Further talk on money management, money management styles
You will learn about the following concepts
- Money management strategies
- Fixed ratio
- Fixed fractional
- Martingale style
- Kelly criterion
In the previous article, we delved a bit deeper into money management and discussed a couple of calculations that can help us project the earnings we might expect from our trading strategy and money management system, as well as a general overview of the risk of going bankrupt. Now we will turn our attention to some of the most common money management styles traders use to improve their performance.
Fixed ratio
The first money management system we will discuss is the so-called fixed ratio management system, developed by Ryan Jones. It helps you determine the optimal number of contracts to trade as a function of profit and loss, thus rewarding better performance. It uses the following calculation:
– N is the number of contracts you should trade
– P is your accumulated profit to date
– ∆ (delta) is the amount of money you need before trading a second contract
Traders use the fixed ratio money management system to increase their market exposure safely while also protecting their accumulated profits. Let us assume that the minimum margin for a futures contract is $1,000. This means you will need to have another $1,000 at your disposal if you want to trade a second contract. Thus, for the fixed ratio calculation, your delta is $1,000.
- Trade Forex
- Trade Crypto
- Trade Stocks
- Regulation: NFA
- Leverage: Day Margin
- Min Deposit: $100
This system is suitable for traders starting with smaller accounts because it requires less profit at the start in order to increase position sizes. Generally, it implies that traders are willing to risk more at the start to spur initial growth, but as their account equity rises they are prepared to take less risk. The fixed ratio system takes advantage of winning streaks in that it encourages more aggressiveness during consecutive wins, but as the capital grows, the system allows the growth in position size to slow down. This averages the risk-versus-aggressiveness ratio over the course of the account’s equity growth.
Fixed fractional
The fixed fractional money management system was developed by Ralph Vince and assumes that the number of traded units is based on the risk of the trade. It defines trade risk as a fraction of the equity. The risk of a trade is the amount of capital the trader is prepared to lose with each trade should it be a loser. This, of course, is adjusted for trading systems that use protective stops.
Basically, the risk remains the same percentage (fraction) of the trading capital. This way, the absolute amount of money risked remains proportional to the equity and rises or declines as the equity itself rises or falls after successful and unsuccessful trades. Here is the formula:
f x (equity/|trade risk|) = N, where
– f is the fixed fraction of your account you have decided to risk per trade
– equity is the value of your total trading capital
– trade risk is the amount of money you could lose in the transaction. Because trade risk signifies a loss, which should be a negative value, you need to use the absolute value (thus the | |).
– N is the number of contracts you should trade.
If you’ve decided to risk no more than 5% of your account equity per trade, and, as in the example above, you are trading a futures contract priced at $3,500, and you have $50,000 in your trading account, then the calculation will look as follows:
0.05 x (50,000/3,500) = 0.714 contracts
However, since you can’t trade less than one contract, you will need to round that up to one contract.
Drawback
One of the biggest advantages of this money management system is its compounding effect. It means that as the trader records successful trades and their trading capital increases, the position size is also gradually increased. Logically, when the trader enters a losing streak and the account equity shrinks, they will automatically begin using a smaller position size and each further loss will narrow proportionally to the account balance.
The proportional adjustment of the position size also means that when you have chosen to risk a small amount of your equity, each winning or losing streak will have a smaller impact on your equity curve, leading to smoother capital appreciation.
One of the main problems this money management system encounters is with small account sizes. First, you will experience difficulties in fine-tuning your position size due to the lot sizes you are forced to work with. Also, even if you think you are ready to increase your position size but you haven’t achieved good enough results yet, you will first need to attain a very high return so that your account balance grows. If you don’t wait and decide to go ahead and increase your position size, you will be risking too much.
Another drawback of the fixed fractional system is the difficult recovery from a losing streak, because your position size will also decline (this opposes the martingale money management style, which will be discussed next).
There is also a problem with winning streaks. As you score more and more winning trades, your position size will keep growing. Eventually, in the absence of drawdowns, your trading capital will soar to a point at which your position size may be well above the level you can calmly and adequately manage. One of the ways to handle such high risk is to withdraw money from your trading account each time it reaches a critical mass (according to your own standards). This way you will: 1. lock in profits and actually touch the money you’ve earned; 2. reduce the risk of operating with a very large position size, thus ensuring smaller future losses.
Martingale style
The martingale money management style is a betting strategy used widely by many gamblers, especially in casinos, but also by some investors. Its goal is to improve your earnings in games at which you have even odds to win, or the odds are in your favour. Because day trading is a zero-sum game, i.e. each winner profits at the expense of a losing counterpart, the martingale system is considered suitable by some traders.
Under this strategy, when a trader bets and gets it wrong, they should immediately bet in the same direction again, but double the position size. This way, if the second time they are right, the second position would offset the first one’s losses. For example, if you enter a trade with $100 and the trade succeeds, you should trade another $100. However, if you lose on the first trade, you should immediately re-enter the market in the same direction with $200 and win back the money lost. If you lose again, then you should trade $600, etc.
The martingale system relies on probability and assumes that as long as you have at least even odds, you will eventually be right and one winning trade will offset all the previous one’s losses.
The main problem with this money management strategy is that a long losing streak might cause you to lose all your money before being able to win it back. You will surely avoid such a scenario if you have an infinite amount of capital, but you don’t. In contrast, the market as a whole has, one could say, infinite resources (at least compared with yours); therefore, in theory, it can drive you to bankruptcy, whereas you cannot do the opposite.
Kelly criterion
The Kelly criterion is a formula that investors and gamblers use to calculate the ideal percentage of their portfolio to put at risk in order to maximise long-term growth. To determine what part of their capital should be committed to each position, traders need to know their percentage of winning trades, the profit from a winning trade and the performance ratio of winning to losing trades. The formula used looks like this:
Kelly % = W – [(1-W)/R], where
– W is the winning probability factor (the percentage of winning trades). This is the probability of a trade having a positive return.
– R is the win/loss ratio and is calculated by dividing the total positive trade amounts by the total negative trade amounts. The result tells investors what fraction of their trading capital they should invest in each trade.
Using the same numbers from the example in the previous article, we calculate the following percentage:
Kelly % = 0.55 – [(1-0.55)/(0.012/0.01)] = 0.175 = 17.5%
According to these results, you should theoretically not run out of money as long as you limit your trades to a maximum of 17.5% of your trading capital. Some traders, however, use a variation of this strategy, limiting the position size to half of the Kelly percentage as a way to avoid incurring heavy losses. This is commonly used when the Kelly formula generates a number larger than 20%.