Risk and Position Sizing

Risk depends on what a position can lose, how losses arrive and whether the position can be changed when needed. A small initial payment can represent a large exposure.

Exposure and leverage

Record contract count, multiplier and notional exposure. For options, also record sensitivities to price and volatility. Offsetting notionals do not necessarily offset risk when instruments respond differently.

Leverage magnifies changes relative to the capital supporting a position. Margin is collateral, not a loss limit. It can increase during volatile periods, and losses can require funds before a position's eventual outcome is known. See CME's margin guide.

Drawdown and liquidity

A drawdown measures a decline from a previous peak under a stated convention. It describes the path of returns, not just the final result.

Liquidity risk is difficulty reducing a position at an acceptable price. Displayed depth can disappear, spreads can widen and a market can stop trading. A stop trigger does not guarantee an exit price.

A risk ledger for a simulation

Keep three separate budgets: position, loss and cash. The position budget limits exposure. The loss budget limits the simulated drawdown tolerated before stopping new trades. The cash budget reserves funds for margin and execution.

Count live orders against the position budget using their possible fills. Reserve cash before submitting orders rather than after they execute. Recalculate the ledger after every fill and price update.

These are rules for the model, not assurances about real losses. A market can move past a threshold before an exit executes.

Scenarios

Reprice the portfolio after price moves, volatility changes and wider spreads. Include a scenario where the hedge becomes less effective or unavailable. Check the cash required as well as the mark-to-market loss.

Several positions can share the same underlying risk. Count exposures by driver rather than treating every instrument as independent.

Position size

Express limits in the units that matter to the instrument. Contract count, notional, delta and a scenario loss each answer different questions. A sizing rule should state which measure it controls and what happens when the limit is reached.

See Futures, Pricing and Greeks and Backtesting.