# (c) 2021 Van Tharp InstituteRecorded Video Handout

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itutestHow to DeveloppInWinning Trading SystemsTharThat Fit You021VanWorkshop(c)2Dr. Van K. Tharp, PhD&CopyrightRJ HixsonRecorded Video Handout

TharpObjectivesInstitutePosition Sizing Strategies1. To gain an overview of basic position sizing strategies,including CPR for traders.Van2. To learn some general guidelines for position sizing strategiesdepending on your objectives.Copyright(c)20213. To learn several strategies used by great traders to get maximumreturns.

021VanTharpInstituteUnderstanding CPR for Traders(c)2This figure shows the relationship between the Risk (R) per unit, the Position Size(P) for the trade, and the total equity or Cash (C) at risk in a trade. With any of thetwo variables the third can be calculated by following the “Y”.htP C / R Or P RT / RUPosition Sizerig(# of units) Cash (the equity you are willing to lose on the trade in or RT)Risk (difference between entry price and initial stop in per unit or RU)CopyWe’ve shown it this way so you don’t have to memorize the formulas. Just rememberthese simple mnemonics that you can use to remember the Y diagram:“I learned CPR at the Y.” or “Cash, Position Size, Risk.”

Martingale vs. Anti-Martingale SystemsWhen applying % of equity strategies - how do you define equity?stThere are three ways:ituteSome Position Sizing Strategy BasicsInTotal Equity: Equity is cash plus equity amounts in open positionsTharpReduced Total Equity: Equity is cash plus equity in open positions that stopsprotect.Core Equity: Equity is available cash only—no portion of open positions areincluded.VanSome Very General Equity Risk Percentage Guidelines0210.1% to 1% per trade when managing other people's money0.8% to 2% per trade when trading your own money3% or greater (according to Ed Seykota) is being a gunslingerAdditional Position Sizing Strategiespyright(c)2Percentage of VolatilityPercentage of MarginPercentage of LeverageOne Unit per So Much EquityScaling InScaling OutGroup RiskPortfolio Heat—Total Portfolio Heat should not exceed 20% to 25%Going for the Moon StrategiesCoRecommended - Market’s Money/Creative Position Sizing StrategiesNot Recommended - Kelly Criterion Percentage, Optimal f: (What fraction ofyour maximum loss should you bet?), Fixed Ratio Trading

ituteSome Position Sizing GeneralExamples For Different ObjectivesstObjective 1: Make as much money as possible withoutworrying about drawdowns or ruin.rpInMethod 1: Risk the % Risk that Gives You the Highest MedianGainSystem Quality Number score above 5.0 – could do as much as 4%,but be careful of multiple correlated positions. System Quality Number score above 3.0 – could do as much as 2.5%,but again be careful of multiple correlated positions. System Quality Number score above 1.75 – could do as much as1.5%, but be careful of multiple correlated positions. System Quality Number score below 1.75 – with this objective,trading this kind of a system is probably a disaster021VanTha (c)2Method 2: Bill Eckhart PyramidingStart at ½-1% of equity and as the price goes up by a certain amount – whichyou define, scale in 3-4 times. Limit, however, your total exposure to themaximum amounts suggested in Method 1.rightObjective 2: Maximize probability of meeting goals.pyUse Percent Risk that Gives Highest Probability of Meeting YourObjectiveCo System Quality Number score above 5.0 – could do as much as 2.5%,but be careful of multiple correlated positions.

System Quality Number score above 3.0 – could do as much as 2.0%, butagain be careful of multiple correlated positions. System Quality Number above score 1.75 – could do as much as 1.25%,but be careful of multiple correlated positions. System Quality Number below score 1.75 – with this objective, tradingthis kind of a system is probably a disasterInstitute Method 1: Market’s MoneyTharpObjective 3: Maximize the probability of meeting your goal,while minimizing any loss to your initial equity.VanOn starting equity use % risk that has 0% chance of ruin. But on profits, userisk percent that is optimal for achieving goal or use median gain %.021Here are some examples for your starting risk (i.e., on your core equity beforemarket’s money):System Quality Number score above 5.0 – could do as much as 1%,but be careful of multiple correlated positions. System Quality Number score above 3.0 – could do as much as 0.8%,but again be careful of multiple correlated positions. System Quality Number score above 1.75 – could do as much as0.5%, but be careful of multiple correlated positions.right(c)2 py System Quality Number score below 1.75 – could probably trade thiswith 0.5%, but would not recommend using much more than 0.75%with Market’s Money.CoFor the Market’s Money portion of your position, use the examples listedabove for Objective 2.

ituteMethod 2: Use a Market’s Money strategy, but convert themarket’s money to equity every month.This is more conservative than Method 1. Scale-Out to maintain constant open riskScale-Out to maintain constant volatilityIn stMethod 3: Scaling-OutTharpThis method could require monitoring your position sizing on a periodicbasis—weekly, daily, or even hourly—to maintain a fairly constant exposure.What potential risk are you exposed to?(c)2021Van Here you need to calculate the difference between the current valueand the stops of each position you have. This is called the open risk ofyour portfolio. What if you controlled the total open risk or limited theopen risk of each open position by scaling-out of positions to limityour open risk? Think about the potential here. You could monitoreach position and make sure that your exposure was always 2% or lessper position. This means that, except in runaway markets, yourbiggest risk would always be about 2% per position. You must have aSystem Quality Number score of at least 2 to do this.right In addition, think about the potential volatility of each of yourpositions. What has the volatility been in the positions you hold overthe last few days? Is this volatility going up? What if you limited it byscaling-out of positions when a certain level of volatility has beenpassed?Copy Consider monitoring both ongoing risk and ongoing volatility with atotal equity calculation.

ituteObjective 4: Minimize probability of ruin or even adrawdown of X%.Method 1: Percent Equity Risked:System Quality Number score above 5.0 – could do as much as 1%,but be careful of multiple correlated positions. System Quality Number score above 3.0 – could do as much as 0.8%,but again be careful of multiple correlated positions. System Quality Number score above 1.75 – could do as much as0.5%, but be careful of multiple correlated positions. System Quality Number score below 1.75 – could probably trade thiswith 0.5%, but would not recommend using much more than 0.75%with Market’s Money.VanTharpInst 021Method 2: Calculate your average maximum R-drawdown and usethat to calculate position size.(c)2Let’s say your objective is to avoid a 25% drawdown at all costs. Andhere, we are talking about a drawdown at any time in the curve of 25%—not just a drawdown of 25% from the starting equity.CopyrightThe way we’ll do that is to calculate the maximum drawdowns of oursystem in terms of R. Let’s simulate a system making 100 trades 10,000times to see what is possible in terms of drawdowns expressed in termsof R.

itutestInrpThanVa(c)2021The median maximum drawdown was 38R. But in 1,000 of the simulations(i.e., the 10% level), we had a maximum drawdown of 62R. The table belowshows other probabilities from the simulator from this particular system.Probability of Maximum R-Drawdowns in Our SystempyrightMaximum y DD100%76.4%50%25%10%5%1%CoYour system, depending upon its R-multiple distribution, will have differentprobabilities.

InstituteLet’s use the 10% level of -62R to do our calculations. Thus, we can feel withcertainty that we have less than a 10% chance of reaching these levels. If wedivide 25% by 60R, we get a risk level of 0.4%. This is pretty similar to ourestimate of our initial risk size. However, if we want to only have a 10% chanceof a 25% peak-to-trough drawdown in our equity curve, then we must neverrisk more than 0.4% with this system. And if we wanted to guarantee a 1% orless chance of such a drawdown, we probably shouldn’t risk more than 0.2%(i.e., 25% drawdown/93R 0.00269).rpMaximumLosing g TradePercentageFrom The Definitive Guide to Position Sizing StrategiesExpected Losing Streaks in 100 Trades(or Losing Streaks as a Function of Winning Percentage of Trades)100%10%1% ProbabilityProbability forAverage LosingProbability forfor a Losinga Losing StreakStreak Lengtha Losing StreakStreak ThisThis LongThis LongLong2345 to 63356 to 7335 to 67 to 8346 to 78 to 94579 to 1045810 to 1156912671013 to 147811 to 1215 to 168913 to 1418 to 1991115 to 1622101318 to 1925 to 26121522 to 2332Method 2 Summary Steps-ht1. Determine the worst-case peak-to-trough equity drawdown you’d like toavoid.rig2. Simulate your system and determine the probability of various R-levelmaximum drawdowns.Copy3. Determine the maximum drawdown in terms of R at the probability levelyou are willing to accept.4. Divide this level into the value you selected at step one and the result shouldbe the position sizing level as a percent risk that you should use.

Objective 5:ituteBelief: Asset Allocation and Position Sizing are the same—they bothare designed to answer the question of “how much.”stMethod 1: Asset Allocation for Classes of Investments.TharpInSuppose you want to always hold some positions in the strongest markets ormarket sectors. You could do this by buying ETFs and staying in those positionsuntil they show themselves to be weaker than the S&P 500 or until they are out ofthe top relative strength positions. One good way to pursue this strategy is toallocate a percentage of your total capital to this strategy (i.e., such as 20%). Thisway you could invest in the five strongest sectors.nMethod 2: Asset Allocation between Systems.021VaTom Basso and Jack Schwager have shown that monthly or quarterly rebalancingworks to improve the performance of non-correlated traders, then it should alsowork with non-correlated systems.If you have 3 different systems, allocate money based on the following:The System Quality Number score of each system, with the best systemgetting the most money.(c)2 If the systems have similar SQN scores, allocate equally between them.rig 5.0 SQN 60%3.0 SQN 30%1.75 SQN 10%htoooCopyEach month (or quarter), rebalance your money between the systems basedupon the initial allocation.In Every Case of Calculating YourPosition Sizing Risk Amount -Remember that you also need to manage your total risk at the portfolio

stitutelevel. Numerous open positions in the market probably constitutemultiple correlated positions. Multiple correlated positions can act likeone big position when exogenous events happen – outside events whichaffect all positions in the market simultaneously. We refer to totalportfolio risk exposure as Portfolio Heat.rpup to 20%up to 15%up to 12%up to 6%up to 3%ThaSQN Score above 5SQN Score 3 - 5SQN Score 1.75 - 3SQN Score 1.75SQN Score 1.3 - 1.75InRough Guideline for Portfolio Heat Amounts021VanExample – You trade a system with a SQN score of 3 and based on yourobjectives, you intend to risk 1% of your equity on each position. You also knowthat you can have up to 24 positions open at any one time. Using the portfolio heatguidelines above you realize you would not want to have more than 12% open riskin the market at any one time. Therefore, you would then adjust your risk amountper position from a max of 1% down to a max of .5%.Copyright(c)212% portfolio heat / 24 open positions max .5% risk per position

Volatility ControlstituteVolatility is the dollar value of the true range of price movement for the day. The higher theamount of volatility, the more it will tend to distract you from your purpose of concentrating ongood trading. Thus, I like to limit the amount of movement in any position to no more than 1%of equity on new and existing positions. This seems comfortable to my clients as well as me.More is a wilder ride, and less volatility is even more stable.InExample: Gold is at 400 and the previous few sessions have averaged 3.00 range for anaverage day. Our equity is still 200,000. How many contracts would volatility allow us to do?rp 3.00 100 per point 300/contractTha1% allowable volatility 1% of 200,000 2,000 per positionContracts 2,000/ 300 6.67 contracts. I'd round this down to 6 contracts.nRisk and Volatility ControlVaLimit your position to the smaller of either risk or volatility. In the two examples shown, riskcontrol yielded 2 contracts and volatility yielded 6, so I'd open the trade with 2 contracts.021Volatility in an Existing TradeCopyright(c)2I limit volatility in an existing trade to 1%, exactly like I calculate it for a new position. Then Ijust peel off the number of contracts necessary to get me back to an acceptable level of 1%equity.

Kelly CriterionstituteOnce you have a trading system and have tested it out, you need to calculate threeprimary statistics to determine the amount of risk that will produce the maximum rate ofreturn for you. The maximum rate of return will also tend to produce the largestdrawdowns. These statistics include the reliability of the system, the size of the averagegain, and the size of the average loss.rpKelly % A – [(1 – A)/B]InGambling has worked out a formula that you can use to determine your maximum risksize as a percentage of equity.ThaWhere A is the % of winning trades in decimal form (reliability of system),And B is the average profitable trade in divided by the average losing trade in .VanFor example, suppose I flip a fair coin. Thus, the reliability of the system (whether itcomes up heads or tails) is 0.5. The rules of the game are you make twice the amount yourisk when you win and you lose the amount you risk when you lose. Thus, B 2. Thequestion is "What percentage of my remaining equity should I risk on each run toproduce the maximum rate of return?"Maximum % 0.5 – [(1 – 0.5)/2] 0.5 – (0.5/2) 0.5 – 0.25 0.25021Thus, a maximum risk of 25% would yield the largest returns in this game. However, aKelly criterion only works when you have two possibilities, not a bag full.(c)2Expectancy Divided by Worst-Case LossExpectancy/ Worst possible risk against yourightNote that the Kelly or the Expectancy criteria gives you a maximum ceiling for your bet.In reality, your maximum risk size should be nowhere near either level. It should be waybelow them!!!! Both could overshoot the optimal risk size as determined by thespreadsheet you were shown.CopyNeither of these calculations is safe—both result in a high probability of ruin!

From The Definitive Guide to Position Sizing Strategies Expected Losing Streaks in 100 Trades (or Losing Streaks as a Function of Winning Percentage of Trades) System Winning Trade Percentage . 100% Probability for a Losing Streak This Long Average Losing Streak Length . 10% Probability for a Losing Streak

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