Each week, I receive email messages regarding the two approaches to trading: Discretionary versus system trading. On one hand are those who distrust "black boxes" and, on the other, those who find discretionary trading imprecise and / or difficult to learn.

I started out as a discretionary trader of chart patterns mainly because that is what people around me at the office were doing. While I mastered the trading technique easily, I was unable to find a time-efficient method to produce trading candidates. I was also physically limited by how many charts I could watch at any given time.

I solved my problem by trading bond and index futures. For a long time, this arrangement was fine, but, when volatility died, I needed to put more capital to work over longer time frames. Then, the old "can't watch all those charts" problem was back. The only way around it was to encode my knowledge into a trading system and play it by the numbers.

First Things First: Position Size
If there is one thing that winning traders can agree on, it is that position size is everything.

Sadly, this subject is barely touched on in most books or even in trading systems, for that matter. That’s too bad because, without it, there is no way to consistently win. If you don't believe me, please read Fortune’s Formula by William Poundstone. This book shows you the difference between aggressive risk and insane risk.

If you take away only one thing from this article, it should be: Position size is everything.

The Tale of Two Traders
Let's take a look at what happens to two hypothetical traders using the exact same signals generated by my trading system. In this example, I used the daily data of a typical speculative stock, StopFactor 2.5, from September 1994 to June 2006.

Big Bet Bob decided to bet $10,000 on every trade. He was quite conservative in comparison to many aggressive traders because he used no margin.

By the time Bob got to trade number 5, he had lost almost all of his money. Not knowing the future, he quit due to "system drawdown".

Marty Mathematician knew nothing about trading. He was a numbers guy, so the only thing he knew was that he would not take insane risks. He traded a fraction of what Big Bet Bob traded. With his $10,000, Marty risked approximately 1 percent of his account equity per trade or $100, give or take.

When the system was winning, Marty's account equity grew; by definition, his subsequent bets were larger. When the system was losing, Marty's account equity shrunk; by definition, his subsequent bets were smaller.

Because Marty Mathematician used the same signals as Big Bet Bob, he initially lost money too. Because of his position sizing strategy, he was only down a couple of hundred dollars by the end of trade number 5. However, the loss was so small he had no reason to panic. Instead, he stuck to the program and enjoyed the ride.

There you have it. Same system. Same signals. Different position size. Big Bet Bob struck out early in the game because his bet size was so big that it virtually guaranteed that the risk of ruin would take him out of the game. Marty Mathematician knew this and took the money to the bank.

Obviously, Big Bet Bob was betting too much, and perhaps Marty Mathematician could have been a bit more aggressive. The point is that if a trader overbets, it is certain that the risk of ruin will catch up to him. Ignoring position size is deadly.