We know that prices can go up or down. We also know that the quality of these ups and downs can be very smooth or very choppy. As such, it's not surprising that the trend and volatility of a market form the two universal characteristics of a price action. No matter which market you trade, the trend and volatility of the prices will influence your trading and P&L. That can be both good and bad as volatility is a double edged sword. A fast paced moving market can rain down gold on you or it can burn your cash away. Most of the time, it's the latter case. Consequently, there are many ways traders adapt to changing volatility in the market. You can tailor your trading strategy, change trading timeframe, switch market entirely, or manage your risk accordingly, for examples. In this post, I'd like to give an example for the use of a statistically-derived forex position size table to fit with market volatility. The problem with market volatility is that it's hard to notice. As opined by Dr. Steenberger, "many traders will adapt to directional changes quicker than they adapt to shifts in volatility." The art of identifying market conditions is not discussed in this post. But obviously, if there is a way to build in an inherent way to manage your risks based on market volatility, you will have built yourself a safety net. That is the logic behind my statistically-derived forex position sizer. It's a data-driven tool to impose an inherent safety net in your trading. What it does is simple. Here's what it boils down to:
- It finds the recent 2 sigma value (i.e., a statistical measure of volatility, see wiki) of each major currency pairs.
- It calculates the maximum position size for each pair using the 2 sigma value.
- Then it converts the number to correspond with your account currency based on a real-time currency exchange rate for each trading pair.
Thus, a table such as this one I published for forex can give you a real-time guideline to the maximum position size you should take given your risk appetite. One shortcoming with this approach is that while you may limit your loss during a volatile market, you are also limiting your potential gain. But this is where the old saying, "let your profit run and cut your losses short" applies. One solution is to simply add to your winning trades, according to your trading setups, of course. That way, when the market moves in your favour or you get confirmation on your setup, you can increase the position size responsibly without stretching your principal. By now, it's probably obvious that the use of such a tool is not, and should not, meant to be a solution to changing market volatility. It is merely a convenience tool to serve as one of the many that a trader has at his/her disposal. Nevertheless, I find the table to be very convenient for me because I don't have to worry about calculating the position sizes manually on each trade. Trading is tough enough already, so I like to develop tools that can make my life ever so slightly easier.