A Short-Term High-Probability, Mean-Reversion Strategy

Includes: IWM, SLV
by: Andrew Crowder

The High-Probability, Mean-Reversion Strategy reaped further success yesterday. Towards the close of the trading session I was able to close out IWM from last week and an SLV trade that I placed in the morning – both for a nice profit. The IWM trade made 21.2% and the SLV made 19.8%. So far the strategy is up 8.9% for the month of April. Check out the results here.

I still have my other trade on from several weeks ago and expect to close it out once the gap from 3/30 is closed.

Previously I mentioned that if SLV opened up that I would send my subscribers a real-time trade alert. Indeed that set-up came to fruition after SLV pushed $0.30 to $0.40 higher at the open. Towards the end of the day SLV had pushed almost 3% lower, so I decided to take the 19% off the table.

I wanted to include a brief discussion on position-sizing – the most important aspect of any successful trading strategy.

Position Sizing

How much should you allocate to each trade?

This frequently asked question lacks definitive answers. Why? The answer is quite simple: As investors, we all have a different set of goals. There are just too many variables out there (age, income, retirement goals, spending habits, etc.) to give a universal answer to the question.

Options brokers allow you, the investor, the flexibility to allocate your account by specified dollar amount, specified quantity, percentage of available buying power, etc. It is your responsibility to figure out what works with your risk tolerance and investment goals.

This brings us to the important and rarely covered topic of position sizing. Too many investors, especially options investors, have a casual attitude toward the management (risk, money) of their investment portfolios. In the constant race for profits, risk management and money management seem to be secondary. The almighty return, the “we want a lot of return, we do not want any risk, and we need the money by Monday” mentality, seems to override the importance of position sizing.

This is particularly true in the options arena. How many websites have you come across that tout outlandish gains with minimal risk with great consistency? All that needs to be said is “think about it." This does not mean that the typical options investor can’t beat the market by a decent percentage annually. It just means that “shooting for the moon” is not sustainable.

The Gallup organization and UBS recently conducted a survey that found 39% of respondents believed stocks would deliver at least a 15% annual return over the next 10 years. This goes to show how wishful thinking consumes a large portion of the investing public’s attitude toward returns. Historically, the notion of such returns is unreasonable.

Says Bruce Kovner:

Whenever I enter a position, I have a predetermined stop. That is the only way I can sleep. I know where I’m getting out before I get in. The position size on a trade is determined by the stop, and the stop is determined on a technical basis.

Position sizing is possibly the most important aspect of any options portfolio and trading system. As an investor you must always be aware of risk management (how much you are comfortable losing per trade) and money management (the size of the position per trade).

So, as far as how much should you allocate to each strategy, trade, etc., the answers are ambiguous. I can only speak to the strategies I use.

Dr. Van.K. Tharp, in his highly recommended book Trade Your Way to Financial Freedom, discusses in great detail the importance of position sizing. In his book, Dr. Tharp back-tests and compares the effects of different position sizing methods on investment accounts. His tests were based on a trading account of $1,000,000 using a trading system that 595 trades over 5 ½ years.

Here are some of more notable position-sizing methods he compared and the results:

Baseline Model

  • 100 Shares of stock per trade
  • Performance – 0.58% annually

Fixed-amount Model

  • 100 shares per $100,000 of equity per signal
  • Performance – 5.75% annually

Percent- risk Model

  • 1% of the account equity per signal
  • Performance – 20.92% annually

His tests produce some interesting results, to say the least, and highlight the importance of position sizing. As I have mentioned before, each investor has different risk tolerances and goals. Dr. Tharp's results are by no means the Holy Grail for position-sizing.

Each method has pros and cons under varying market conditions. Ultimately as the investor, you need to create suitable investment objectives that coincide with your risk tolerance.

With that said, go ahead and explore varying ways to use position sizing. Try out different scenarios based on the trades we have placed so far this year. Discover which one fits your investment objectives and stick with it. Remember, investing is not a sprint; it is a marathon.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.