Position sizing is determining HOW MANY contracts to trade when your

system gets a signal. It is one of the most powerful and least understood
concepts with many traders. Its purpose is to manage risk, enhance returns
and improve robustness through market normalization. Position sizing can
end up being more significant than where you buy or sell! Most systems
and testing platforms either ignore position sizing, or use it illogically.

A big problem with many trading systems is that they risk too much of a
traders equity on any given trade. Most professionals agree that you should
never risk more than 1% to 3% of your equity on any given trade. This also
applies to the risk for each sector. For example, if you are risking 2% a trade
in highly correlated markets like 2yr bonds, 5yr bonds, 10yr bonds and 30yr
bonds, this is essentially like risking 8% in the same trade. Overtrading this
way can produce incredible looking results with returns of 100% or more,
but this is usually just a case of using too much leverage and risking too
large a percentage of the account on each trade (or sector) and or "cherry
picking" the best starting date (like right before a series of winning trades).

When you run a "Worse Case Analysis" at those high-risk levels you see that
your risk of ruin climbs dangerously high. A series of losing trades or starting
on the wrong day could cause you to lose it all (or have an enormous
drawdown).

The bottom line is that when you put a trade on, you should know what
percentage of your equity you will lose if you are wrong. This should only be
a small portion of your available trading capital. This also means you need to
know your risk when you enter the trade. Some systems like moving
average systems do not know how much risk they are taking. This is
because the system does not know how far the market needs to move to
trigger an exit. We think it is dangerous to trade this way and do not
recommend it.

Another large problem is the lack of market normalization (such as single

contract based results). For example, we do not think it is logical to trade
one contract of natural gas with an average daily volatility of around $2,000
for every one Eurodollar contract with an average daily volatility of around
$150. Doing this would mean that natural gas is a more significant market
than the Eurodollar. If Eurodollars trend, we want to give them just as much
weight as natural gas (or any other market). In the previous example, you
could just simply remove the Eurodollar from the equation and nearly get
the same performance. In essence, the results are unintentionally biased
(curve fit) to natural gas. An average $150 winning trade in the Eurodollar is
not going to offset an average $2000 losing trade in natural gas.
The reason you trade a basket of commodities is to be diversified, however,
if most of your profits and losses arise from a few of the markets in the
portfolio you are not diversified. The problem is that going forward; you are
going to be dependent on those few markets to perform. It is far better
knowing that any market has the potential to perform at an equal level
rather than being dependent on specific markets in that portfolio.

It is likely that most systems ignore position sizing, or use it illogically

because the design of most software packages is to work with single
contract based testing. Of the numerous back testing products available for
sale, we are only aware of two software packages that can properly do
position sizing and money management testing. There are many products
that claim to do it, but we have found that almost all these products do not
do position sizing & money management correctly (there are many reasons
for this, contact us for details). We use Bob Spears state-of-the-art testing
software Mechanica (which sells for $25,000 a copy) for most of our position
sizing based research and testing.

Other problems include vendors that only report the smaller drawdown
numbers like "closed trade" drawdowns or "average annual" drawdowns.
There are also problems with position sizing concepts such as "Optimal F" or
"Fixed Ratio". In our opinion, both of these are just a dangerous form of
hindsight biased curve fitting.

Another common fallacy says that you should find your "best" single contract
based system FIRST and THEN apply position sizing to it. This is not the
correct approach; position sizing can change the risk-to-reward profiles of
single contract based systems. A system that looked terrific, with a smooth
equity curve on one contract basis, can look far less attractive when all
markets are equally weighted for robustness.

For all the reason cited above, we develop our systems with proper position
sizing logic. We believe this raises the robustness and significance of our
testing results. This also helps avoid the inadvertent optimizing that can
occur with other types of position sizing / money management based testing
software.