Money Management

Trading for money is good, trading while controlling your losses is better. This is the goal of Money Management, which is to prevent you from losing too much money.

Traders generally know how to describe the methods they use to enter and exit trades/trades. However, when describing methods for determining the amount of capital at stake on a trade, few of them have a real solution. Some of them make vague references to experts who recommend risking 1-2% of the capital on each trade. Others rely on intuition to determine when to increase their position in a given trade always risking a different amount. (It is clear that most French and European traders had no concept of this issue unlike their American counterparts).

Experienced traders know that having an efficient method of entering a position is as important as determining how much to risk. A trader who risks too much increases his chances of not sticking around long enough to realize the long-term benefits of a valid trading strategy. On the other hand, too little risk creates the possibility that the trading method does not fully exploit its potential. So, while positive expectation of winning is the minimum requirement for successful trading, how you capitalize on that hope will be the cause of your success or failure. In fact, this is one of the biggest challenges for traders.

We observe that at the same time traders reach a certain level of comfort with a system, they begin to realize that the supposed money management methods are lacking in their trading strategies.

There is no such thing as a magic money management formula or money management. In fact, different trading strategies and systems require different approaches to money management. In addition, one should always consider a trader’s ability to follow a money management method taking into account his tolerance for risk and other psychological factors. For example, sometimes strategies that focus on optimizing the amount of capital to invest often result in significant periods of loss. Some traders can morally accept periods of decline in capital of 40, 50 or even 60%, which is not trivial in the case of certain aggressive strategies. Therefore, it is important to match a trader’s risk tolerance with the theoretically greatest possible loss period.

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The trader’s capital is also important and can affect his ability to execute the strategy of money management. Even in cases where the strategy is preferred using money management methods, traders who are undercapitalized may not be able to implement the strategy due to insufficient funds. In this situation, the trader is then unable to reap the potential profits. So, regardless of the success of a particular strategy on the trading method, two important variables must be taken into account: the psychological preferences of the trader and the level of his capital. If one of these 2 factors does not support the money management strategy used, it is unlikely that the trader will be able to use the strategy effectively. While it may seem unimportant, this point of money management cannot be stressed enough. The trader must be confident enough to stay in his strategy even if positive results do not come immediately.

Hopefully this money management article helps you to realize and assess the type of money management you use, at least we hope to spark your imagination about the various ways to implement the strategy. In general, too many traders devote all their creativity to trading logic alone when it would be beneficial for them to spend a little time determining their position size in order to get the most out of their position trading method.

The subject is broad and beyond the scope of this article, although there are several template guides for you to determine position size.

In general, we can measure trades with the following 6 position management models. (Where all lots are rounded to the nearest integer).

1) Fixed lots

Trade a constant lot size with each trade (100 shares or 1 contract). This model never misses a trade, and stops trading if the capital falls below the margin required to trade a lot.

2) fixed fraction

Adjust the lot size so that each trade allocates a fixed percentage of your capital.

Lot Size = K * Capital
Where K = CapitalFraction / InitialMargin

This model never misses a trade, but stops the trade if the fixed capital fraction (Capital * FractionCapital) falls below the initial margin amount.

There are several variations of this model. All these variations simply determine the value of K in different ways. Example :

K = Initial Fraction / Margin
Trade 1 lot for each AmountenDollars of Capital: K = 1 / AmountenDollars.
K = Fractions / PlusBigLoss (Larry Williams)
Fixed Risk (eg, constant stoppage of money management) K = Fraction / AmountofFixedRisk.

Once you have determined the value of K among these variants, you can define parameter values ​​for the other variants.

There is another variation that uses a non-constant value of K (if K is different on each trade). Two of these models are the #4 (Percent Risk) and #5 (Percent Volatility) models described below.

% Risk of using a risk variable (early discontinuation).
% Volatility uses changes in market volatility to determine position size.

3) Fixed ratio

This model was popularized by Ryan Jones in his book “The trading game”.

It is calculated by adjusting the lot size as a function of net profit.

The formula is as follows:

LotSize = SquareRoot (2 * ProfitNet / delta + 1/4 + (InitialLotSize^2 – 1))
If LotSize < 1 then LotSize = 1

We use an input value of 10,000/delta so that the input has the same scope as the other inputs. The entry is then divided by 10,000 internally before calculating the number of lots to trade. The entry “batch size” will be used by InitialLotSize. This model never runs out of trades. He stops trading only when the capital becomes less than the margin required to trade a lot.

Due to the fact that the fixed ratio model does not take into account capital, and that capital gains and losses are dependent on capital, special attention should be paid to the InitialLot Size parameter, according to initial capital, to arrive at a result. .optimal results and drawdown values.

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4) % risk

Adjust the lot size so that the total amount at risk (stop loss) for each trade is a fixed part of your capital.

Lot Size = Risk Fraction * Capital / Trading Risk

This model can skip trades or stop trades, if the capital risk fraction becomes smaller than the risk or initial stop loss to support entering the trade. If your input risk contains a constant risk value (if you don’t have risk data on a trade-by-trade basis), then this model becomes a fixed fraction model. Its strength comes from the fact that we know the risk or initial stop loss size for each individual trade.

5) % Volatility

Adjust the lot size so that the market volatility (in dollars per lot, often measured by the actual profit range from the last 10 to 20 bars) is no more than a fixed fraction of your capital.

Lot Size = Volatility Fraction * Capital / Volatility.

This model can skip trades or stop trades, if the volatility fraction of the capital becomes less than the market volatility.

This model is also converted to a Fixed Fraction model if you have a constant input volatility value. The first 2 techniques are quite crude and commonly used by traders. The 3rd fixed ratio technique will usually offer the best performance regardless of individual trading risk or market volatility (which makes this model a bit aggressive for small accounts).

The last 2 techniques are more advanced and can yield more profit than the first 3 techniques for a certain amount of withdrawal. The %Risk and %Equity models, while simple, provide fundamentals of capital preservation, risk control, and conservatism that other models do not have.

6) F. optimal

Described by Ralph Vince in his book “Portfolio Management Formulas”, it represents the ideal fraction of capital that should be staked on each trade to maximize capital growth. Too small a trade size and you will make money too slowly; trade with too large a size and you risk going bankrupt. Somewhere in the middle there is a fraction of the optimal capital to take on risk.

Problem: With F optimal, the position size found to get maximum capital always carries a very large risk that only a few traders can take. Other problems are answered only on the given trade order. Although the optimal fraction (using the fixed fraction model) would be the same if the trades arrived in a different order, the payoff and drawdown would be different. Applying the optimal F to a single sequence will not give you a complete picture of what your strategy can deliver in terms of payoff and drawdown.

Solution: This is where a Monte Carlo simulation can come in handy. Using it, we can recreate these trades in random order hundreds of times, collect yield statistics, and get a good idea of ​​the variability in capital development and drawdown curves we can expect. We can then use these statistics to determine an optimal F that is more reliable for the trading system, has acceptable returns, and tolerable risk.

However, note that all traders use one form or another of money management. However some of them are not even aware of the strategy or method they are using and determine the entry position with a spoon, even a pifometer! Others (the minority) use proven strategies to determine position size as well as when to add or liquidate positions consistent with their risk tolerance. Hopefully you are now part of the last category…

Sources: PinterPandai, Investopedia, Manulife, Smart Asset

Photo credit: Pxhere