In our last lesson we furthered our discussion on the importance of position sizing in successful trading and talked about the % Risk Model which many traders use to determine their position sizes. In today’s lesson we are going to talk about another method which Dr. Van K Tharp talks about in his book Trade Your Way to Financial Freedom, the % Volatility Model for position sizing.

As we have discussed in our previous lesson on the Average True Range, Volatility is basically how much the price of a financial instrument fluctuates over a given time period. Just as the Average True Range, the indicator that was designed to represent average volatility in an instrument over a specified time, can be referenced when determining where to place your stop, it can also be used to determine how large or small a position you should trade in a given financial instrument.

To help understand how this works lets take another look at the example we used in our last lesson on the % Risk Model for position sizing, but this time determine our position size using the % Volatility Model for position sizing.

The first step in determining what your position size will be using the % Volatility Model is specifying what % of your total trading equity you will allow the volatility as represented by the ATR to represent. For this example we will say that we will allow Daily Volatility as represented by the ATR to account for a maximum of a 2% loss of trading capital.

If you remember from the example used in our last lesson we had $100,000 in trading capital and we are looking to sell crude oil which in that example was trading at $90 a barrel. After pulling up a chart of crude oil and adding the ATR you see that the current ATR for Crude is $2.55. As you may also remember from our last lesson a 1 point or 1 cent move in Crude equals $10 per contract. So with this in mind that volatility in dollars per contract for crude equals $10X255 which is $2550.

So as 2% of our trading capital that we are willing to risk on a volatility basis equals $2000 under this model we cannot put a position on in this instance and would have to pass up the trade.

As Dr. Van Tharp states in his book, the advantage of this model is that it standardizes the performance of a portfolio by volatility or in other words does not allow financial instruments with a higher volatility to have a greater affect on performance than financial instruments with a lower volatility and vice versa.

The position sizing methodology that one ultimately chooses for his strategy should be decided by testing the strategy, the methodology for which we will cover in later lessons, and seeing which method works best with that particular strategy.

That’s our lesson for today and while there are many other methods of position sizing out there which I encourage you to explore, this finishes up my series on the subject. If you are seeking more information on position sizing I have included a link to additional resources below if you are watching this video on InformedTrades.com or in the description section if you are watching the video on youtube or one of the other video sites.

As always if you have any questions or comments please feel free to leave them in the comments section below so we can all learn to trade together, and have a great day!

Hi 4XLegalEagle,

Thank you for your kind note and welcome to the community. I am working hard to make this a place where people can come to learn to trade from scratch all the way up to expert level. We are not quite there yet but with the participation of people such as yourself we are getting closer by the day.

Best Regards,
Dave

Hey David,
Again, thanks for everything. I have a question about position sizing using the ATR indicator. In your oil example, the ATR is $2.55 and a pip is $10 per contract. Now I apologize if this is answered somewhere in the forex section and I overlooked it but, if the ATR reads off as say 0.0144 would I enter it into the equation (for simplicity sake, oil @ the same $10 pip) as 10x0.0144? Also, USD is always a straight forward example because of the simplicity/familiarity or the currency, but do you have a trick or a link to somewhere that could help me anticipate the pip value for currencies that I am not as familiar with, like the NDZCHF. As you can imagine, the ATR position sizing method becomes a bit more difficult without knowing how much each pip is going to cost/earn you.

Thank you,
Stephen

Hi Stephen,

Glad to hear from you.

If you are trading on the FXCM platform then they have the value of a 1 pip move listed in the quotes window which you can see by right clicking and then selecting "simple dealing rates". Once you have done this a window will come up with a line that says "pip cost" which lists the value of a one pip move in the market. Below is a video on this as well:

How to Calculate Forex Trading Profits and Losses

Hope that helps. Please feel free to post if there are any other questions or comments.

Best Regards,
Dave

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Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.