Exponential Growth
There are 3 sides to profitability.
Edge and strategy creates profits.
Psychology of trading emotion reduces profits.
Position sizing and risk management multiply the net profits
Betting with accuracy
We will start off with the multiplier. Traders often think about risk in terms of how much of their portfolio they could lose on a trade. If you’re risking 1% per trade, that means you’re willing to lose 1% of your total portfolio value on that trade.
But not all 1% risks are created equal. Your stop is static as it is set at a logical point regardless of entry, like the low of the day. Thus your risk is determined by your entry. Depending on how accurately you time your entry, your stop loss might vary. A poor entry could mean a 10% stop loss, while a great entry might allow for just a 2.5% stop.
I’m not suggesting you tighten your stop loss just for the sake of it. That increases the chances of getting stopped out prematurely. What I mean is that if you can use the same logical stop for both trades, a better entry gives you more potential reward without increasing your overall risk.
Let’s say you have a $100,000 portfolio. If you risk 1%, that’s $1,000. Now, imagine you’re trading a stock that could theoretically gain 20%. With a 1% portfolio risk and a 2.5% stop loss, you can put on a $40,000 position. A 2.5% loss on $40,000 equals the $1,000 you’re willing to risk. So, you’re using 40% of your portfolio on this trade. But if your entry isn’t as good and you can only take on a $10,000 position with a 10% stop loss, you’re still risking $1,000, but with a smaller position. The reward outcome is dramatically different for the same overall risk.The way you can consider tighter stops is timing volatility using the Volatility Contraction Pattern.
Betting through scaling
Another strategy for exponential bet sizing is the reverse pyramid. Imagine you’re trading a stock that’s about to take off, following an S-curve where you expect it to rise for 8 out of 10 days. In this scenario, you’d start by allocating small amounts and keep adding as the trade goes in your favor. This way, if the trade doesn’t work out, your loss is minimal because you started small. But if it’s going well, you keep adding, turning it into a large position. While your cost basis might increase and the return on each individual position might be lower, the larger position size on a portfolio level can lead to significant growth.
Consider this: would you rather have a 5% position double in value, netting you a 5% total portfolio gain? Or would you prefer a 30% position going up 50%, giving you a 15% total portfolio gain? The reverse pyramid approach aims to maximize gains by ramping up your position as the trade goes in your favor, even if the return on each new addition is lower.
Betting with probabilities
Another approach to exponential bet sizing involves looking at probabilities. When the odds are in your favor, you increase your bet size. But keep in mind that there’s always the risk of ruin, especially when you factor in volatility and sequence of returns risk. The more volatile the trades you’re making, the smaller your bet size needs to be. This is to avoid losing so much capital during a bad streak that you can’t recover. After all, you need money to make money.
