Position Sizing in Momentum Models

In an ideal investment model, the investor should target a roughly equal amount of portfolio influence with each asset they invest in. In other words, a trade in Bitcoin should have no more or less impact on your portfolio than a trade in Treasury bonds. (Recognizing that some trades will always be much more profitable than others, while many will be a loss.)

The foundation for calculating this impact is based on pre-determined stop losses. Before entering a trade, you need to know where you will exit the trade. That works in two parts.

First, you should have an initial price level at which you will exit the trade. In trading, approximately one-half of all trades will go against you. No signal—or combination of signals—is perfect. Having a pre-determined initial exit price is crucial to limiting losses and sizing your initial trade.

Second, you should have a system in place to determine where to exit trades that move in your favour. This isn't about targeting a profit. A good trend can continue much longer and be much more powerful than you could initially predict. You need to take advantage of these long, powerful trends to push your portfolio forward. Rather, your system should be specific in determining when the trend direction is changing and it is time to take your profits on the trade.

I have published several posts on position sizing using various methods for calculating initial stops:

Position Sizing with Average True Range

Position Sizing with Percent Risk

Position Sizing with Breakouts

Position Sizing with LEAPS Options

Position Sizing with One-Signal Models

Charts can be very helpful in visualizing your trades and finding entry points on a moving average model. Whether you use Price > Moving Average or Moving Average Direction or Moving Average Crossover, the idea is similar and the challenges surrounding position sizing are similar.

This is a simple example of entries and exits with Moving Average Direction with a 50-day simple moving average.

Credit: StockCharts.com, TheRichMoose.com

As the chart shows, entries and exits are easy. Position sizing is not so clear. For the October to April trade, the trend was profitable so a large trade would have been to the trader's advantage. However, the May swing trade was a classic whipsaw and would have seen the investor in at $1,305 and out at $1,275. That's a 30 point or 2.3 percent drop.

With one signal models to calculate momentum, entries, and exits, I would suggest that using methods such as Average True Range or recent price lows (such as the 50-day low if using the 50-day SMA) can be highly effective. These methods incorporate recent market conditions, allow for flexibility in the markets, and can backtest very well.

Percent risk is not as effective across a wide range of markets, but can be very effective for an investor who only invests in small cap stocks, tech stocks, IPOs, or cryptocurrencies. These instruments are less predictable, need small position sizes, and can have unreliable, or even non-existent, historical data.

However, in a model where we measure momentum in many different ways and can measure the strength of that momentum, a different option may be available that is still very robust.

Position Sizing with Multi-Signal Models

Where we use multi-signal models, we can stick with moving average signals and find the points where the momentum direction changes based on the signals we use. If we translate chart data and moving average data to an Excel spreadsheet, we can actually plot the price forward to find these points.

Using this time period example (with LBMA data which is slightly different from the futures data shares above) we can create a simple signal.

Source: TheRichMoose.com, Quandl.com

Above we have the comparable data in Excel format with the 50-day simple moving average in red. (A single model system, but it helps illustrate the idea.) We see the buy and sell signals for the entire trade. In this case we know the Buy signal failed between $1,285 and $1,275. Of course we never know future prices when we enter a position; however, we can easily calculate that fail point by "walking the market forward" to find point where momentum fails and the signal would say sell.

Using a momentum model that tracks many signals (mine tracks momentum in dozens of calculations in several different styles) this type of stop-loss system is quite robust. Price movements have less impact on the trading system across the many signals. Also, by scaling into and out of positions we can reduce the impact of entry and exit signals. There is no "all-in" or "all-out" unless we have a major move.

At the point of entering positions and building positions, we need to think about how much of our portfolio capital we are willing to risk. How much of our money is in stocks, options, futures, ETFs, or volatile currency pairs and how much do we have in the safer stuff—such as short-term bonds. Once again this forces us to think about capital efficiency, use of instruments like options, and futures which trade around the clock.

Comments & Questions

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Trend System on Other Assets

This post is a continuation of a series on the multi-model trend system which I have developed. In the past weeks we looked at different applications of my trend model. First, I looked at several backtests on the S&P 500. I then applied the exact same trend system on other major equity indices: the Nikkei 225, NASDAQ Composite, and CAC 40.

The following links cover these backtests and some other information about the system I developed.

Long and Short Trend Systems

Long/Flat Equity Trend Systems

Long Trend System on Other Equity Indices

Reminding readers... I have developed two trend systems which have many similarities in their structure. The major difference is the time examined. The shorter duration system uses a lookback period of trends that are identified at two weeks through three months. The longer duration system sees trends forming at three months through twelve months. I've called them the short-term trend system and long-term trend system.

In this post I will apply the exact same systems on other assets. This includes currencies (EUR/USD and JPY/USD), interest rates (10 Year Treasury Yield), and alternative commodities (gold and Bitcoin). The currencies and interest rates will be using the long-term trend strategy that goes both long and short the asset, betting on either side of the trade based on the trend.

Gold will be using the long-term system in a long/flat format (betting with the trend fully or partially, or being in cash). Since Bitcoin is a newer asset that is highly volatile and difficult to short, I modeled it long/flat with the short-term trend system.

Note: All data is calculated in nominal terms and is not adjusted for local interest rates or inflation. The objective is to demonstrate the behaviour of my trend system across a range of markets. These are simulated results.

Euro/U.S. Dollar Currency Pair

Since the Euro was created as the new pan-European currency it has become the dominant alternative currency to the U.S. dollar. It is also the biggest currency pair trade with a massive number of futures contracts trading hands each day.

The EUR/USD futures contract is a great place to start for people aspiring to be currency traders. One contract controls delivery of 125,000 Euros. This contract requires a margin (deposit) of just $2,000 to hold.

Understand and trade based on the contract value, not the margin requirement! As you can see, the leverage factor is enormous.

The following charts backtest my long-term trend system using absolutely no leverage. This simulates the underlying return of the strategy. Most traders would use some leverage in practice.

Total Performance (Growth of $100)

Credit: TheRichMoose.com, Quandl.com.
Right-click to expand image.

Drawdowns

Credit: TheRichMoose.com, Quandl.com.
Right-click to expand image.

3-Year Rolling Returns

Credit: TheRichMoose.com, Quandl.com.
Right-click to expand image.

If an investor were to buy 100 Euros in 2000 when this backtest started, they would have paid about $102. Today it would be worth about $112, translating to an approximate 10 percent gain to the investor over the backtest period.

With my trend system, that same $100 would have grown to be worth about $168. That implies a gain 5x larger than just holding the Euro.

The Euro/U.S. Dollar is a very stable currency pair to trade and a great place for investors to start with currency trading. The largest drawdown in my trend system was about 18 percent. Many traders can comfortably use some leverage in this asset to increase their exposure on the trade.

Japanese Yen/U.S. Dollar Currency Pair

The second largest currency pair trade is the Japanese yen against the U.S. dollar. As with the EUR/USD contract, this is a major futures contract that trades over 100,000 contracts each day.

A single contract controls delivery of 12.5 million yen worth approximately $115,000 at current rates. The margin requirement for the contract is just $1,800.

The following backtest and charts use no leverage to simulate the underlying return of the strategy. It is a long/short trading strategy as it is extremely easy to short currencies and futures contracts.

Total Performance (Growth of $100)

Credit: TheRichMoose.com, Quandl.com.
Right-click to expand image.

Drawdowns

Credit: TheRichMoose.com, Quandl.com.
Right-click to expand image.

3-Year Rolling Returns

Credit: TheRichMoose.com, Quandl.com.
Right-click to expand image.

Futures contracts on the JPY/USD currency trade have existed for a long time. My data goes back to 1977 and covers a range of market conditions for the Japanese and U.S. economy. If an investor were to buy $100 worth of yen in 1977, that would have grown to be worth about $240 today. That's a 140 percent gain.

With my trading system, $100 would have grown to nearly $600 in that same time period.

As with the Euro, the yen is a pretty stable currency in general. However, we do see quite large moves from time to time. Drawdowns with my system peaked at 36 percent. We also see a relatively long period of declining returns from the late-1990s to 2011. Since then new highs were made with the system.

Looking at the 3-year annualized rolling returns, we can see the sharp difference between the return characteristics of currencies compared with stocks when applying a momentum strategy to both markets. Returns on the yen do not see significant negative returns when smoothed, but the declines are grouped together into several years of poor performance.

Interest Rate on 10 Year Treasury

Trading interest rates can offer investors a return stream that is very unique, different from bond investing, but yet relatively stable. The interest rate often take the inverse of bond returns in the shorter term. When interest rates go up, bond values drop; when interest rates drop, bonds jump up.

Interest rates can be trading via futures contracts. I would not recommend short-selling a bond ETF. Futures allow you to trade more closely in line with interest rates in a liquid market. A single contract controls $100,000 of Treasury notes.

As with currency pairs, with futures it is easy to go long or short the contract (buy or sell) at a very low margin requirement of just $1,050 on the 10-Year Note Contract.

Total Performance (Growth of $100)

Credit: TheRichMoose.com, Yahoo Finance.
Right-click to expand image.

Drawdowns

Credit: TheRichMoose.com, Yahoo Finance.
Right-click to expand image.

3-Year Rolling Returns

Credit: TheRichMoose.com, Yahoo Finance.
Right-click to expand image.

Yields on 10 Year Treasuries often move slow; a long-term trend system works particularly well. If an investor put $100 into this strategy in 1963, it would have grown at a pretty steady rate to nearly $4,000 today.

Drawdowns reached about 40 percent, but in the backtest the recoveries were very quick compared with many other assets we looked at. The drawdowns seem to have gotten bigger in recent years. This may be indicative of a shift in the market characteristics.

Gold

In this backtest I used my long-term trend strategy on gold, buying and selling in U.S. dollars. Gold has long been a favourite alternative asset for many investors. I would describe gold as a sort of crisis asset. It often does well when many other markets do not. Being the classic "hard asset", it is particularly a good asset to hold when trust in currencies fades.

Although it isn't necessarily difficult to short-sell commodities via futures contracts, I don't think it makes as much sense as short-selling currency pairs or interest rates. With commodities short-sellers have the headwinds of a long-term upwards bias due to inflation and depletion of resources.

Gold can be purchased with ETFs such as GLD or IAU and with futures contracts. A single gold contract controls delivery of 100 ounces of gold. It is a highly liquid contract with roughly 270,000 contracts traded daily.

In this backtest I compared my long-term trend strategy against simply buying gold and holding it throughout the period.

Total Performance

Credit: TheRichMoose.com, Quandl.com, FRED-Federal Reserve St. Louis.
Right-click to expand image.

Drawdowns

Credit: TheRichMoose.com, Quandl.com, FRED-Federal Reserve St. Louis.
Right-click to expand image.

3-Year Rolling Returns

Credit: TheRichMoose.com, Quandl.com, FRED-Federal Reserve St. Louis.
Right-click to expand image.

Many investors see gold as a safe asset that is linked to inflation and should always go up. This isn't the case. Since the U.S. dollar was delinked from gold, the yellow metal has had periods of high returns and long periods of negative returns.

Even during the inflation period of the early-1980s, gold actually dropped in price. If you bought gold in 1979, you didn't see a profit until 2008. Instead of being safe, gold took a massive 70 percent drawdown over 30 years.

Using a trend system, we substantially reduced the severity of the drawdowns. We also saw nice gains when gold moved up. The overall return for the trend system was only about 4x higher, the returns were more stable and allowed long periods where an investor could do other things with their money (held in cash in this scenario).

Bitcoin

Bitcoin is a newer asset that still carries many questions. While certainly interesting, its viability as a usable currency is not there in my view. I also have a hard time seeing Bitcoin as a safe asset with gold characteristics.

Since Bitcoin was spawned, many other cryptocurrencies with improved technology and capabilities have come to the market. One day we could see some type of decentralized cryptocurrency used in daily life. We are definitely some time away from that yet.

Right now I would say that Bitcoin in simply another asset to speculate with. It is not a buy-and-hold item. It is not where anyone should put a substantial amount of their wealth. There are issues with security, storage, scalability, among other problems.

Thankfully it is getting better. There is an increasingly popular Bitcoin ETN on the market trading with the ticker GBTC. This makes Bitcoin a bit more accessible and possibly a bit more secure to hold, albeit with regulated third-party risk.

Bitcoin is a new, volatile asset. It is also not easy to short-sell. For this reason I applied my short-term trend strategy in a long/flat format, compared to simply buying and holding a single Bitcoin.

Total Performance

Credit: TheRichMoose.com, Yahoo Finance.
Right-click to expand image.

Drawdowns

Credit: TheRichMoose.com, Yahoo Finance.
Right-click to expand image.

Annualized Rolling Returns

Credit: TheRichMoose.com, Yahoo Finance.
Right-click to expand image.

Bitcoin is a truly crazy asset. Since 2010, it has seen numerous 90 percent drawdowns. Bitcoin also saw enormous annualized returns. As the market is maturing, the swings are getting less severe.

My trend system cut drawdowns on Bitcoin nearly in half and, as usual, nicely smoothed returns for an otherwise rough asset. By dancing out of the worst of the drawdowns, the trend system would have returned over 3x more to the investor.

For those interested where Bitcoin fits into the portfolio, this article recommended investors have no more than about 2 percent of their portfolio in Bitcoin. Many investors should probably have none.

Is Bitcoin in the Optimal Portfolio? - Of Dollars and Data

Personally I believe you should risk no more money in cryptocurrencies than in any other asset. The rule of thumb is to risk about 1 to 3 percent of your assets per trade, depending on your level of aggression. Since Bitcoin and cryptocurrencies have huge drops in value and could realistically become worthless, that means you should have a maximum of 1 - 3 percent of your assets in cryptocurrencies.

I currently don't hold any cryptocurrency but I am watching some of the developments on the newer third-generation crypto projects with interest.

Summary

A good investment system is not limited to a single market. It is applicable and effective across a range of markets experiencing very different market conditions.

I will continue to update readers on the momentum factors of the markets I am personally invested in. In the meantime, I will be working on my systems trying to improve the systems and make them easier to invest with for my own purposes.

I'm interested in hearing your questions about investing or personal finance and ideas for blog posts. Please leave a comment or send me an email at: richmooseblog @ gmail . com.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.