Risk Management Volatiltiy Method

Money Management – Volatility Method

Example: If the gold price varies between $1,200 and $1,224 then the average true range is  $24 or 2%. Supposed that you have $100,000 in your trading account and you want to buy gold futures. Let’s say the daily range of gold for the last three days is 2% on average. We will use a 3-day simple moving average of the average true range to measure our volatility. If the daily range is $24 and a point in the futures contract is worth $100 that gives us the daily volatility of $2,400 per gold contract. Let’s say we are going to allow volatility to be a maximum of 5% of our equity. 5% of $100,000 is $5,000. If we divide our $2,400 per contract fluctuation into our tolerable limit of $5,000 we get 2.08 contracts. Therefore our money management model allows us to trade a total of 2 contracts.  Take into account if we use the total equity model ( account value + open position value) we increase the amount of units traded compared to our total equity. The position size is then calculated based on our equity and the gains we have in our actual positions.

If you use volatility for your risk management you might also limit the amount of your portfolio at risk. Giving a percentage number is talk in large so always evaluate your strategy performance before you choose the final portfolio exposure. Also important is your risk tolerance and the psychological factors that come into play. How would you feel if your $100,000 portfolio went down to $90,000 in a single day ? How much heat can you handle ? That’s a question only you can answer.

This concept could be further developed and adjusted. To give you some ideas you can include concepts like group risk, average true range based on hourly adjustments (trading during the day or after hours is giving us different levels of ATR, primary market for specific contracts – NIKKEI futures experience the largest swings when the asian markets open ), ATR calculations and counting the number of directional changes during a trading session.

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Money Management – Volatility Method

The volatility-based money management method is a practical approach to determine position sizing according to market fluctuations and your personal risk tolerance. Unlike fixed-percentage models, this method adjusts trade size dynamically based on the instrument’s recent volatility, helping to control risk while allowing participation in larger moves.

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Step 1: Measure Market Volatility
A common way to quantify volatility is using the Average True Range (ATR). For example, suppose gold has traded between $1,200 and $1,224 over the past day. The daily range is $24, which represents roughly 2% of the price. Using a 3-day simple moving average (SMA) of the ATR smooths short-term fluctuations and provides a more reliable measure of recent volatility.

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Step 2: Translate Volatility into Dollar Terms
For gold futures, assume that 1 point = $100. With a daily ATR of $24, the daily dollar volatility per contract is:

$24×100=$2,400\$24 \times 100 = \$2,400$24×100=$2,400

This means that each contract is expected to fluctuate approximately $2,400 per day based on recent activity.

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Step 3: Determine Your Risk Tolerance
Next, define the maximum portion of your equity you are willing to risk per day. Let’s say your account balance is $100,000, and your maximum daily risk is 5%, i.e., $5,000. To calculate the number of contracts to trade:

Contracts=MaximumRiskDollarVolatilityperContract=5,0002,400≈2contracts\text{Contracts} = \frac{\text{Maximum Risk}}{\text{Dollar Volatility per Contract}} = \frac{5,000}{2,400} \approx 2 \text{ contracts}Contracts=DollarVolatilityperContractMaximumRisk​=2,4005,000​≈2contracts

This ensures that, under normal market conditions, a single day’s typical volatility would not exceed your risk threshold.

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Step 4: Adjust for Total Equity
Some traders calculate position size based on total equity, which includes the current account value plus the value of open positions. This allows the model to increase trade size as profits accumulate, maintaining a consistent percentage risk. For example, if your account grows to $120,000 and volatility remains similar, your 5% risk limit rises to $6,000, allowing slightly more contracts while keeping relative risk constant.

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Step 5: Portfolio-Level Considerations
When trading multiple instruments or contracts, consider portfolio risk aggregation:

• Group Risk: Avoid overexposure to correlated assets. For example, trading both gold and silver futures simultaneously may increase total portfolio volatility since they often move together.
• Position Diversification: Assign a maximum percentage of portfolio risk to any single trade. Even if one contract fits your volatility model, multiple correlated trades could exceed tolerable risk.
• Dynamic ATR Adjustments: For intraday traders, calculate ATR on hourly or 15-minute intervals to capture session-specific volatility. For example, NIKKEI futures typically experience the largest swings when Asian markets open, so ATR during these periods may be higher than daily ATR.

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Step 6: Incorporate Directional Changes and Market Behavior
Some traders refine volatility-based position sizing by tracking the number of directional changes within a session. More frequent swings may suggest smaller position sizes even if ATR is moderate. For example, an asset with $50 ATR but 10 intraday reversals may pose greater psychological stress than one with $50 ATR and fewer reversals.

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Step 7: Psychological and Risk Tolerance Factors
Money management is not purely mathematical. Ask yourself:

• How would you feel if your $100,000 portfolio dropped to $90,000 in one day?
• How much “heat” can you endure without abandoning your strategy?

Your risk tolerance will dictate whether the theoretical number of contracts is actually comfortable to trade.

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Step 8: Iterative Testing and Fine-Tuning
Finally, backtest your volatility-based model across different market conditions, instruments, and timeframes. Consider:

• Session-Specific ATR: Measure ATR during different market sessions (e.g., London vs. New York for FX).
• After-Hours Volatility: Some contracts, like stock index futures, can swing differently outside primary market hours.
• Adaptive Risk Limits: Adjust the maximum percentage of equity at risk based on recent drawdowns or volatility spikes.

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Practical Example: Gold Futures

Traders can either round down to 1 contract or adjust risk tolerance for high-volatility sessions.

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Key Takeaways

• Volatility-based position sizing ensures that trade sizes are proportional to market fluctuations.
• Combining ATR with equity-based risk control helps prevent catastrophic losses.
• Incorporate psychological limits and real-world trading behavior to complement mathematical models.
• Session-specific and directional adjustments improve precision in live trading

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TradeStation Implementation – Example EasyLanguage Script

Concept: Automatically calculate ATR-based position size for futures (or stocks) and adjust risk according to account equity. Include optimization variables for ATR period, risk percentage, and maximum contracts.

Inputs:
    ATRLength(3),          // ATR moving average period
    RiskPercent(5),        // % of account equity to risk
    MaxContracts(5),       // optional hard cap on contracts
    PointValue(100);       // $ per point for the contract

Vars:
    ATRValue(0),
    DollarVolatility(0),
    Equity(0),
    ContractsToTrade(0);

// Get account equity
Equity = PortfolioValue;

// Calculate ATR
ATRValue = Average(TrueRange, ATRLength);

// Convert to dollar volatility per contract
DollarVolatility = ATRValue * PointValue;

// Calculate position size
ContractsToTrade = IntPortion((Equity * RiskPercent / 100) / DollarVolatility);

// Apply maximum contract limit
If ContractsToTrade > MaxContracts Then
    ContractsToTrade = MaxContracts;

// Optional: Print values for verification
Print("ATRValue: ", ATRValue:1:2, " DollarVolatility: $", DollarVolatility:1:2, " Contracts: ", ContractsToTrade);

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How to Use:

• Attach this strategy to your futures symbol (e.g., Gold Futures / GC).
• Adjust ATRLength to reflect your preferred volatility smoothing (e.g., 3-day, 5-day).
• Set RiskPercent to your desired daily equity risk (e.g., 5%).
• Set MaxContracts if you want a hard cap.
• Use TradeStation’s optimization feature to find the best ATRLength, RiskPercent, and MaxContracts for your trading style and instrument.

Further Enhancements:

• Add session-specific ATR calculations (e.g., Asian vs. US session).
• Include directional filters or entry signals (mean reversion, breakout, etc.) to combine position sizing with strategy rules.
• Integrate with equity curve trailing stops or drawdown limits for additional risk control.