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October 13, 2012

How to build a position sizing system.

Talking about position sizing is not an easy task. First of all, if you decide to take on a trade you are persuade by a lot of stuff, rules, indicators and so on. In your brain everything is pressing you to buy or sell with all the money you’ve got; otherwise you won’t be buying anything. This should be the way.
But it’s not like that. When you want to buy, you’d buy everything. In your mind, this is the ‘perfect time.
But it’s not like that. It we were talking about random choices, and maybe we are, you’ve got 50% chance to win that game.
So why buying everything? If you can buy ten future contracts, why on earth should you only buy three? The anwer is because of risk. When you are losing, if you’re losing with only three contracts you can think:
‘I’m so lucky, I’m losing with only three contracts…’ When you win, the opposite, of course.
There’s a lot of stuff written on it. From pyramid buying, to martingales, and so on.
I think there’s a little truth in all of them.
I studied Kelly Criterion a lot. Thorp, Mit Students, and Ralph Vince work on it. Many papers have been published. Everything upon Bernoulli’s work.

So Kelly is simply fundamental.
This is for position sizing. How much money on my bet? This criteria can answer the question.

Kelly % value ensure the maximum final equity value for the system. This has been mathematically demonstrated.
I’m not going on the details of the formula and with other technicalities. There’s really a lot in the net.

When I said I use Kelly in my trading, It’s true. But i’ve modified with an idea I found in a Larry William’s friend work. We are trading high probability setups, when we’re losing rarely like in a mean reversion fashion, but when we lose, our losses are worst then trendfollowing losses. The odds of success increase a lot after loosing a trade, so Kelly can be modified in…

I will share this little secret and my exact position sizing algorithm with members signing in my e-mail list.

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