Create a Basic Risk Model: Position Sizing Matrix

Strategy building, trading system design and models must have the single most important factor set in stone. That is the risk portion of your strategy. Without a solid grasp of the risk, you will never succeed over time.

The position sizing matrix is a very simple solution to help gauge your position sizing with relation to risk. I use this every day and adjust it based on my performance. Building the risk portion of your model is the most important part. You must look at risk as a model in itself to fully understand your strategy or trading systems complete cycle. I increase this as I feel the need to  take on more risk or less based on how I feel about my trading and or strategies I may be deploying. If I’m trading well, I simply adjust my share size up a little. The key here is a little. I never adjust my share size more than a couple of hundred shares at a time. If I’m not trading well, I simply decrease the share size.
If you run back tests  or test strategies on a paper trade engine, this method is great for controlling your back test and paper trading assessment of a strategies performance.  Think of back testing like a scientist would think of his experiment in a laboratory. The scientist always wants a “Controlled” laboratory. He measures exact levels of this and that and uses an exact temperature to control things. He does this to keep as many things consistent as possible. As a trader, you can back test and paper trade in the same way by
controlling your share size every time just like the scientist does for his
experiment. Using the matrix is a perfect example of controlling our environment
to test and fully understand exactly what the strategy can and can’t do for specific
stocks or specific volatility ranges.  And is extremely important in the building blocks of your strategy.

The matrix is used in all situations, that’s why it’s so great to use. It starts with back testing strategies or creating a new test strategy, I use this Matrix every time. This way, when I trade live, I know exactly what my risk levels are for each and every type of stock and situation.

In the TradersThinkTank model, I simply refer to the matrix  so I know exactly what my risk is in dollar terms based on the volatility of the stocks and shares I deploy to trade.  Back up a notch, as my stops are ATR  (Average True Range) based and I have a set model that I can also adjust on the fly if necessary.
Here is a very basic example of the matrix:

The example above is easy to explain:
1. The vertical column to the left with the ATR (Average True Range) levels
indicates the volatility of the stock as measured by its 5 day ATR ( I use 5 day and you should use the ATR time frames your comfortable with).

2. The top horizontal menu is the style or length of time you are trading. So
for day trading stocks with an ATR of .5 -.9 would be non – applicable
(N/A) because I don’t day trade stocks with such a low Average True
Range. But you can see my next level of volatility is .9 – 1.5 and I would
trade 2200 shares, swing trading about 1300 shares and if I’m thinking of
running a longer term strategy, the share size would be 900. I stopped at the 5.2 level  as an example but you can customize your matrix based on your stock selection and go as high as your comfortable with. The key is as volatility (ATR) increases  your share size decreases.  Get the idea?

You can even create the same style of Matrix based on the price of the stock
instead of ATR or even both. Only you know how much you have to trade, so
also take into consideration stock price if you choose and total number of
strategies you intend to run at any one time or expected positions at any one time.
How do I come up with the amount of shares to trade for each ATR level?
1. I figure out how much I’m willing to lose on a specific time frame and / or
my strategy based on the strategies exit rules.
2. So if my exit rule on a swing trade uses an ATR % of 100% as a stop for
ranges between .5 and .9 and I’m only willing to lose $500 dollars on the
trade, then my share size should not be in excess of $500 shares using
the top-tier of .9 as a worst case scenario. I then back off about 100 or 200
shares to be sure I don’t get really hurt in a scenario of a stock gaping
down thru my stop levels. This allows me to cover all situations of risk and
worst case scenarios.
3. I always assume I will be running and possibly execute 3 to 6 stocks in my model, both short-term and longer term and I will be executed in 4 of the 5 for a scenario that I can
use to gauge my entire risk amount spread over the account.
Practice this method for back testing and paper trading until you fully understand
the method to size your trades.

Remember that this is just a starting point and the matrix is a simple example of how you can customize your own entry sizing to accommodate your risk levels.

You can follow along in real-time as I deploy my system daily and learn how to create your own trading model here:

Nick Pirraglia

About Nickolas Pirraglia

Nick Pirraglia started his career in trading in 1991 after returning to the US as an Army Officer deployed in Iraq. He began as a bond broker and worked his way into trading. Expert mentoring, hard work and a disciplined approach to the markets has allowed Nick the ability to maintain a very successful career in Capital Markets and Trading for over 20 years as a professional OTC Market Maker and independent trader. Nick has also managed the trading desks for a two Dallas based capital management companies and traded equities for a Dallas based hedge fund. Nick has trained and mentored thousands of customers in the rigors of trading, technical analysis and risk controls. Recently, Nick had broadened his market experience through the design and product management of two automated trading platforms. He has the pleasure of working with some of the brightest minds in the trading community and has collaborated with experts in data, design, engineering and trading psychology. An avid long distance runner, Nick completed several marathon events, qualified for the Boston marathon, completed several long distance Triathlons to include finishing a full Ironman triathlon.
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