Building a Trading Backtesting System — Part 4: Risk Management and Position Sizing

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There are various methods of position sizing that we can employ to determine the appropriate amount of capital to allocate to each trade:

• Fixed Amount. We allocate a fixed amount or a fixed percentage of trading capital to each trade. For example, we may decide to risk $100 per trade regardless of the size of our account or the volatility of the market.
• Fixed Percentage Risk: In this approach, we determine the percentage of our trading capital that we are willing to risk on each trade. For instance, we might choose to risk 2% of our account balance on each trade. The position size is then calculated based on the difference between the entry price and the stop-loss level.
• Volatility-Based Position Sizing: This method adjusts the position size based on the volatility of the asset being traded. Higher volatility may warrant a smaller position size to account for larger price swings, while lower volatility may allow for a larger position size.
• Optimal f Position Sizing: This method aims to maximize the geometric growth rate of the trading account by dynamically adjusting the position size based on factors such as the probability of success, the size of the trading account, and the expected return of the trading strategy.