How trading size matters

The other day @donnelly_brent  the author of Alpha Trader and a must follow on Twitter made the following observation, ”In trading, there are times when you should take positions so big they make you feel uncomfortable.

But still in control.

You need to be able to drive the car fast enough to win … But not so fast that you slam into a wall.

Do you generally trade too big, or too small?”

I thought this was an interesting take and a great question because it contains an underlying assumption that many miss. Do you trade discretionary or systematically? If the former, then absolutely Brent is right, if the latter then I think the complete opposite is true.

DIscretionary traders are trading narrative. Most of the time that narrative is fundamental in nature but it can also be technical. The point is that they are trading a very specific  story and depending on their level of confidence in the story they should size up accordingly, because  great stories are rare and the opportunities are few.

The all-time champ of discretionary trading is George Soros who once famously noted that, ““It's not whether you're right or wrong, but how much money you make when you're right and how much you lose when you're wrong.” Soros of course was wrong a lot, but his single greatest talent  was to bet huge when he was right. The quintessential example of that style was the British Pound trade when Soros made one billion dollars ( back when a billion really meant something) in a matter of a few weeks.

Soros was the ultimate probative trader he would poke and poke the market to test his thesis and if the price would go his way he would press the trade with all his might. In the pound battle against the Bank of  England, Soros’s fund bet the whole year's profits on that one position and came out a trading legend as result.

However, if you are a systematic trader like yours truly the Soros way is probably the fastest route to ruin. That is because systematic trading tries to capture a completely different edge. Instead of being driven by narrative, systematic trading focuses on market behavior. The idea is that certain types of patterns are so repetitive and predictable that a systematic approach  can carve out a positive stream of profits if you can wrap proper stops and targets around the trade.

I trade one primary systematic idea - namely that price will often reverse from sessions highs and lows. There is of course a lot more to it than that, but the basic premise is that in auction based markets mean reversion is far more common than continuity and you can exploit that dynamic if you can structure the setup properly. My setup is traded with a 1:1 risk reward ratio so I only need to be 51% right to have a positive edge. 

You should think of systematic trades as  factory produced donuts  that taste the same - unlike discretionary trades which can be sublime or inedible depending on the day.  Therefore it's much better to trade systematic strategies with uniform size. In fact I would argue that trading smaller rather than bigger is always an advantage with systematic trading because often the donut batch can become spoiled (probabilities change in different regimes) and it is much easier to absorb such losses and make proper adjustments when your inventory losses (your equity drawdown) is relatively modest.

Systematic approach relies on the law of large numbers and therefore requires small size to capture a small edge. There is a reason that Ken Griffin's Citadel trades 100 shares of stock a billion times a day for a tenth of a penny and 51% win rate and still makes billions of dollars a year. But that is a far cry  from making a billion dollars on one well placed macro bet as done by Soros.  Retail traders rarely understand the difference between the two and in their chase of profit often make the dangerous mistake of trading systematic ideas with a discretionary size.