Size Matters

Sizing is the rule for deciding how many shares or contracts to buy.

Extra Insight:

Sizing is critical to risk management, worthwhile returns, and also making comparisions between backtesting runs.   For the backtesting runs, I use a very common and straightforward sizing:

• If there is no stop loss for the strategy under test, my backtesting trade size is 1000 shares (and the amount at risk is the total amount of the trade).
• If there is a stop loss, my backtesting trade size is the nominal risk amount of $1000 divided by the distance from the expected entry price to the stop price.   If its a next-day market order then today’s close serves as the expected entry price.   This way, the risk amount is constant for every trade but the trade size varies in both dollar amount and number of shares.

(Backtesting Blog is an Amazon Associate.)

Updated 11/13/08.

Tags: backtesting, expectancy, loss, management, risk, sizing, stop, strategy, trade size, trading

A Stop Order typically comes in two flavors:  a stop loss which turns into a market order when price goes below it, and stop limit which turns into a limit order for the stop price. 

A Stop order may be either a buy or a sell.     It may be used to enter or exit a position. 

Check with your broker for the exact commands to use for your own trading. 

Extra Insight:

The stop order is typically thought of for exiting a trade, however, it can also initiate a trade.   For example, a trader buying on new highs may set a buy stop slightly above the current high.   If the price hits the new high, the stop is triggered and the buy order executes.    In this case, the cool guys say the stop was “lifted”.

Many traders use a stop order to cut losses.   Some traders also “trail” the stop by moving up the stop trigger as the stock price goes up to protect partial profits.

In backtesting, I do not use the stop limit order, just the regular stop order.    The historical price data cannot show the potential effect of our stop might on a live market — that is a known inaccuracy.   Even so, backtesting can show the benefits and trade-offs of using stop orders.

Click here for BackTesting Reports on Stop Losses

(Backtesting Blog is an Amazon Associate.)

Updated 11/13/08.

Tags: backtesting, data, entry, exit, loss, protect profits, stop, trading

Trading System refers to the whole set of rules, practices, and habits that make up the process of trading.    This includes market selection, portfolio selection, when to trade, which trading strategies to use when, entry signals, exit signals,  sizing, record-keeping, risk management.   The whole enchillada.

Extra Insight:

Even though I often use the terms interchangably, I think Trading System is bigger than Trading Strategy.

A Trading System is said to be either mechanical, discretionary, or a mixture of the two. 

Most mechanical systems are run by a computer, but they need not be.  A person could conceivably make manual calculations and monitor trades according to rigid rules.   Even in a fully automated mechanical system, the human element is present — someone must decide which system, when to turn it on, how to keep the computers running, etc.   However, backtesting is an obvious step in the development of a mechanical trading system. 

For discretionary traders, modern trading also relies on computers acting according to fixed rules.  For example, many people, wheither they consider themselves traders or investors, fundamental or technical, consult stock charts populated with their favorite analysis techniques and indicators.   Backtesting can inform the judgement of a discretionary trader by outlining the potential performance of various strategies and indicators.

Ed Seykota often says that a trader’s system is really the set of emotions he/she is unwilling to feel.  (See Sat, 17 July 2004 in his Trading Tribe FAQ).   I feel like dodging by saying the emotional side is beyond the scope of this blog.  

Now that I think about it, its not so hard to backtest a general example with software.    For example, the Rational Choice book cites a few studies that prove our human tendency for loss aversion.  To codify that, write a system with: 

• no stops in order to avoid the pain of taking a known loss,
• close targets to avoid the pain of giving profits back, and
• quick file deletion to avoid the pain of knowing its unprofitable. 

(Backtesting Blog is an Amazon Associate.)

Updated 11/13/08.

Tags: backtesting, behavioral finance, discretionary s, Ed Seykota, entry, exit, indicator, loss, mechanical s, Rational Choice, risk, signal, sizing, strategy, system, technical, trading