Mechanical strategies for trading futures usually include fixed fractional position sizing to limit initial risk from any single trade to around x% of the total capital value of the Fund and to equalize the position size in different markets at initiation in terms of relative volatility.
Read Volatility Based Stops first to understand how a trader sets volatility based stops.
Note that the examples set out below are by way of demonstration only. Let us assume that a fund’s assets under management are $100,000,000 and that a new long position is to be taken on 6th May 2010 in the June 2010 Crude Oil contract on NYMEX, at an expected price of $80 per barrel (around the previous day’s closing level). The protective stop will be set at $69.38 per barrel of Crude Oil (calculated as in Volatility Based Stops).
One Crude Oil contract bought on the NYMEX exchange represents 1,000 barrels of Crude Oil. For every $1 increase or decrease in the price per barrel of June Crude Oil, the investor will gain or lose $1,000. If the investor buys one June contract at $80 and sets his stop loss at $69.38, the investor stands to lose $10.62 per barrel for a total loss on one contract of $10,620 if the position goes against him and is exited at the stop level. If, at the initiation of the trade, the investor wishes to risk 1% of his total portfolio value, then he must take the dollar value of that 1% and divide it by the total dollar risk per contract to arrive at the number of contracts to buy.
On a portfolio value of $100,000,000 a 1% risk of $1,000,000 is divided by the per contract risk of $10,620 to arrive at a position of 94 contracts (1,000,000 / 10,620 = 94 contracts rounded down to the nearest whole contract).
Let us assume that a new long position has also been signaled for 6th May in the three month forward contract for LME Nickel. On 5th May, the three month forward for Nickel closed at US$21,925 per tonne and 5 times the 20n day ATR is calculated at $4,835. The LME contract for metal is for 6 tonnes, so for every one dollar movement in the price per tonne, an investor gains or loses $6. An investor’s predicted risk per contract at an assumed entry price of US$ 21,925 and a stop of $17,090 is therefore $29,010 ($21,925- $17,090 *$6).
The investor wishes to risk the same fixed percentage of his portfolio value on a position in Nickel as he risks in Crude Oil and therefore buys 34 three month forward contracts on the LME calculated as follows: ($100,000,000 x 0.01) / $29,010 = 34 rounded down to the nearest whole contract.
Fast markets, gap openings and liquidity constraints mean that it will not always be possible to execute a stop loss at the intended level but the hope is that the exit can (on average) be executed near enough the stop loss level to achieve the desired protection for the portfolio.