Position Sizing Implications of Multiple Open Positions (Part 2)

I left off http://www.optionfanatic.com/2012/11/08/position-sizing-implications-of-multiple-open-positions-part-1 discussing total financial commitment as a challenge for trading all S&P 500 stocks in lieu of SPY itself.  When I look closer, another problem and challenge to system development also comes to the fore.

This second problem is unreasonable total risk.  Trading SPY alone could cost $200 when risking 2% per trade on a position size of $10,000.  Trading S&P 500 stocks individually means a potential total risk of 500 times that or $100,000.  Don’t think for a moment that it couldn’t all be lost in one fell swoop with a sudden and substantial market move.

Rather than entertaining the possibility of 500 open positions at once, I could use the maximum number of open positions ever seen in the backtest.  This would probably be fewer than 500.  A problem would then arise if at some future time market conditions were to require more open positions than those for which I allocated.

Either possible solution to an instance demanding more open positions than allocation provides would cause problems from a system development perspective.  I could simply skip additional trades once I’ve reached my limit.  Alternatively, I could implement a rotational system where the top X trades are selected based on selected criteria.  Either way, this is a rare and infrequent occurrence.  With the total number of instances being so few and far between, the sample size would be too small to determine the trading system impact.  To proceed blind without understanding the potential risk would be dangerous at best–this is the whole reason system development incorporates backtesting in the first place.

In an attempt to avoid being forced to open too many positions, I could allocate for more positions than the maximum number of positions ever seen in backtesting.  While this would decrease the possibility of sequelae described in the previous paragraph, it certainly does not provide any guarantee.

Next up:  a Sci-Fi twist and exciting conclusion.