When to trade BIG and when to trade SMALL

Progressive Exposure

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Position sizing the right amount at the right time!

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Hi all. In this video we discuss a complex but important trading topic - Progressive exposure.

If you study many of the legendary traders, they swear by one thing in trading, they get most aggressive when the market direction is in their favor and hold mostly cash in choppy and volatile markets. This way they can create a system of positive expectancy which helps them win big in favorable markets and lose small in unfavorable markets. It’s the same principle I apply in my strategy, thereby producing a far more stable equity curve.

The reasoning behind this principle is quite straightforward. Let’s understand more with an example.

If you begin trading in a favorable environment and end up with a winning position 60% of the time, you can achieve a 135% return on your capital, compounded in 50 trades. This assumes you take 5 trades at a time and maintain a reward-to-risk rate of 2.5:1, equal to an average loss of 8% and an average gain of 20% per trade.

You can see with my trade summary, that even with a win rate of less than 50%, you can still churn a great return if you keep the losses considerably less than the profits.

Be mindful however that achieving such results would be very difficult if you continued to trade through unfavorable market conditions, this would likely reduce your win rate substantially.

By using our Monte Carlo calculator, which is free to download using the links below, we can see differing outcomes depending on the market environment. For example, when trading in poor market conditions a win rate of around 30% is certainly feasible, and with a 2 to 1 win to loss ratio, we can see that 1000 trades would mostly result in huge losses accompanied by significant volatility.  

That however is a theoretical scenario. Many new traders lose a lot more when they experience a poor market, they throw discipline out of the window as more positions hit stop losses. Traders often end up taking a lot more trades and more risk to get even. Such revenge trading coupled with poor conditions usually results in further losses.

Notice how this is Progressive Exposure, but in reverse. Throwing more and more money into a poor market environment is only going to end one way. What we want is to be throwing more and more money into a great market environment, identifying such an environment is something we touch on later in the video.

Let’s now assume we are in a favorable environment and manage to achieve a 60% win rate. Using the same 2 to 1 win to loss ratio, which is very conservative, we can see that the equity curves across the numerous simulations are far more favorable and less erratic.

This is why a higher win rate promoted by a favorable market environment is so important, couple this period with progressive exposure and we have a great recipe for success.

The end goal for all traders is to be profitable and beat the market. While beating the market, good traders don’t try to force returns when the markets are continually offering losses. Instead, they try to maximize their gains when the markets are favorable and put less capital at risk when they are not. In essence, we want progressive exposure in good markets and progressive unloading in bad.

Theoretically, this all sounds great but when it comes to applying this in real-world trading, most traders find themselves at crossroads. It’s simple but not easy because the market signals aren’t always clear and binary. There is no guaranteed signal, and a lot of ambiguity when determining the perfect market conditions. What we can do however is improve the ‘likelihood’ of trading in the right market condition.

Ideally each trader should have a mechanism to determine market direction and trade accordingly, and there are several ways to do that. Members of our group will know that I like to use the 10 and 20 week EMA crossover to identify the broader market direction, and I’ll leave a video link at the end which discusses this in more detail.

Others may apply various other moving averages, Dow theory, or something more bespoke like William O’Neil’s approach to determine the health and direction of the market. However, there can be no better approach than taking feedback from your own trading statistics and adjusting the position size accordingly. This is where progressive exposure comes in.

Progressive exposure requires the adjusting of position size based on how your last batch of trades have performed. This allows us to move from a risk-averse stance to a more aggressive stance and vice versa.

Using an approach discussed by Mark Minervini and circling back to the example we discussed earlier, let’s assume that the markets have been good, and our win rate has been 60%. Let’s say we pick up the last 10 trades and discover that the win rate has deteriorated to perhaps 50%. If we are maintaining a favorable reward-to-risk, we would still have a positive expectancy.

However, given the recent hard data, we take a cautionary stance, we get off leverage and reduce our position size by perhaps 20%.

We do this exercise again with the next 10 trades and discover that the win rate has deteriorated further to 40%. We still have a positive expectancy in the long run, nonetheless the recent set of data is a good enough trigger to moderate your position size on the next set of trades. If the markets continue to be hostile resulting in further losing trades, you could consider further position size reductions.

The reverse of this would be applicable when the markets are turning from being hostile to being more conducive. The win rate will start looking better and we can progressively increase the position size and gradually move to full exposure, or perhaps induce leverage based on our risk appetite and style.

This is called ‘evidence-based progressive exposure’ which lets you trade your largest when you’re trading your best, and smallest when you’re trading your worst.

I do something similar using the Kelly Criterion method, it’s a dynamic position sizing calculator based on win rate and expectancy. I’ll leave a video link at the end.

Progressive exposure is especially helpful if you’re a breakout trader like me. As a breakout trader I have a natural defense in hostile markets, simply because volatile or down trending markets don’t present many trading setups. Therefore by default, in the absence of trading setups, we will naturally have less exposure and be mostly cash during poor market environments.

There will however be times in choppy markets when I will see a few setups. When those setups emerge, it isn’t a signal that the markets have turned. It is rather an indication that we can test the water with some capital. By applying the progressive exposure approach, we can go from being fully in cash, to trading on leverage in a very methodological way.

Let’s assume you are sitting at 100% cash and some setups start emerging in the markets. You could start testing the market strength, you get involved and take two trades with a 5% position size and a stop loss of 8%, effectively risking less than a percent of your capital if both trades hit their stop losses. So, for example, assuming an account size of $10000, you put $500 in each trade and stand to lose $40 on each trade if the stop losses get hit.

Let's say one of the trades hits your stop loss and the other ends up delivering a 16% return, which is a 2x return on risk. You netted $40 from these trades. You could consider this $40 to be the risk money for your next trade. You still trade a 5% position, putting in $500, with a stop loss of 8% or $40, which is what you made from the first two trades. If the next trade hits the stop loss, you start again when you see more setups. You would still be at breakeven after the loss. However, if that trade delivers another 16%, you will then have $80 more to risk. You would also have some confirmation that the market may be becoming conducive as two out of three trades you took worked.

With $120 in profits and some market confirmation, you increase your position size on the next trade to perhaps 10% or $1000 with a stop loss of 8% or $80 - the money you earned from the immediately preceding trade. If this trade goes wrong, you reduce the bet size again to 5% and use the remaining $40 profit as risk i.e. the stop loss. On the flip side, if this trade delivers another 16% or $160 in profits, you will now have a profit buffer of 160 plus 80 plus 40 or $280, which is a good enough buffer to further increase the bet size in the next trade. Similarly, you can adjust the further bet sizes based on the risk money you’ve accumulated. So, for example, if you now want to risk half of your accumulated profits or $140 in the next trade, your bet size would be $140 divided by the stop loss percent on the trade. If we assume the same 8% stop loss the bet size would be $1750, which is 17.5% of capital. You can see how we took a progressive exposure starting from a 5% position size to 17.5% in five trades while managing the risk safely.

This feedback loop from your previous trades will be an automatic position sizing method for all your future trades, while not putting too much capital at risk. As the mechanism builds into your trading process, you need worry less about determining the direction of the market. You can be trading your largest in the best of the markets and smallest in the worst of the markets - A phenomenon that can help you compound at a tremendous pace in the long run.

I refer to my equity profile often through my videos, but only to show what is possible with the right approach. In the profile you will see the result of the broad market indicator, being the 10 and 20 EMA tool, and the natural progressive exposure or progressive unloading, by using break out trades, which generally only appear during conducive market environments.

By also combining the feedback loop from your previous trades, you will have a very accomplished, objective, Progressive Exposure approach.

Lastly, no matter how good a process or mechanism is, it won’t deliver good results if you aren’t disciplined to follow it rigorously. The markets, by their volatile nature, are always trying to put you off the track. The key is to shut the noise and diligently follow the process without getting emotionally impacted by all the things that the market throws at you.

Again, I hope these videos build or reinforce all the aspects needed to take your trading goals to the next level. You are also more than welcome to join our group and access all our tools to support your growth. Thanks for watching.

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