At iSigma, we consider position size to be a very important concern in trading. Site visitors are encouraged to study our other articles on money management techniques and traps. However, we are careful to distinguish between what is important and what is most important. If a trading method does not include a good way of knowing when to get in and when to get out, the only advisable position size is zero. No amount of number crunching can turn a bet into a good one just by adjusting the amount wagered.

When other systems advertise that they use some very sophisticated money management techniques, that should be a warning sign that the system developer ran out of good ideas for entry and exit and is trying to compensate by adding in aditional rules for position sizing. At iSigma, our approach to the markets relies on a very advanced method for deciding when to get in and when to get out. When the entry and exit part of the system is well designed and robust, no elaborate position sizing method is necessary.

This is a very popular concept in trading, partly because the name suggests mathematical sophistication and partly because the concept sounds like a guaranteed way of reducing risk. The idea is realtively simple. If a trader is interested in several instruments that usually move together, some rule in the system should keep the trader from taking positions in all of those instruments at the same time. After all, the positions might all go sour together causing the trader to bear an undesirable amount of risk.

The problem with correlation limits is that the whole theory starts from the illusion that there are instruments that move together. In reality, there are instruments that have moved together in the past and instruments that will move together in the future. Since trading in the past is not an option, the first category is useless. Since there is no way to know what instruments will move together in the future, the second category is no help either.

The correlations that affect a trader are the correlations that manifest themselves when the trader has positions on in multiple markets. No one can know these in advance. Markets that were once independent can suddenly move together. Markets that were once closely correlated can diverge wildly. Bad traders deal with this using covariance and correlation matrices reflective of past events. Good traders place their trades so that when multiple markets move together it works in their favor.

The term "pyramiding" is trader jargon for increasing the size of a position because the position is doing well. A lot of traders do this on a discretionary basis, but there are also many trading systems that have very elaborate quantitative rules for adding to existing positions. While this might seem like a very measured way of easing into a position, this practice also subjects the trader to a new set of risks. Several trades all establishing or adding to one position have the same effect as trading several different positions in highly correlated instruments. The difference is that unlike the case of different markets that have shown some correlation in the past, the corelation is real and persistent.

While there is no way to know when different instruments will begin to move together, one of the few sure bets in trading is that all units of the same instrument will move together. One lot of a currency will rise and fall the same as any other lot of that same currency. In quantitative terms, all units or shares of the same instrument do move together with a correlation of one and a covariance equal to the standard deviation of that instrument.

Unlike the situation described above, traders would do well to ensure that they do not take too many positions in the same instrument because if the trade goes sour, those positions will all decline together. When the time comes to enter a trade, that's the time to decide how closely the volatility of the portfolio should be tied to the volatility of a particular instrument. Once the trade is on and doing well, it can be very tempting to change the rules and let that instrument occupy a larger space in the portfolio. Be aware that any such practices only serve to tie the trader into multiple positions with a guaranteed correlation coefficient of one.

Inadequate Diversification

Most traders, even novices, have some understanding of diversification. The basic concept is to include multiple positions in the portfolio so that the variability of the trader's returns are not bound to the variability of one financial instrument. This is a very sensible way to approach the markets and it's the reason we do not care much for trading approaches that only follow one instrument. Diversification is generally a very good thing. Unfortunately, there are certain easily avoidable pitfalls where the best intentions to diversify can go wrong.

One common misconception is the idea that diversification is only about the number of instruments a portfolo contains. Mutual fund marketers have been very effective in spreading the idea that holding many different stocks is all the diversification anyone needs. Diversification across multiple instruments is only one of the ways traders can benefit from diversification. Here are a few more:

• Degrees of market participation

  Sometimes it might be wise to have many positions open but other times it's wiser to have only a few positions or possibly none at all. The newsletter portfolio is built with this in mind. Sometimes it will show a position in every instrument and other times only a few positions. Occasionally it will show no positions at all.

• Timeframes for holding positions

  There is no universally perfect timeframe for trading. Sometimes it's wise to hold a position for no more than a few days. Other times several weeks or even months will yield better results. Sometimes even longer timeframes are even better.

• Directional diversification

  Taking only long positions is a sure way to connect one's entire portfolio to one market direction. In reality, markets move both up and down providing oportunities to trade both long and short. This might seem like a small improvement but if a trader is contemplating a long only approach, adding in the possiblity of short trades effectively doubles the number of positions available for diversification in the portfolio.

Artificial Diversification

Another diversification mistake comes from the desire to try and target only the very best diversification opportunities. The same traders that rely on correlation studies to develop correlation limits will often try to do the oposite when correlation data shows that instruments have been unrelated in the past. For example, they might construct a porfolio only of instruments that have shown little or no correlation. The problem, as in the case above, is that the lack of past correlation provides no information about how different instruments will behave in the future. Worse yet, if a large number of traders try this all at once, these instruments that used to be relatively uncorrelated will soon become very closely correlated, defeating the purpose of the strategy.

How We Stack Up

• Money Management

  Our money management structures are simple because we believe the only purpose of money management should be to determine how much to trade. Ensuring that our trades work is a matter of good entry/exit methods.

• Correlation Limits

  Correlations in the past are useful for economic historians, but not for traders. Our system doesn't use correlation matrices, covariance measures or any other historical analysis for trading in the present.

• Pyramiding

  No pyramiding, never. When the iSigma system has an entry signal in some instrument, it also determines the largest amount of influence that that instrument will ever have on the total performance of the portfolio.

• Diversification

  The newsletter portfolio follows multiple instruments (16 possibilities), is sometimes in and sometimes out (2 possibilities), long and short (2 possibilities) and to date has held positions from timeframes as short a one day to more than sixty market days (more than 60 possibilities). That's (16 x 2 x 2 x 60) or almost 4000 possible positions.

At iSigma, avoiding these and other pitfalls is an integral goal in the design of our approach to the markets.