In this installment of the MT Driver’s Manual, we’ll delve into the basics of position sizing, starting with standardized units of risk.

What does that mean, standardized units of risk?

To start, consider the following quote from Louis Bacon of Moore Capital — one of the largest global macro funds in existence today — that captures both the psychology and the logistics of trading:

[Paul Tudor Jones] taught me to think in points, not dollars, and he always used to say, ‘It’s just points, it is not money.’ He gave me an ongoing tutorial in disassociating oneself from the result of the trade, yet still having passion about it.

You have heard that it’s important in trading not to be fixated on the money. Yet at the same time, it is vital to keep track of risk, and minimize risk in relation to reward.

One elegant way this is done is by thinking of trading capital in terms of points – or, more specifically for our purposes, in basis points.

Imagine dividing your trading account into ten units. If you did that, each unit would be worth 10% of your capital. Now imagine dividing those by ten again. You would then have a hundred blocks, each one representing 1% of your capital.

Basis points go one step further. A basis point is 1/100^th of a percent, or 0.01 percent.

While often used to discuss bond yields and interest movements — e.g. “the Fed hiked by 25 basis points” — the terminology is useful in many instances where granular percentage movement is the thing that counts. For instance:

• If a hedge fund reports being up 6% on the quarter after fees, that is 600 basis points.

• If the S&P is down three quarters of a percent this afternoon, it is down 75 basis points.

• Risking 80 bips (shorthand for basis points) on a trade means risking 0.8% of capital.

Basis points have the further benefit of neutrality when it comes to dollar amounts. If your portfolio is up 500 basis points, that means 5 percent of your capital for the period, regardless of what the currency amount is.

It doesn’t matter whether you began with $5,000 or $500,000 or $5 million, or whether it was denominated in dollars, euros or Swiss francs. The actual size of the account is taken out of the equation. This allows for easy general comparison.

The habit of describing returns in basis points also makes it easier to focus on pure peformance (as opposed to the money). You can mentally focus on protecting and growing your capital without sweating over every dollar (or euro etc) won or lost.

So – a basis point is a highly useful unit of accounting for thinking about trades and trading performance. For this reason, basis points also have use in expressing how much to risk on a trade, or what we call planned risk.

So for example:  If you say, “I intend to risk 100 basis points on this trade,” that means you have planned risk of 1% of your trading capital.

Now we have to further clarify what “planned risk” is. Planned risk is not the total capital placed in the trade. Instead, planned risk is the amount you reasonably expect to sacrifice if your risk point is hit.

For example:

• If you purchase 200 shares of a $50 stock with a stop loss at $47, you are long $10,000 worth of stock (200 * 50 = $10,000). But your planned risk is only $3 per share — the distance from $50 to $47 — or $600 total (200 shares * $3 per share of planned risk = $600).

• If you sell short 500 shares of a $10 stock with a stop loss at $11, you are short $5,000 worth of stock – but your planned risk is $1 per share x 500 shares, or $500 on the trade.

• With a futures contract, like the e-mini S&P 500, the idea becomes even more apparent. If you buy an e-mini, you are required to put up a predetermined “margin” as a buffer against losses on the contract. But the margin amount isn’t what really matters – it’s your risk that matters. So if you purchase 3 e-minis with a stop loss 10 handles away, your planned risk is $1,500 (10 handles * $50 per handle * 3 contracts = $1,500 of risk).

There are many reasons why thinking in terms of planned risk makes more sense than focusing on the underlying share or contract value.

One big reason is volatility, which can vary greatly from one instrument to another ($10,000 worth of IBM and $10,000 worth of NFLX are not the same). And in certain vehicles like index futures and forex, the margin doesn’t express underlying value at all – it’s just there as a good faith buffer against loss on the position.

In terms of calculating loss levels beforehand, planned risk is not foolproof.

With certain forms of options trade, you can know your maximum risk of loss down to the penny. But movements in underlying vehicles like stocks, futures or forex can be different.  You might have planned to sell that long stock position at $47 but had to take $46 instead, or something worse.

Sometimes too you can see gaps where the market “blows through” your planned risk point, or where your stop limit price gets jumped, forcing you to take the market price.

This means that risk envelopes have to make sense in respect to the volatility of the instrument (something we’ll talk about another time).

For this reason it’s good to be conservative (epecially around volatile events like earnings) when considering risk. But estimating planned risk is still a good working practice.

To quickly review:

• We have talked about the importance of thinking in “points.”

• We have talked about the utility of basis points in describing both portfolio performance – how much the P&L is up or down – and trade sizing.

• And we have talked about the concept of planned risk, which is generally expressed in basis points, e.g. “I’ve got 150 bips of planned risk on this trade.”

Now to tie it all together via standardized units of risk.

Much of the time, a discretionary trader will have a routine, or standardized, amount of risk to take on a typical trade: A sort of benchmark, or baseline if you will, for what is common.

Traders will often hold this standard in their mind in the form of dollars or percentage terms, i.e. “I typically risk $500 per trade,” or “I typically risk 2% of capital per trade.”

Taking this a step further, we can start with whatever a “typical” trade risk is and think of it as a “full position” – as expressed in basis points of planned risk.

Then, once you have a mental picture of a full position, it becomes easier to talk about half positions, quarter positions, double or triple positions, and so on.

For example: Our standard “full position” entails 50 basis points of planned risk. So, all things being equal, a trade established as a full position will warrant (if all goes as expected) a risk of 0.5% of equity, or one half of one percent.

A more aggressive trader, or one working with a smaller capital base and a greater appetite for volatile swings, might have a standard full position risk of 100 basis points, or 1%.

Yet another trader might prefer risking 2% per trade, or even 5%, and so on. The more you risk per trade on average, the bigger your swings will be – in both directions.

And again, once the “full position” baseline is established, it’s a simple step to go bigger or smaller with reference points that are easy to mentally convert.

For example:

• If a full position is 50 bips of planned risk (0.5%), then:

• A half position is 25 bips (0.25%)

• A 2X (2.0) position is 100 bips (1%)

• A 4X (4.0) position is 200 bips (2%) and so on.

Now we have an all around picture of what “standardized units of risk” means.

Once you start using standardized units of risk, you get a better handle on (1) what your initial risk is for each trade, (2) how to think about risk and position sizing on a day-to-day basis, and (3) how various trades match up in the portfolio.

But what goes into the actual setting of risk points, and choosing of share or contract amounts, for a trade?

We’ll talk about that next time…