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Ripe Trade

Im sure most of you have read Dr Van Tharps book Trade your way to financial
freedom. If you haven’t read this book, do yourself a favor and read it!

From page 284 to the end of the book Dr. Van Tharp goes over the effects that
different position sizing strategies have on the same trading strategy.

He describes 4 position sizing methods:

Units per fixed amount of money- This model allows you to take one position per
so much money. It basically treats all investments alike and always allows you to
take a position. For example trading 100 shares for every $50k in my account.

Equal units model- This model gives an equal weighting to all investments in your
portfolio according to their underlying value. Its commonly used by investors and
equity traders. For example dividing my $50k equally into 5 and investing $10k into
each stock or strategy.

The percent risk model – This model is recommended as the best model for long
term trend followers. It gives all trades an equal risk and allows a steady portfolio
growth. For example if I decide Im comfortable risking 2% of my $50k account
equity and my stop loss is 10% on a $60 stock or $6 . I take ($50k account equity *
2% risk) = $1000 percent risk. ($1000 % risk/ $6 stop loss) = 166 shares to trade.

The percent volatility model- This model is best for traders who use tight stops. It
can provide for a reasonable balance for risk and opportunity. This is similar to the
percent risk model in that you risk a certain percent on a trade but the size position
traded is determined by account equity percent divided by the average true range
of the stock or market traded. For example if I decide to risk 2% account equity on a
$50k account I risk $1000 if the ATR of the market Im trading is $10 my position
size is $1000/ $10 = 100 shares.

Each one of these position sizing strategies has a maximum threshold when annual
performance peaks and then beyond that point the account goes bust. All plungers
eventually go bust!

As an example Dr. Van Tharp tested the same breakout strategy from 1981 to 1991
on the same basket of commodities with a million dollar account. The results are
below.
Units per fixed amount of money- This model peaked at total profit of $30,919,632
or 38% annual gain with a $30k per unit size, any size larger than that took the
account to zero.

The percent risk model –This model peaked at a total profit of 1,212,000,000 or
93.5% annualized gain using 25% of account equity per position. Percentage risk
greater than 25% took the system into negative equity.

The percent volatility model- This model peaked at 1,034,000,000 or 90.7%


annualized return using 5% volatility. A position size greater than 5% volatility
caused the system to go into negative equity.

Below is a table that shows how much your account will have to gain to recover
from a drawdown.