5. Money Management Models
Fixed Lot
Also called “Fixed Value” money management, this is the simplest of all the available money management models. With the Fixed Lot model, you set the number of lots you would like to trade per position. No matter how much your account balance or equity curve oscillates, you will still trade a fixed number of lots per position.
A basic example of this method is saying I have a 10,000 US Dollar account and I will trade one mini lot on every trade. It does not require a calculation, but still the fixed lot size should be determined by predetermined risk measures and not by the market behavior.
Pros:
- It's easy to manage and understand because of the consistent lot size.
- It allows profits to grow arithmetically - that is, by a constant amount per time period. It is useful, for instance, if you withdraw your profits after each month of trading, starting anew with the same capital. Some traders perform poorly if their accounts start to grow exponentially - finding in this model an ally for their trading style. Others just prefer to trade with a large account and withdraw profits regularly - not aiming at growing the account.
Cons:
- It does not provide an ability to maintain a constant leverage as account balance shrinks and rises. This can lead to big Drawdowns since during a string of losses the leverage increases with each new trade (please refer to the first part of this chapter and to Chapter A03 if the concept of leverage is still unclear to you).
- Another drawback of this model is that by trading the same position size on any given trade, you will soon find out that the trading results are very much dependent on whether the system continues to work or not - while the whole purpose of adopting a money management technique is to get rid of the burden of the system's profitability.
- Each withdrawal from the account puts the system a fixed number of profitable trades back in time. Therefore, this may not be the best model to trade if you pursuit an efficient growth in your trading account.
A trader that risks too much increases the chance of not surviving long enough to realize the long run benefits of a good trading strategy. Conversely, risking too little creates the possibility that a trading methodology may not realize its full potential. Therefore, while a positive expectation may be a minimal requirement to trade successfully, the way in which you are able to exploit that positive expectation will largely determine your success as a trader. Therefore, wisely choose which money management technique is better adapted to your system and to your trading profile.
Imagine a system with a Fixed Lot size of 1 mini lot averaging 10 pips per trade. After each 100 trades, the account grows by 1,000 USD. After the first 100 trades, this is a Return of 100% but after 1,000 trades the same result in pips accounts for a Return of 10% only.
1000 USD + 1000 pips @ 1USD/pip = 2000 USD
2000 USD + 1000 pips @ 1USD/pip = 3000 USD
3000 USD + 1000 pips @ 1USD/pip = 4000 USD
4000 USD + 1000 pips @ 1USD/pip = 5,000 USD
5,000 USD + 1000 pips @ 1USD/pip = 6,000 USD
6,000 USD + 1000 pips @ 1USD/pip = 7,000 USD
7,000 USD + 1000 pips @ 1USD/pip = 8,000 USD
8,000 USD + 1000 pips @ 1USD/pip = 9,000 USD
9,000 USD + 1000 pips @ 1USD/pip = 10,000 USD
10,000 USD + 1000 pips @ 1USD/pip = 11,000 USD
Fixed Fractional
Fixed Fractional position sizing has been developed by Ralph Vince in his book "Portfolio Management Formulas" (John Wiley & Sons, New York, 1990) to remedy the problem of the equity drifting out of proportion in relation to the fixed lot size pointed in the prior model. The Fixed Fractional defines the trade (risk) as a fraction of the equity. This is a model that directly incorporates the trade risk.
The idea behind the Fixed Fractional model is that the number of traded units is based on the risk of the trade. The risk is the same percentage or fraction of the account equity on each trade. By risking always the same percentage/position size, the risked fixed fraction stays proportional to the equity while the equity rises and falls.
The risk of a trade is defined as the capital amount that the trader would lose per trade if it were a loss. Commonly, the trade risk is taken as the size of the money management stop applied, if any, to each trade. If your system doesn’t use protective stops, the trade risk can be taken as the Maximum Drawdown or the Average Loss.
Pros:
- One interesting artifact of the Fixed Fraction model is that, since the size of the trade stays proportional to the equity, it is theoretically impossible to go entirely broke so the official risk of total ruin is zero. As an anti-martingale technique, it is designed to accomplish the preservation of one’s capital for as long as possible.
Note, that in the practice however, the abandonment of a trading methodology should come earlier than the account’s depletion.
- The compounding effect kicks in every time you have a winner. By using this method the position's size is gradually increased when winning and decreased when losing. Increasing the size of positions during a winning streak allows a geometric growth of the account (also known as profit compounding); decreasing the size of the trades during a losing streak minimizes the damage to the trader's equity.
- At lower percentages of equity risked, a winning or a losing streak simply does not have a spectacular impact on the equity curve. This results in smoother capital appreciation (and much less stress for the trader or the investor). This is because, when you risk small fractions of your equity (up to 3%), each trade is given less "power" to affect the shape of your equity curve which leads to smaller Drawdowns and consequently greater ability to capitalize on the winning signals in the future. In other words, the size of Drawdowns is directly proportional to the risked percent.
Geometric capital growth is produced when the profits are reinvested into the trading which leads to progressively larger positions being taken and, consequently, to bigger profits and losses. This is one of the advantages of the retail Forex industry and the allowed small trade sizes - without it, the growth of small accounts would be much more difficult. Depending on the Equity Model, the trader can accelerate or smoothen the account growth.
Remember that besides the equity model used, the pace at which the account grows is determined by the Average Profit and by the Win Rate. The speed (geometricity) and the smoothness of the account's growth also depend on how much you risk per trade.
It is noteworthy to underline that only geometric capital growth allows making regular profit withdrawals from an account (as a certain percent of the equity) without seriously affecting a trading system's money making ability.
Cons:
- If you have a small account balance you are forced to work with a lot size which doesn't help in fine sizing the positions.
- This model will require unequal achievement at different size position levels. This means that every time you want to increase the position size it may require you to produce a high return before you can increase the trade size from one lot to two lots- otherwise you would be risking too much. So for smaller account sizes it will take a long time for this money management to actually kick in.
- For larger account sizes the number of traded lots will inversely jump wildly around.
- The reduction of the relative position size after every loss makes more difficult to recover from a severe Drawdown and makes of this model an anti martingale type of technique. It should be used if you have enough statistical data on the Drawdown series.
- If a large loss exceeds a certain amount and the risked percentage is now less than the smaller lot size, the trader is forced to break the risk rules just to trade the minimum allowed lot size.
- Once the account reaches a higher size, the growth of the position size accelerates to a degree which is unrealistic and highly risky.
Let’s say you've got 1,000 US Dollars, you employ a Fixed Fractional methodology and a trading system that makes you about 10 pips per trade on average. You decide you're going to start by trading 1 mini lot, a sensible thing to do with an account of this size.
After your first 100 trades you've build up 1,000 US Dollars in profits. Since your account size has just doubled, you can now double your trade size according to the fixed fractional technique, so you're now trading 2 mini lots each time. Another 100 trades at 10 pips per trade on average, and you've doubled your account again to 4,000 US Dollars. Getting the idea? Each time you make 1000 pips, you double your account size. Following this logic, your trading progress would look like this:
1000 USD + 1000 pips @ 1USD/pip = 2000 USD
2000 USD + 1000 pips @ 2USD/pip = 4000 USD
4000 USD + 1000 pips @ 4USD/pip = 8000 USD
8000 USD + 1000 pips @ 8USD/pip = 16,000 USD
16,000 USD + 1000 pips @ 16USD/pip = 32,000 USD
32,000 USD + 1000 pips @ 32USD/pip = 64,000 USD
64,000 USD + 1000 pips @ 64USD/pip = 128,000 USD
128,000 USD + 1000 pips @ 128USD/pip = 256,000 USD
256,000 USD + 1000 pips @ 256USD/pip = 512,000 USD
512,000 USD + 1000 pips @ 512USD/pip = 1,024,000 USD
The downside of the above fantasy is that each time you increase the trade size, you are also increasing the risked dollar amount and any violent Drawdown can severely damage your account.
Risking a high percentage of your account might indeed have dramatic effect on the geometric growth of your account balance in the very short-term. This happens because winning streaks (however long) are always followed by losing streaks (however short) and much of what was “given” by the high percentages is very likely to be “taken away” by the same percentages.
But even if you keep the risked percentage the same, as in this model, the amount of capital risked increases as the available capital grows. Psychologically it may be hard to bear a risk of 2% in a 100k account- there fore other money management models have been designed to solve this problem.
Periodical Fixed Fractional
In this variant of the previous model we recalculate the risked percentage not in every single trade, but only if after a certain time the account equity has changed, let's say after one day, one week or one month.
Pros:
- This will smooth the compounding mechanism during winning and loosing trades. If you win 10 trades in a row using the Fixed Fractional method you will significantly compound because after each trade you are taking the new balance into account to reevaluate the absolute risk amount. Using the Periodical Fixed Fractional you don't change the trade size even if you are having a winning or a losing streak. This breaks the geometricity of the equity curve.
- By compounding per day, the result will be similar to the Fixed fractional if the trade frequency is close to one trade per day - the more it varies the greater will be the difference.
- By compounding per month, you can't expect huge compounding returns but on the other hand you are also locking in the risk. The maximum profit potential will be not dependent of the alternation of Profit and Loss trades.
- Regardless of the alternation of winning and losing trades, by compounding per month, your result will be always the same- means the system's performance is less impacted by winning and losing streaks.
Cons:
- The problem with this technique is when you have strings of losing trades. These strings hurt because now you have to take the account back up and you are trading smaller sizes as your account decreases. Typically this will bring an account balance lower and lower.
Using the classical Fixed Fractional model, you will always have a potential lowest return, a potential highest return and a potential average return. The higher the period chosen to size the positions, the narrower will be the potential lowest and highest returns.
This means that the less impact has the alternation of wining and losing traders on the system's performance and the closer the end result will be to the potential average return.
Profit Fixed Fractional
The profit risk position sizing method is another variant of the Fixed Fractional position sizing.
In Fixed Fractional position sizing, the dollar amount risked on a trade is a percentage of the current account equity or balance. In the Profit Fixed Fractional method, the dollar amount risked on a trade is a percentage of the starting account equity plus a percentage of the total closed trade profit. Once the risk amount is determined, the number of units is calculated the same way as in Fixed fractional, namely: the amount to be risked is divided by the trade risk per unit.
Compared to the Fixed Fractional model, the Profit Fixed Fractional method is sometimes more convenient because it separates the account equity into initial equity and closed trade profit. The percentage applied to the initial equity provides a baseline level of position sizing independent of the trading profits. Note that if both percentages are the same, the Profit Fixed Fractional method will produce the same result as the Fixed Fractional model.
Pros:
- This strategy is for traders looking for higher return and still preserving their starting balance.
Cons:
- The increased risks in the buffer fraction of your account: if a Drawdown occurs when trading with the first accumulated buffer, it may force the trader to start anew if the buffer is depleted by a string of losses.
As an example, consider a start balance of 10,000 US Dollars and after 1 year, this amount might be 15.000 where the risk was kept to 1% of your balance. Now you have your initial balance + 5.000 US Dollars in profit. You can now increase your potential profit by risking more from the profit while restricting your initial balance risk to 1%. For example, you can calculate your trade through the following pattern:
1% risk of the 10.000 USD (initial balance) + 5% risk of 5.000 USD (profit)
In this way, you will have more potential for higher returns and at the same time you are still risking 1% of your initial deposit.
In the recorded webinar “Position sizing and money management”, John Jagerson points those contingencies that usually happen down the road and explains money management techniques beyond the Fixed Fractional model as being the most common method. He also treats diversification as a function of risk control, a subject which falls out of the scope of this chapter.
Optimal Fixed Fractional Trading
The concept of “Optimal F” is that a Fixed Fraction of a trading account will grow it at the most efficient rate. In other words, it gives us the optimal fraction that we place in each trade for maximum net return.
It is a variant of the Fixed Fraction model that Ralph Vince developed to enhance a model based on fixed odds, that is, where winners and losers were of consistent amounts. Since any trading performance may have strong deviations – after a loss of 2.5% on one trade, a gain of 6.18% may happen on the next trade, and so on - Vince created a model for variable returns. But in order to measure the results of variable returns it’s helpful to understand the concept of the so called “geometric mean”.
What is the Geometric Mean?
Geometric mean is simply the effect of compounding. An example might be this: two trades increase our portfolio by 10% each one. At the end of the second trade, how big is my portfolio? If you said 120%, you missed the effect of compounding that geometric mean will yield. The right answer is: 110% * 110% = 121%.
A Return of 120% would be an arithmetic mean.
Vince explained that Optimal F is that fixed fraction which grows the portfolio at that highest geometric mean. Determining Optimal F consists of trying different values of F and determining which one provides the best geometric returns. This is done using software, or you can simply use the GEOMEAN() function in excel.
Pros:
- The resulting value, whatever the Fraction is, is supposed to achieve the larger amount of profits. So if your Optimal F is 15%, you place 15% of your account at risk on each and every trade. Then, at the end of a given amount of trades, you will have built up your account to a larger amount than if you had you risked 14% or 16% of your account.
Cons:
- While this might be mathematically the best way to grow a portfolio, it will be psychologically challenging for most to execute it faithfully, as it is usually very aggressive.
- If we use a fraction above the Optimal F we will ruin the account by over aggressiveness, whereas if the Fraction is below the Optimum F the growth of our account will be too slow.
- Clearly this is not a method that shows a ratio with which to operate since the Optimal Fraction will provide the greatest net return, but with a risk level measured by the Drawdown that very few traders can bear.
- Note that the Optimal F is based on the past trade results - if the F number was 15% for the last hundred trades, it doesn't mean that it will be the same for the next hundred trades. This means you can be over trading and turning a winning situation into a losing one. And conversely it can lead you to under trading, and you're obviously not going to get maximum growth.
- Note as well that the Optimal F is still a fixed fraction. The problem with a fixed fraction is that if you go too low, you're never going to see growth. And if you go too high with the Optimal F you're going to be very aggressive and probably face huge Drawdowns.
"We know that if we are using optimal F when we are fixed fractional trading, we can expect substantial drawdowns in terms of percentage equity retracements. Optimal F is like plutonium. It gives you a tremendous amount of power, yet it is dreadfully dangerous. These substantial drawdowns are the problem, particularly for novices, in that trading at the optimal F level gives them the chance to experience a cataclysmic loss sooner than they ordinarily might have."
Source: "The mathematics of Money Management" by Ralph Vince, Wiley and Sons, 1992.
Secure Fixed Fractional
This model is another variation of the Fixed Fraction and was introduced by Ryna Systems. The Secure F is similar to the Optimal F except for the introduction of a restriction on the Maximum Drawdown the trader is willing to tolerate.
Leo Zamansky and David Stendahl in their article “Secure fractional money management” (Stocks & Commodities magazine, June 1998), observed that this strategy had to be made more operational. The reason was the inability of most traders to withstand large losses and the high risks inherent to the Optimal F model.
Instead of the Maximum Drawdown, the Optimal F can also be calculated using a maximum risk tolerance level.
If the Maximum Drawdown is a very small value, we are facing a very conservative strategy, so the Secure F can be adjusted to the risk tolerance (or appetite) of each trader.
This is a question out of the Practice Chapter:
If a trader was wrong 20 times in a row and still has 80% of his or her equity left, what is the model is he/she trading?
Measured Fixed Fractional Model
Many traders have passed through the experience of giving profits back to the market after a winning period. This happens usually when the adopted money management model is not adequate to the kind of trading methodology used, or when there is no money management regime at all. Yet there is another variant of the Fixed Fractional which aims to protect the trader's gains: the Measured Fixed Fractional model.
Like other methods, this one also increases and decreases the trade size on a regular basis, and for doing this, it scales the equity's (or account balance) growth in fractions. Instead of increasing the position size after each trade, or after a certain time, it does it after a predefined amount of capital growth.
Pros:
- It smoothes the equity curve more than in the traditional Fixed Fractional model.
- It simplifies calculations as the position size has only to be changed once the account has grown of a certain amount.
- It helps traders to recover faster from losses because the position size is not reduced immediately after the loss is produced. After a loss you are still trading with the same size, and although your leverage might increase, it does it only slightly.
Cons:
- For more aggressive traders it may represent an impediment to profit from the compounding effect during a winning streak.
Here below we take the example of risking 1% of the account balance. Remember that instead of account balance you can use any of the equity models explained in the third section of this chapter. The Measured Fraction is calculated simply by rounding down the available capital to a lower fraction. Depending on your trading style, you can increase the measured fraction each 1,000 units of accumulated profit – as in the below example - or set any other amount.
Capital |
Measured Fraction |
1 % Risk |
10.000 USD |
10.000 USD |
100 USD |
10.500 USD |
10.000 USD |
100 USD |
10.700 USD |
10.000 USD |
100 USD |
11.000 USD |
11.000 USD |
110 USD |
11.200 USD |
11.000 USD |
110 USD |
11.300 USD |
11.000 USD |
110 USD |
12.500 USD |
12.000 USD |
120 USD |
12.380 USD |
12.000 USD |
120 USD |
12.700 USD |
12.000 USD |
120 USD |
12.580 USD |
12.000 USD |
120 USD |
13.500 USD |
13.000 USD |
130 USD |
21.000 USD |
21.000 USD |
210 USD |
25.000 USD |
25.000 USD |
250 USD |
Fixed Ratio
The Fixed Ratio model was developed by Ryan Jones in his book "The Trading Game" and addresses the relationship between growth and risk. For those who always dreamed of knowing when and how to increase or decrease the lot sizes, this might be the adequate model.
In Fixed Ratio Trading the position size increases as a function of profit and loss, hence rewarding the higher performance with more lots and vice versa.
The goal is to grow the available margin as an asymmetrical rate, while steadily decreasing the risk.
It is primarily intended for traders starting out with a small account size, because it requires less profits in the account to begin with in order to increase the trade sizes. Its underlying premise is that you are willing to risk more initially to grow your account, but as your account is growing you are prepared to risk less.
The aim of this model is to take advantage of consecutive winning trades. During winning streaks, the Fixed Ratio model allows you to be aggressive. But at the same time, when the account grows, the trader is also able to slow that position size growth down compared to the way the classical Fixed Fraction models does. Essentially, it slows the position size growth down so that the risk vs. aggressiveness becomes equal to the entire way as the account size grows.
Facing a performance Drawdown the trader is able to reduce the lot sizes, and thereby the position size, in set increments. If the system continues to generate losses and the Drawdown continued to exceed reasonable expectations, the position size is reduced until the trader eventually stops trading. The difference with other models is that you would stop trading earlier, thus keeping more profits.
Pros:
- The Fixed Ratio offers a seemingly neat solution to the problem of asymmetrical leverage. You don't reduce your position size after every loss. For example, if you lose 200 pips, you can bring your account balance back to break even by winning 200 pips and no more. That means your account can become impervious to single losses (not to Drawdowns, however).
- This approach can take a mediocre profitable system and convert it into a dynamic and considerably much more profitable system, taking more advantage of the winning streaks.
- A trader is able to take full advantage of a system while it is profitable and consequently, he will have a lot more money to take off the table if the system stopped working. This may happen, for instance, if you are trading a range system and the market starts trending and generating losses.
- Another advantage is that it allows geometric growth with higher risk percentages per trade.
Cons:
- While it's true that during a losing streak, risk is taken away by reducing the position size, there is a crucial assumption here: the Drawdown shall not exceed a specified expected amount. If it does, the account will suffer more compared to an account where a Fixed Fraction was applied because here the position size has been reduced all the way down and therefore it has more of its capital.
- Therefore, if you are using a system that tends to have large Drawdwons, you'd better use a Fixed Fraction money management model. This means that if your system goes into a Drawdown in the early stages of trading, using Fixed Ratio could make your account take a serious hit. In terms of risk, the most critical moment of blowing out the account is when you increase size for the first time.
- If, on the other hand, you have a system which, without being necessarily better than one which loses most of the time, doesn't produce large Drawdowns, the Fixed Ratio is the way to go.
- For larger accounts, it may be seen as a disadvantage the fact that it may take an unreasonable amount of time to increase the number of lots to a level that takes full advantage of the available equity.
Let's walk through some numbers and see how to put the Fixed Ratio money management model into practice. We will start with a simplified version:
- To begin with, the start balance has to be determined, let's say 1,000 US Dollars.
- The second step is to determine how many pips of profit the system needs to achieve before the trade size can be increased. Let's say 200 pips, which is an average of 10 pips per day for 20 trading days in a month. In order to be more conservative, simply add more pips profit in the formula. For example, increase the number of lots traded only after gaining 400 pips instead of 200 pips.
- The third step is to determine the lot size to start with. For the purpose of the example we will take 1 mini lot. In order to keep the calculation simple, let's suppose a pip is worth 1 US Dollar. Once the trading starts, the system has to accumulate 200 pips in profit in order to increase the size to 2 mini lots. After another 200 pips in profit the size would increase to 3 mini lots and so forth.
The results could look like this:
Month 1: After one month trading a start balance of 1,000 US Dollar and accumulating 200 pips in profits, the new account balance is 1,200 US Dollar by using 1 mini lot.
The trade size can now be increased to 2 mini lots. But if the balance falls below 1,200 then you will go back to trading 0.1 lots.
1,000 + (200 pips x 0.1 lot = 200 ) Total: 1,200
Month 2: By starting the month with 1,200 US Dollars and trading 2 mini lots, where each pip equals 2 US Dollars, by achieving 200 pips, the account balance rises to 1,600 US Dollars.
If your account falls below 1,600 the model forces go back to trading 2 mini lots.
1,200 + (200 pips x 0.2 lots = 400) Total: 1,600
Month 3: Starting month three with 1,600 and accumulating 200 pips in profit, and trading 3 mini lots, the result is a new account balance of 2,200 US Dollars.
Should the balance fall below 2,200 then the trading size has to be reduced to 3 mini lots.
1,600 + (200 pips x 0.3 lots = 600) Total: 2,200
Month 4: Starting the month with 2,200 US Dollars and winning 200 pips while trading 4 mini lots, a new balance of 3,000 US Dollars is in the account. Should the account fall below 3,000 then the size screw back to 4 mini lots.
2,200 + (200 pips x 0.4 lots = 800) Total: 3,000
Month 5: By the start of the fifth month the balance is at 3,000 US Dollars. If at months end the profit reaches again 200 pips by trading 5 mini lots the new account balance should now show 4,000 US Dollars.
Should account fall below 4,000 then the position size has to be adjusted back to 5 mini lots.
3,000 + (200 pips x 0.5 lots = 1,000) Total: 4,000
All right, you got the logic. The following months would be:
Month 6: 4,000 + (200 pips x 0.6 lots = 1,200) Total: 5,200
Month 7: 5,200 + (200 pips x 0.7 lots = 1,400) Total: 6,600
Month 8: 6,600 + (200 pips x 0.8 lots = 1,600) Total: 8,200
Month 9: 8,200 + (200 pips x 0.9 lots = 1,800) Total: 10,000
Month 10: 10,000 + (200 pips x 1 standard lot = 2,000) Total: 12,000
A more advanced version of this model adds a Delta factor to the calculation:
- Determine the starting balance, let's say 1,000 US Dollars.
- Here is the Delta factor: in order to determine how many pips of profit the system needs to achieve before the trade size can be increased, take the largest historical (or expected) Drawdown. If the expected Drawdown is 20%, that is 200 US Dollars in our example. Now divide the absolute Drawdown amount by a certain amount. In our example we are going to be neutral and divide it by 2, but here is where you can decide how aggressive or conservative you are going to be.
- Once divided the Maximum Drawdown by 2, we have 100 US Dollar as our fixed ratio number, means we will increase the position size by 1 mini lot this amount is accumulated in profits. To be more aggressive, then we would need a number that is lower than that. Conversely, in order to be more conservative, we would need to go with a lower number, dividing the Drawdown by 0.5, for example, resulting in a Fixed Ratio of 400 US Dollars.
- The third step is to determine the lot size to start with. It is advised to make use of micro lots if you are starting with a small account.
As you can see, the Delta factor, which is required to move to the next lot size level, is the result of a statistical figure. Therefore, the lower the Delta factor the more aggressive the money management is.
The formula is:
Max. Drawdown = 200 USD
Initial Capital = 1,000 USD
Fixed Ratio (Delta) = Max. Drawdown / 2
200 USD / 2 = 100 USD per lot
The third step in the previous formulas has been to determine the lot size to start with. This can also be done by defining the Effective Leverage (Please refer to Chapter A03 to calculate the Effective leverage).
The formula with all the variable looks like this:
Max. Drawdown = 200 USD
Initial Capital = 1,000 USD
Fixed Ratio (Delta) = Effective Leverage x Largest Drawdown / 2
1% x 200 / 2 = 100 (effective leverage of 100:1 - trading 0,1 lot)
2% x 200 / 2 = 200 (effective leverage of 50:1 - 0,05 lot)
3% x 200 / 2 = 300 (effective leverage of 33,3:1 - 0,03 lot)
Comparing the Fixed Ratio with the Fixed Fractional we notice that, at the lower account levels, less equity is required whereas as the account grows the number of traded lots becomes less aggressive. The main difference is thus the introduction of a Fixed Delta.
If you are asking if there is such a thing like an optimal Delta, the answer is no, it doesn't exist. Therefore, it will be at the trader's discretion to determine the acceptable risk levels.
Kelly's Percentage
The oldest model used today in financial markets was introduced by J. L. Kelly's in a seminal paper titled “A New Interpretation of Information Rate”, and published in 1956, where the author examined ways to send data over telephone lines.
One part of his work, the Kelly formula, can be used in trading to optimize the position size. It consists of betting a fixed fraction of the available capital on each trade. The rate of growth will vary according to this fraction.
Pros:
- The Kelly Percentage maximizes your long term growth rate by equalizing it with your risk.
- With a positive Expectancy, your trading account ought to grow exponentially, making use of the compound effect.
- Despite fluctuations along the way based upon the Law of Large Numbers and equipartition, the Kelly formula is a an effective strategy in the long-term.
Cons:
- As long as you win it's great but it will increase the risk to very high levels, increasing the danger of a Drawdown. If you hit a Drawdown the Kelly's formula it will take a long time to recover.
- In order to mitigate the danger of a Drawdown, common sense is needed. One rule to keep in mind, regardless of what the Kelly percentage may tell you, is to never commit more than a certain percentage to any given trade. For example: if Kelly says to risk 7%, then you just limit it to 4%; if it says 8% you risk 5%, and so on until you hit a minimum tolerated risk percentage and don't move from there. Many of these models can be creatively modified as you see!
- If you bet only a tiny fraction you will not go bankrupt but a drawback of this model is that your wealth grows very little. Make the risked fraction large and the losses may will wipe you out.
The formula determines the fraction of capital to allocate to each trade, as a function of the Win Rate as well as the Profit Factor (see Chapter C02 for a detailed explanation of statistical numbers). This is the formula and its components:
Kelly's Percentage = Win Rate – [(1 – Win Rate) / Profit Factor]
For example, the Profit Factor is 2:1 with 50% Win Rate. Then ...
K = 0.5 - (1 – 0.5) / 2 = 0.5 - 0.25 = 0.25
Kelly indicates the Optimal Fixed Fraction size is 25%.
Effective Cost
Effective cost management is a well-known measure of accountability for business leadership. In business terms, cost management requires effective strategy implementation as well as the resources and the process discipline to enable and ensure the highest possible level of quality, reliability and productivity at the lowest overall cost. It is not about “cost” in the sense of “cutting cost”, but rather a process of optimizing performance. It is as much strategic as it is operational.
This technique considers each taken position as individual and works on the basis of opening and cutting positions. A trade set-up starts with an initial idea and initiates the positioning with one trade, called the “core position”. The initial idea and set-up is what brings the trader to the market.
The technical profit and loss levels are calculated per open position. If there are two or more open positions in the same pair and direction they will equally be treated separately. It works like this:
- If the first position hits the target and the general idea is still valid the trader will search for the next entry.
- The second and third positions are aimed to improve the cost of the first position. If the second position hits its target - remember it is treated independently as a new position although inside the same idea - then this profit will help to improve the cost of the previous one. The effective cost of the first position is the entry price minus the profit from the second position.
- A pre-determined maximum of open positions in the same direction is set initially for the worst case scenario. This is called the “Same Position Maximum” (SPM) and it is set before any first position in a currency pair is taken. The SPM is based on the equity Drawdown per trading idea.
- The technique works on the basis of pre-set losses to understand maximum risks associated with a particular position.
A recommended number of equally sized positions is set to 3. However, risk tolerance (or appetite) and style of trading will determine the maximum.
The technique should not be compared with the Dollar Cost Average or Averaging Down. The difference relies on the fact that trades are closed when profits are on the table, in order to have a better average price for the core position.
It is aimed at protecting and enhancing counter trend, indicator-based trading methodologies, specially when facing difficult trading conditions. Other techniques explained above may be more efficient for trend following methods, but since there are many traders who have an inclination to trade counter-trend, this technique may be very useful. If you're trading based on divergences for instance, and wonder why they don't work as in text books examples, it's probably because you are not managing these kinds of set-ups with the appropriate technique.
It is a defensive technique. It is based on the probabilities of success of a particular position initiated. It was built to prepare for the worst-case
trading scenarios
Passionately embraced and implemented, this technique was explained in the ITC presentation of Toni Juste in 2007. While the first part of the video covers the basics of the technique, the second introduces several case studies.
Pros:
- It allows moderate profits while attempting to keep losses under control.
- It improves the win probability of success of any position.
- It allows a trader to enter into a position dictated by the market and to exit it through the market's command as well. There is no room for second guessing and no fear of big losses. It works as a stress-reducer in difficult trading environments.
- This technique proves that trading based on technical indicators of common use can be profitable, reducing technical complexity in any trading environment. Think in terms of running a business: if a sophisticated (maintenance management) system is not working, it is often better to shut it down and go back to the basics than to add the ongoing cost of fixing and maintaining a low value system.
Cons:
- It should not be applied to trend following systems where other money management techniques may perform better.
- Understanding one's capabilities, priorities and preferences is key to apply any money management technique. As part of such self-understanding, this technique requires a certain maturity as a trader.
It's not based on a formula, but it takes into account the following elements:
- Same Position Maximum (SPM)
- Range of pips per time frame
- Maximum Drawdown allowed per lot size in a trade
The stop loss level is determined based on equity Drawdown or based on technical triggers. The second is strongly recommended - this way you are brought into and out of market by technicals and not by fear or greed.
The position size calculation - when basing stop-losses on equity Drawdown – is the following:
- Account Size: 50,000 USD
- Maximum Equity Drawdown: 6% (3,000 USD)
- Assume SPM = 5 (600 USD X 5 = 3,000 USD)
This means that initially the worst that a single position can reach is 600 USD, that is, 60 pips with a 100,000 lot size, or 120 with a 50,000 size or 240 pips with a 25,000 lot size.
Dima Chernovolov portrays the function of a money management system in relation to the traders' psyche in a beautiful manner:
"As with the forex trading system, you can receive protection from your own destructive tendencies by closely following your money management system. It will protect you from greed and pride (which always demand that you overtrade) when your system generates unusually large number of winning signals in a row. It will also protect you from trader paralysis (inability to open new positions) when your system goes through a losing streak because you will know that, as long as you risk a small fraction of your equity per each trade (as is set by your money management system) and use a currency trading system with positive mathematical expectation, no string of losses can wipe out your trading account."
What technique to use? Like many other questions related to trading, there is no right answer to what method is the best. However, you have to use techniques that maximize your chances of survival and success. The number one goal of trading is to survive. That starts with the risk control measures.
The second goal is to figure out your position size and how aggressive you're being with that. This is about setting the levels at which you're going to increase your position size in order to maximize your gains.
That is going to be decided on the basis of what strategy you're using. If you are using a good trend following system which nevertheless produces large Drawdowns from time to time, your first objective should be survival and so you should choose the best technique to achieve that. If, however, you have a highly reliable system which doesn't produce either big Drawdowns or big profits, you should concentrate on maximizing those small profits. Remember that the wrong money management applied to your system could actually hurt the end result.
Just as there are no “Holy Grail” trading systems, there is no “one-size-fits-all” money management approach. Each trading system requires a certain money management technique and each technique may be valid for one trader and be useless for another. In addition, the trader’s ability to test and implement that money management strategy has to be considered. The key when choosing a money management model is often self-understanding.
Sizing and managing market positions is often seen like a burdensome, unpleasant activity. And unfortunately, most traders can only absorb the lessons of risk discipline through the harsh experience of monetary loss.
Many times traditional advice such as making sure your profit is more than your loss per absolute trade does not have much substantial value in the real trading world compared to the great potential of a sound money management technique.
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What have you learned from this chapter:
- There is always a certain amount of randomness in the markets, and it can affect your returns.
- Money Management is not all about betting small. While that is an important part of it, it is not all by itself.
- Money management is as powerful as any trading system.
- Money management is more stable than any trading system. It is based on math, and math does not change.
- It is more logical to implement proper money management to a trading system than to trade that system without it. Money management will take you further with less.
- While being independent from the system rules, money management works hand in hand with the trading system. In fact, it determines the style of the trader whether aggressive, moderate or conservative.
FXstreet.com contents:
- Confessions of A Forex Trader - Part II: The Leverage Connection, by Mihai Nichisoiu
- Minimizing trading risk through proactive threat and error management, by The Trader's Journal Collaborators
- Choose wisely Dr. Jones, choose wisely, by Forex Journal's Collaborators
- Portfolio management – Diversification, by LearningMarkets.com
- Portfolio Management − Position Sizing and Stop Losses, by LearningMarkets.com
- Understanding the simple rules of Money Management – Part I: The Risk-to-Reward ratio, by Sunil Mangwani
- Understanding the simple rules of Money Management – Part II: Position sizing, by Sunil Mangwani
- Managing Risk to Target Consistent Profitability in the Forex Market, by James Chen
- Risk Management, by Valeria Bednarik
- Position sizing and money management, by John Jagerson
- Money Management in Forex Trading, by Dima Chernovolov
- Conversations with a Pro Trader - Part I: Cutting Your Losses, by Andrei Pehar
External links:
- Money Management Using the Kelly Criterion, by Justin Kuepper, investopedia.com
- Kelly criterion, by wikipedia.org
- Forex: Money Management Matters, by Boris Schlossberg,investopedia.com
- www.probabilitytheory.info
- Martingale (betting system), by wikipedia.org
- "Martingale Money Management" by Bob Pelletier, Stocks & Commodities magazine, 07/1988
- "Martingales" by James William Ferguson, Stocks & Commodities magazine, 02/1990
- "Reverse Martingales" by James William Ferguson, S&C, 03/1990
- "The Trading Game" by Ryan Jones, Wiley and Sons, 1999
- "The mathematics of Money Management" by Ralph Vince, Wiley and Sons, 1992
- "The mathematics of gambling", by Edward Thorp, Gambling Times, 1985
- "Trade your way to financial freedom" by Van K. Tharp, Mc Graw-Hill, 1999
- "Special report on Money Management" by Van K. Tharp, IITM, 1997
- "A new interpretation of information rate" by J. L. Kelly, 1956
- "Managing your money" by Burke Gibbons, Active Trader Magazine, 2000
- "Probability of investment ruin" by Sherwin Kalt, Stocks & Commodities magazine, 02/1985