
risk.

We will look at four position sizing
examples:

1. Volatility adjusted

2. Martingale

3. Anti-Martingale

4. The Kelly method

A volatility adjusted sizing rule uses
the size of the account and the size of the risk assumed per contract
per trade.

Definition:

**Volatility adjusted**position sizing determines the number of contracts or shares per trade as a fixed percentage of trading equity divided by the trade risk.
For example, assume:

1. A risk size of 3 percent of equity

2. A risk per contract of $1,000

3. An account size of $250,000

The trade unit would be seven contracts
and is calculated as follows:

Total Equity to Risk = $7,500($250,000
× .03)

Number of Contracts = 7($7,500/$1,000 =
7.5 rounded down = 7)

An example of a well-known money
management rule is

**the Martingale strategy**. It is derived from a gambling money-management method.
Definition:

**The Martingal**e sizing rule doubles the trade size after each loss and starts at one unit after each win.
There are a number of variations on
this theme. One such variation is anti-Martingale.

Definition: The

**anti-Martingale**sizing rule doubles the number of trading units after each win, and starts at one unit after each loss.
Optimal f (fixed fractional trading)
was introduced by Ralph Vince in 1990. It is based on a formula
derived from

**the Kelly method**, which was, in turn, applied by Professor Edward Thorpe to gambling and trading.
Let us look at one implementation of
the Kelly formula.

Kelly% = (Win% − Loss%)/(Average
Profit/Average Loss).Position size |

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