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Position sizing is a critical aspect of trading that directly influences the risk and potential reward of each trade. It involves determining the appropriate amount of capital to allocate to a specific trade based on factors such as account size, risk tolerance, and market conditions. Effective position sizing aims to strike a balance between maximizing profit potential and managing risk. By implementing well-defined position sizing strategies, traders can optimize their risk management practices, enhance consistency in performance, and ultimately contribute to the longevity of their trading endeavors in dynamic and sometimes unpredictable financial markets.
Considering the important role that position sizing plays in trading, it is surprising that relatively limited attention has been directed toward this aspect in comparison to the extensive focus on trading signal generation. Reference [1] introduced a novel approach to position sizing grounded in the volatility index, VIX. The author pointed out,
We build on the recent literature on volatility-managed portfolios and explore the possibility of scaling with implied instead of realized volatility. The scaling is based on the CBOE implied volatility index (VIX) observed from the daily data over the past month. Using a large set of test assets involving ten equity factors, six classes of mean-variance efficient portfolios and 176 anomaly portfolios, we show that the proposed VIX-managed strategies generally outperform the one based on realized volatility in terms of spanning regression alphas, with limited improvements in the Sharpe ratios. This situation changes dramatically in the presence of trading frictions. Spanning regression alphas of VIX-managed portfolios survive under the majority of realistic transaction costs. In contrast, the alphas for management strategies relying on realized volatility generally evaporate under the same assumptions.
In short, utilizing the VIX for position sizing is an effective risk-management strategy. Nonetheless, we hold reservations regarding their assertion that the VIX is inherently forward-looking. From our perspective, the VIX represents the market’s estimation of future realized volatility, rather than a definitive forward-looking predictor.
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References
[1] Bozovic, Milos, VIX-Managed Portfolios (2023). https://ssrn.com/abstract=4507634
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