I was listening to a podcast featuring John Bollinger and he mentioned that "volatility is the most important, least analysed and worst understood". The importance of volatility in trading is indeed under emphasized as the limelight typically shines on entry and exit rules. I first came across usage of volatility in position sizing used by the Turtles and Richard Dennis and that definitely gave me one of those "Light bulb" moments.

In this article I will share a common way to position size your trades using volatility.

Firstly we need to decide how to measure volatility. For much of the investment community volatility is standard deviation. Another way to measure volatility is to measure the Average True Range of the time series.

True Range is the maximum of either:

• Distance from today's high to today's low
• Distance from yesterday's close to today's high
• Distance from yesterday's close to today's low

Average True Range of past 100 periods is the average of True Range of the last 100 periods. The same method goes for any periods (e.g. 20 or 50 periods) of Average True Range.

When we trade different markets and instruments, the volatility profile of each would be different. For example, bonds would have very different volatility profile compared to stocks. Different stocks would also have different volatility profiles. We would like to take larger positions with less volatile instruments and smaller positions with more volatile instrument with the aim that the profit and loss generated per trade has roughly the same impact to the overall strategy regardless of the instrument traded.

We will illustrate using a simple example below:

We would like to risk 50 basis points per trade with a portfolio of $1 million in value. Thus the impact per trade would be 50 basis points * $1 million = $5000

We calculate the Average True Range of past 100 periods of 1 unit of stock to be $10.

No. of units of stock to be traded = $5000 / $10 = 500 units

We calculate the Average True Range of past 100 period of 1 unit of bond to be $1.

No. of units of bond to be traded = $5000 / $1 = 5000 units

While the example above is overly simplified, I'm sure you see the idea behind position sizing using volatility.

Next, if you have a stop-loss level based upon volatility, you would be able to size the trade such that the maximum amount that you lose is the risk percent you have chosen. For example, the stop loss can be 3 units of ATR above or below your entry price.
Again we will illustrate using a simple example below:

We would like to risk 50 basis points of capital per trade with a portfolio of $1 million in value. Thus we would like to calculate the size of the trade such that we will lose $5000 when stop loss level is triggered.

Suppose a stock is trading at $80 and our stop loss is at $70. Hence we would make a loss of $10 per unit of stock when stop loss level is triggered.

No. of units of stock to be traded = $5000 / $10 = 500 units

Suppose a stock is trading at $80 and our stop loss is at $75. Hence we would make a loss of $5 per unit of stock when stop loss level is triggered.

No. of units of stock to be traded = $5000 / $5 = 1000 units

Hence we can see that when stop loss is wide, the size is smaller and when stop loss is narrow, the size can be larger.

Position sizing is important in trading and it is important to place emphasis on it.