Introduction to D-VaR Position Sizing (Part 1)
Position-sizing is the least exciting topic in trading. We all find ourselves too busy looking for the ultimate trading strategies or indicators to bother with spending time thinking about how much to bet. Contrary to what you might think, figuring out how much you should bet is not just a matter of determining your expected edge. Unlike casino games with defined odds, markets are uncertain and adjusting for the unexpected tail loss is just as important as adjusting for the expected size of your edge.
This concept is not new to hedge funds, and to those that trade for a living; They often think about risk first because their continued existence depends on staying in the game. For this sophisticated bunch, position-sizing, diversification, and hedging are the cornerstones of their risk management approach. Many of them are well aware that initial stop losses (in contrast to trailing stops which are very useful) are highly overrated as a means of managing risk–and if used improperly will increase your chances of going broke. This is because if they are placed too tight they will protect you from tail risk but expose you to more noise. If they are place too far the reverse is true– especially with unexpected gaps. The tradeoff is simple: death by one severe blow, or death by a thousand cuts. Finding the optimal balance is very difficult. Initial stops are not sufficient to manage risk by themselves and function much better when they are integrated with other risk management tools. In contrast, position sizing is very useful since you a) don’t face timing risk and b) can only lose what is invested–if you bet 5% of your portfolio no surprise gaps will lead you to losing more than you have bet.
To the best of my knowledge, I do not believe that this particular position-sizing method has been published somewhere before. However I do know that it is based on the well-known concept of “Value-at-Risk.” From Investopedia this is defined as follows http://www.investopedia.com/terms/v/var.asp:
A technique used to estimate the probability of portfolio losses based on the statistical analysis of historical price trends and volatilities.
VaR is commonly used by banks, security firms and companies that are involved in trading energy and other commodities. VaR is able to measure risk while it happens and is an important consideration when firms make trading or hedging decisions.
|VAR Position- Sizing DJIA 1928-Present|
|Buy and Hold||0.24||4.5%||18.4%||-22.6%|
|D-VAR 1% risk||0.45||5.2%||11.5%||-7.6%|
|D-VAR 1.5% risk||0.41||6.9%||16.7%||-11.4%|