This is the third method I am sharing on correctly sizing the position of each trade with proper risk management techniques. The breakout system method may be the easiest of all the position sizing calculations.
The first method is a recent volatility system which uses Average True Range as the key indicator.
The second method uses Percent Risk, either a static percent for every trade, or a percentage of the annual standard deviation of that asset.
In this post, we will explore position sizing using a breakout system method. The lookback period low will be the predetermined stop price.
Naturally, this method for position sizing and risk control pairs particularly well with a breakout box trend investing strategy.
The breakout box strategy is a simple trend investing method which has shown great results over time.
You buy an security when it makes a new high in a predetermined lookback period; you sell that security when it makes a new low in that same lookback period.
When you use a breakout box trading system, you simply move the box forward each day. When it comes to trend investing, it does not get more simple than this!
There is a growing amount of academic research into time-series momentum. We know that there is a persistent, pervasive phenomenon across asset classes where if the price of an asset makes a new high in the past 3 months to 12 months, it is likely to continue climbing for some time. Likewise, if the asset price makes a new low in the past 3 months to 12 months, it is likely to continue falling for some time.
Those time periods are not exclusive. One successful group of trend followers was rumoured to use much shorter time frames such as 20 trading days (approximately 1 month) for each market.
The chosen time frame doesn't necessarily matter if the risk control is done correctly.
By combining this research, entering an asset when it makes new highs and exiting when it makes new lows, an investor can potentially achieve outsized risk-adjusted returns.
Identifying Good Breakout Systems
Breakouts on the buy side and sell side are very easy to identify. Simply choose a lookback period that is fits your investment style based on what you want out of investing.
Generally speaking, the lookback period used should be the same across all the assets you track.
If the chosen market hits a new high within that lookback period, it is a buy side breakout. If the market hits a new low within the lookback period, it is a sell side breakout. These breakouts are your position entry and exit signals.
To develop your personal breakout system portfolio, in a disciplined way systematically track buy signals and sell signals over a long time period for a number of different asset classes you can access.
Compare the results of different timing periods and different asset classes. Performance aside, the timing period you decide to use should be one that is consistent with your personal preferences.
Generally speaking, longer time periods (such as 12 months) are likely to be much slower paced with few signals. Depending on the market, you may average less than 1 signal per year per security.
Shorter time periods (such as 3 months or less) are going to have many more signals in each market. It may not be uncommon to trade in and out of the same market several times a year in certain time periods.
A good breakout system is a system that works for your personal situation while providing a long-term positive return. It should fit your risk tolerance and your desired trading frequency.
Example Breakout Box
The price entry signal for silver (SLV) is $14.59 on February 8, 2016. That price made a new 3-month high over the previous high of $14.38.
The Stop Price on this purchase would be set at the 3-month low of $13.06.
Eight months later, silver (SLV) hit the exit signal on October 4, 2016 at $16.94 for making a new 3-month low. That's below the prior lowest price of $17.62 in the past 3 months.
Steps to Calculate Your Position Size Using Breakout Systems
These are the steps to identify all the components you need to complete a proper calculation of maximum position size using Breakout Systems.
- (R) Determine the maximum amount of equity you are willing to lose for each trade. This should be based on your total account equity at the time you enter the trade. (New traders should risk less than 1 percent per trade.)
- (P) Identify the current price of the security. I do most of my trade entries near the end of the trading day as volume tends to be higher. If you do your calculations after hours, use the closing price of the security. In this system, the current price should be a buy side breakout.
- (S) Identify the Stop Price. The stop price will be the lookback period low price, the potential sell side breakout. This is the lowest closing price of the security within the chosen lookback period.
The calculation for maximum position size using the Breakout System is as follows:
R/(P-S) = U (Total Number of Units)
U*P = Max Position
or, in a single, simplified calculation:
[R/(P-S)]*P = Max Position
This example will be a position size calculation using the Breakout System method in silver (SLV). To demonstrate how it works, we will use the entire time period of the silver trade I shared in the example above.
- (R) This investor has a $100,000 investing account. His risk per trade is 1 percent. (The maximum amount of money he wants to lose if this trade goes against him is 1 percent of $100,000.) Therefore R = $1,000.
- (P) The breakout price of SLV on the purchase date of February 8, 2016 was $14.59. Therefore P = $14.59.
- (S) The Stop Price of SLV was the prior 3-month low closing price of $13.06 on December 14, 2015. Therefore S = $13.06.
R/(P-S) = U
Calculation for U: 1000/(14.59-13.06) = 653.59 units
U = 653
Calculation for Max Position: 653*$14.59 = $9,527.27
The maximum position size of SLV for this trader purchasing today will be $9,527.27, or 653 units of SLV.
The trader will enter a purchase order to buy 653 units at a limit price of $14.59 per unit. On this trade, he will allocate 9.53 percent of his account equity to SLV.
The initial stop loss price was $13.06. If the price of SLV fell below $13.06 near the close of the trading day, the trader would sell the position for a total loss of $1,000 on the trade.
Alternatively, the trader can set a Stop Limit Order and have the trade automatically executed if the price fell to this level.
In this example, the trader sold his position of SLV when it made a new 3-month low of $16.94 on October 4, 2016. The profit on this trade was $1,534.55 (less commissions). That means his profit was more than 50% higher than his initial risk of $1,000—a decent trade!
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