Pegasus Position Sizing Strategies

Money Management for accounts over $100,000

The term “Money Management” can be confusing to some. It actually deals with Position Sizing. The Pegasus system will tell you the “when”, i.e. when to buy, when to sell, when to enter, when to exit. It will even compute and tell you the estimated risk per trade which you will use for Position Sizing purposes. That is automatically handled for you by the system. This section, however, deals with the “how much”, i.e. how many contracts to trade. So far we have been showing sample portfolios all based on single contracts per trade. If you are trading a large size account (over $100,000), you should implement a Position Sizing strategy (Money Management strategy) to begin to trade multiple contracts per trade. This will grow your account exponentially instead of linearly.

To better understand this lets begin with the following easy to follow example. Suppose you manage to invest $10,000 at 30% simple interest per year over 20 years. You will hence receive $3000 per year (30% of 10,000). After 20 years your account is now at $70,000 (60,000 accumulated in simple interest plus the original investment of 10,000). So you have gone from $10K to $70K – you have grown your account 7 fold. Not bad. This is the equivalent of trading single contracts. If you think this is good you are missing the boat.

Now suppose you invest the same $10,000 at the same 30% for the same 20 year but now you compound your returns instead. This means that as your account grows you will re-invest the profits. After the same 20 years you will end up with $1.9 Million! You have grown your account 190 fold! This is not magic – its mathematics. You invested the exact same startup capital in the exact same investment over the exact same time period. The difference here is that you compounded your returns. The difference in results is dramatic. Furthermore, you did not increase your risk in any way. You had your money in the same place and invested it in the same investment. What changed here was only the “how much” you invested every year. This is the equivalent of trading with Position Sizing.

So now lets look at an example using Pegasus.

You will still continue to limit your risk to $3000 based on a single contract per trade. This is the default value for the Initial Risk Limit setting. This means that trades whose risk exceeds $3000 on a per contract basis will be by-passed. Even if you have $10 Million you should still adopt this risk control measure since it will keep you out of those trades that carry a disproportionate high risk. Those trades are known as “high risk outliers”.

Using the Pegasus Large Size 22 market portfolio previously presented in this manual, recall from our single contract example that our net profits came out to $1,313,112. Suppose we have $200,000 available to trade Pegasus with. If we add the starting account equity of $200,000 this means that we grew our account from $200,000 to $1,513,112, i.e. just over $1.5 Million. Over a 32 year period we would have multiplied our initial capital almost eight-fold. Not bad, but we are truly limiting ourselves! While this is fine for single contracts, what would the returns be if we applied position sizing (money management) to trade multiple contracts, and thus compound our returns and grow our equity exponentially instead of linearly?

First Position Sizing Example:

As you can see from the file, when applying position sizing we grew our $200,000 account to the realm of $20 Billion! Yes, that is not a misprint - it is a B for Billions. Again, this is not magic – its mathematics, however totally unrealistic as will soon be explained. So for illustration purposes bear with us for a moment. We applied the exact same system under the exact same conditions; the only difference is that we now applied a Position Sizing technique to grow the account exponentially. Notice how the single contract file grows in a linear (constant) manner while the multiple contract scenario grows in an exponential (compounded) manner. Furthermore we began in 1980 but the increase in the first 15 years is so minute (only in the millions) compared to the billions that it explodes into afterwards that you hardly see the equity growing at the start of the chart.

And what about risk? Was it increased? Actually we reduced it! All along, we never risked more than 2% of our entire equity on any trade. In contrast if your account is at $20,000 and you take a trade whose risk is $2000 that’s a 10% risk. Unfortunately you have no choice but to trade it since the minimum contract size you can trade is 1 contract. At the $200K level, risking 2% you would trade 2 contracts since 2% of $200K is $4000 and the risk of this particular trade came in at $2000. Hence comparatively speaking, you are trading twice as much as the small account, yet risking only 2% of your capital while the small trader is risking 10% (5 times more risk for half the potential profits!). This shows you how larger traders always have a huge advantage over small ones. Like it or not that's just a fact of reality, and this example proves it mathematically. The larger your account, not only the more can you diversify and begin to trade different markets, even different systems on different time frames, etc, but you can employ position sizing techniques that are simply not feasible for small accounts.

Problem with this first example:

Going back to our $20 Billion profits.... sounds amazing doesn't it? You may be wondering if this is truly possible. The answer is NO! The reason is that at that level of the equity curve you are "in theory" trading MILLIONS of contracts per trade/signal. In the real world this is simply not possible. The Futures markets are big, but not that big! So sorry to pop your balloon here but profits of $20 Billion on a starting account size of $200,000 is just not going to happen - impossible. Donald Trump will still continue to be richer than you!

The reason why this example is shown is to illustrate the power of compounding, by applying simple, sensible and conservative risk, position sizing, money management strategies to grow your account profits exponentially.

So to bring us back down to "reality", following is another example with the difference that a cap of a maximum of 100 contracts is placed, i.e. once you hit 100 contracts per trade that is as far as you go and the number of contracts traded per trade stops growing.

Second Position Sizing Example:

As can be seen from the chart above, this time the total profits ended up almost $90 Million (that is with an M for Millions and not a B for Billions). Still not bad at all, and this is more acceptable since we are capping the maximum number of contracts traded at 100, otherwise, like the equity itself, the number of contracts will continue to grow and grow exponentially into unrealistic figures.

Please note that in this example it assumes that the trader would have started with $200,000 back in 1980 and stuck with the system for over 32 years, never making any withdrawal from the account. This is highly unlikely as well since routine withdrawals would significantly impact this performance, but the whole point of this illustration is to show the power of compounding your returns by applying position sizing, money management strategies like Fixed Fractional Trading, such as the one that was applied in this example.

Fixed Fractional Trading

In our above examples we employed a popular Position Sizing (Money Management) methodology known as Fixed Fractional Trading. Here is how it works. Suppose you have a half a million dollars in your account and you are applying a fixed fraction of 2%. This means that you will risk $10,000 on your next trade (2% of $500,000). When the next trading signal is generated, suppose Pegasus reports a risk per trade per contract of $2500. That means that you will trade 4 contracts ($10,000 divided by $2500). If you get a decimal you will always round down to the nearest whole number. If the risk per trade was $2550 instead and you got 3.9 contracts (10,000 divided by 2550) that means you would trade 3 contract and not 4. This way your estimated risk never exceeds 2%. However, you would always trade at least 1 contract. So if you get 0.8 contracts you will go ahead and trade 1. This is the only exception since you would not round down to zero. Otherwise you will always round down to the nearest whole number.

IMPORTANT: For TradeStation users: to see the risk per trade per contract please open up the Pegasus Risk .csv files located in your C:\Pegasus\Risk folder. Please read the “TradeStation Manual” for further instructions on this. You will need the information contained in these files to determine how many contracts to trade. These files will tell you the estimated risk per trade. Whenever a new trading signal is generated, Pegasus calculates the initial estimated risk based on one contract. It then prints out a report as a csv file (comma separated values) that you can open up with any spreadsheet program like Microsoft Excel or Lotus 1-2-3. You will then plug in the corresponding risk per trade into the Fixed Fractional Trading equation explained above to compute how many contract to trade.

A strategy like Fixed Fractional Trading has several advantages:

The last bullet means that for example your risk allocated to Corn will be the same as that to Natural Gas. Obviously a Natural Gas contract is much larger and thus will impact both your profits and loses much more than a Corn contract. If you are trading single contracts then your portfolio will be unevenly balanced. With Fixed Fractional Position Sizing you balance things out since you are trading more contracts for Corn relative to Natural Gas.

Position Sizing strategies like the one we have illustrated here are not practical for small accounts. This is because you simply don’t have enough money to begin to trade multiple contracts. Even if you were to apply Position Sizing formulas you would end up trading single contracts most of the time anyways until you enter the realm of 6 figures (above $100,000). Then you can begin to grow your account exponentially instead of linearly.

Please Note: our fixed fractional position sizing example also makes the following 2 assumptions:

For a detailed explanation on Position Sizing techniques such as the one presented here, please see the manual "Pegasus Portfolios & Performance".

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