We are trading forex and this formula applies to the futures markets. Thus, our position- sizing model, based on volatility, would allow us to purchase 3 contracts. If we divide our 300 per contract fluctuation into our allowable limit of 1,000, we get 3.3 contracts. Lets say that we are going to allow volatility to be a maximum of 2 percent of our equity. How many gold contracts can we buy Since the daily range is 3 and a point is worth 100 (i.e., the contract is for 100 ounces), that gives the daily volatility a value of 300 per gold contract. We will use a IO-day simple moving average of the average true range as our measure of volatility. Suppose that you have 50,000 in your account and you want to buy gold. Heres how a percent volatility calculation mightwork for position sizing. This is basically Wells Wilders average true range calculation as shown in the definitionsat the end of the book. If IBM varies between 141 and 143 then its volatility is 2.5 points, However, using an average true range takes into account any gap openings. Volatility, in most cases, simply is the difference between the high and the low of the day.
If you equate the volatility of each position that you take, by making it a fixed percentage of your equity, then you are basically equalizing the possible market fluctuations of each portfolio element to which you are exposing yourself in the immediate future. Its a direct measurement of the price change that you are likely to be exposed to-for or against you-in any given position. In the first few levels of the game, you will get the result immediately.MODEL 4: THE PERCENT VOLATILITY MODEL Volatility refers to the amount of daily price movement of the underlying instrument over an arbitrary period of time. In the game, as with real trades, there’s only one position sizing question to answer when entering a trade: ‘How much do I risk on each position?’ You establish the risk amount through your initial stop price (what’s your risk per share?) and your decision about how many shares to buy (which determines your total risk). In this game, position sizing controls how much equity you risk on any given trade. The golden rule of trading describes exits-abort losses and ride winners.
All Market Wizards agree that the key ingredients to your success are (1) the golden rule of trading (cut your losses short and let your profits run) (2) position sizing (the part of your trading system that tells you how much) and (3) the discipline to do both. Picking the right stock has nothing to do with success and neither does the accuracy of your stock picking. Consequently, they search for great entry systems that they think will help them pick the right stock.
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