VanTharp's Commentaries

The Percent Volatility Method

by VanTharp on May 12, 2008

Q: I have read and re-read (as you suggest) your book "Trade your way to financial freedom". It think it is great material, it is such a mind-opener.

However, I would like to clarify one point that it is yet not clear enough to me. It is about the Percent Volatility Method. If I use such Position Sizing Technique, then the Stop Loss is set by this position sizing method, I mean, the strategy must have a Stop Loss that is equal, for instance, to the 20-day SMA of ATR. If that is the stop loss, then the model is the same as the % of my equity.

I am getting confused. Let;s say that, prior to Position Sizing, my strategy has a Stop Loss that is 20-day SMA of ATR. Thus, the % of my equity and % volatility method are just the same. And if my strategy has no stop loss (let´ts say), if I use the Percent Volatility Method, it will be the method that will calculate the Stop Loss and place it 1ATR below the entry price.

A: Position sizing and the initial stop are two entirely different issues. The stop is NEVER set by the position sizing.
However, if the stop is 1 ATR, then percent risk and percent volatility are the same.




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Comment from ipsips on Apr 9, 2010
ipsips
I'm a bit confused here too. This method doesn't seem to take stop loss into account. Suppose I want to trade the forex market (gbpusd for instance) and the input data is as follows: ATR(10) = 30 pips 1 pip is worth 28 pln (my account is in pln) for 1 standard lot so vol = 30 * 28 = 840 pln I'm willing to lose 200 pln (2%) on this trade. SL = 3 * vol = 90 pips = 90 * 28 pln = 2520 pln Now on to position sizing: using the percent risk model gives me: Lots = 200 / 2520 = 0.08 lots however using the percent volatility model: Lots = 200 / vol = 200 / 840 = 0.23. Now if I use the percent vol model and the worst comes to the worst and my SL is hit, I'm gonna lose not 200 pln but 580 which is much more than I'm willing to. Where did I get this wrong? Where do you get the stop loss into account in this method?

        

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