Van Tharp Teaches Position Sizing Strategies and Risk Management

Van Tharp dives deep into position sizing strategies. It’s a lesser-known topic, but aside from your own psychology, it’s the most important subject you could ever learn about trading. Position sizing strategies guide you on how much you should have on throughout the course of a trade. What many traders don’t realize is that achieving your objectives (whether maximizing your chances of a certain profit or minimizing your chances of a significant drawdown) is achieved through position sizing, not your trading system.

“Position sizing, not the trading system, is key to achieving your objectives.” – Van Tharp

Why Position Sizing Matters

A Game to Demonstrate the Concept

Van Tharp says I often play a game with my audiences to illustrate the impact of position sizing. In the game, everyone gets the same trades, but we end up with as many different equities as there are attendees, except for those who go bankrupt. This can be as high as a third of the audience. I’ve repeated this game with thousands of people around the world, and the result is always the same – numerous ending equities but only one set of trades. The key differentiator? How much each person bets and risks on each trade.

Academic Evidence

In a 1991 study by Brinson and his colleagues published in the Journal of Finance, they examined 82 portfolio managers over ten years, focusing on their allocations in bonds, cash, and stocks. This study found that position sizing (the “how much” variable) accounted for 91% of the variability in performance. Hence, while your trading system can be seen as a distribution of R multiples, position sizing aligns your risk across all trades.

Understanding R Multiples and Expectancy

If you’re unfamiliar with R multiples, I have another video on the topic. In essence, your system has a mean R-value or expectancy, which tells you the average return per trade given the risk taken. Position sizing allows you to standardize R multiple across trades.

For example, you might decide to risk 1% of your portfolio on every trade. If your stop loss varies across different stocks, you adjust your position size so that your risk remains constant – say $1,000 on a $100,000 portfolio.

Position Sizing Calculation: The CPR Framework

Here’s a simple framework for calculating position size:

• C is the total risk or the percent of equity you’re willing to risk.
• P is your position size.
• R is your unit risk.

Formula: P = C/R

Position Size = Cash/Risk Per Unit

Examples

Let’s look at some examples:

1. Example 1:
   • Total Risk: 1% of $100,000 = $1,000
   • Unit Risk: $100
   • Position Size: 10 shares
2. Example 2:
   • Total Risk: 1% of $100,000 = $1,000
   • Unit Risk: $10
   • Position Size: 100 shares
3. Example 3:
   • Total Risk: 1% of $100,000 = $1,000
   • Unit Risk: $1
   • Position Size: 1,000 shares
4. Example 4 (More Normal):
   • Total Risk: 2% of $100,000 = $2,000
   • Unit Risk: $25
   • Position Size: 80 shares

Sample Trades

Here are some trades to illustrate the effect of position sizing:

1. Starting Equity: $100,000
   • Risking 1% of equity = $1,000
   • Trade 1: 1 R loss = $99,000
   • Trade 2: Risk 1% of $99,000 = $990
     • 1 R loss = $98,010
   • Trade 3: Risk 1% of $98,010 = $980
     • 1 R loss = $97,030
   • Trade 4: Risk 1% of $97,030 = $970
     • 5 R loss = $92,180
2. Increasing Profits:
   • Risk 1% of $92,180 = $920
     • 10 R gain = $101,380

Notably, even after four losses, one 10 R gain puts you ahead. This demonstrates the power of position sizing.

Crafting Your Position Sizing Strategy

To effectively use position sizing strategies, ask yourself:

1. Who are you as a trader?
   • Risk manager aiming for slow appreciation with minimal risk?
   • Speculator seeking maximum profits without concern for potential losses?
   • Speculator wanting outstanding returns while minimizing risk?
2. What are your objectives?
   • Achieving a specific profit target annually?
   • Avoiding a critical drawdown?
   • Balancing goals with drawdown limits?

Every trader’s objectives can vary greatly, which means there are countless possible objectives.

Various Position Sizing Strategies

Here are some common strategies:

• Risking more after losses: This can be a disaster but is still a strategy.
• Constant amount per trade: Risking a fixed dollar amount each time.
• Percentage of equity: As demonstrated earlier, risking a consistent percentage, like 1%.
• Combination: Risking a percentage of equity plus a larger percentage of profits.

Learn More

For those eager to delve deeper into position sizing, I’ve written “The Definitive Guide to Position Sizing,” detailing 93 different strategies. This book is available on our website, along with the Introduction to Position sizing Sizing course.

Isn’t it time to master the factor accounting for over 90% of your performance variability? Position sizing is indeed crucial in achieving your trading objectives. Even a holy grail system can fail with poor position sizing, whereas a weak system can surpass expectations with excellent position sizing.

Learn position sizing, and transform your trading strategy today!

“Even a holy grail system, you can blow up through improper position sizing, whereas even a weak system, you could conceivably achieve your objectives with excellent position sizing.” – Van Tharp