bet or trade is more accurate than everyone
else’s. And if you trade too big based on assumptions, and you’re wrong, and the trade
loses money, it can cost you a big chunk of
It’s not that the Kelly Criterion is mathematically incorrect. When it comes to
trading, there are so many variables that
fixed odds for a single trade aren’t possible.
Moreover, the market has thousands of participants driving stocks and options prices
to an equilibrium that might represent a
theoretical fair value. I’m not picking on the
Kelly Criterion. There are options pricing
models that use stochastic volatility inputs.
It sounds great, until you try to come up
with a predictive volatility model.
But the motivation for using the Kelly
Criterion can be valid: You want some
sort of method to determine how much
you might risk on a given trade. Start with
a more reasonable and safe assumption.
Unlike card games, there are no “edges”
in trading. Arbitrages don’t exist for retail
traders. Guaranteed profits beyond simple
risk-free interest rates don’t exist, either.
With all that out of the way, there are a
couple of approaches to position sizing you
POSITION SIZES: BEYOND VEGAS
Capital Requirements. One approach
suggests you can balance positions by capital
requirements and/or risk. The amount of
money required to put on a trade is determined by your broker, the clearing firm, and
regulatory agencies. And that amount is
typically tied to a position’s level of risk.
Riskier positions can have larger capital
requirements. It doesn’t assume anything
about the probability of making money or
whether it’s a good or bad trade. But that
assessment of risk can tell you something. If
you don’t pick favorites, no position should
require more capital or risk than others. This
means the risk might be roughly balanced
across positions in your portfolio. For example, if the other positions in your portfolio
have $100 capital requirements or max losses, you might consider a trade with a capital
requirement or max loss of $25. If a trade has
a capital requirement or max loss of $200,
maybe you pass.
Beta-Weighting. The second approach
is similar to the first, but considers the beta-weighted deltas* of your positions. Delta
is a measure of market risk, and beta-weighting your position deltas to a common index,
like SPX, basically lets you turn grapes and
bananas into apples, then compare apples.
For example, a position in ABCD might show
a delta of +200, and a position in XYZ might
show a delta of +50. But ABCD’s SPX beta-weighted deltas might be +75, and XYZ’s
SPX beta-weighted deltas might be +100.
You could say that the XYZ position is riskier
than the ABCD position because XYZ could
theoretically act like +100 deltas in SPX,
versus +75 deltas in ABCD.
To see the beta-weighted deltas of your
portfolio, hop on to your thinkorswim® platform by TD Ameritrade, select the Monitor
tab, and look under the Position Statement
section. If the beta-weighted deltas are
roughly the same across the positions in your
portfolio, the risk might be roughly balanced.
Now, to figure this out before you place a
trade, you can see the beta-weighted deltas
on the Analyze page, too. You can enter a
simulated trade and see how its beta-weighted delta compares to the others in your
portfolio (Figure 1). If it’s smaller, you might
consider increasing the size of the trade. If
it’s larger, you might consider trading fewer
shares or contracts, or passing on the trade
completely because it’s too risky.
GANGSTERS ARE A MIRAGE
Good position sizing can help keep your
trading account out of trouble. Bad position
sizing can destroy you. And any approach to
position sizing can be misused. Luckily for
you, you have the tools on thinkorswim to
help analyze potential trades and your portfolio so you don’t rely on dangerous assumptions. Market uncertainty can threaten you
all it wants with its Vegas-style tough talk.
At the closing bell, put on a Frank Sinatra
record, kick your feet up, and revel in your
superior trading brain. After all, size matters.
FIGURE 1: Size Up Your Positions. From the Analyze tab, enter a simulated trade, select the beta-weighting
option, and see how the delta of the trade stacks up against others in your portfolio.
Source: thinkorswim by TD Ameritrade. For illustrative purposes only.
Thomas Preston is not a representative of
TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the
author and may not be reflective of those held by
TD Ameritrade, Inc. For more on the general risks of
trading and trading options, see page 37, #1– 2.