Q: Many of the experts say that 1% risk of your capital is fine to trade and it goes to max 5%. However, Van says there is a point at which 1R will give you a maximum return. How is that calculated to check its value, probably between 1 to 5%, if the percent risk position sizing model is used.
A: The answer to finding the max return position size requires trading system information and then some simulation work. You can find an optimal position size from a simulation based on your risk/reward parameters and your system’s trading characteristics. In short, you would need to gather a statistically valid sample of trade results from your system and simulate those results using different position sizes. As part of the process, you need to define your upside targets and downside limits. Van provides guidance on this area in his book The Definitive Guide to Position Sizing.
I would add that the position size that earns you the maximum return is also the position size that will most often reach your drawdown limit.
To paraphrase Van, however, traders who are the most willing to sustain deep drawdowns are the ones most likely to achieve steep gains. Do you know where you stand in terms of ability to endure drawdowns? That is the more important question than what kind of gains you are trying to achieve.
Traders I have spoken with who have sustained deep drawdowns seem to agree that your drawdown tolerance is probably a lot less than what you might imagine. You might consider using our new position sizing game (v4.0 releases next week) in simulation mode to vary position sizes with your system results. This will let you see the effect of large position sizes on your equity and give you a feel for what drawdown percentage starts feeling uncomfortable. —R.J.
