Money management is an interesting subject and it plays a far bigger role in trading than many people think. This two part article is a sneak peek inside my next book. More on the book in another update. For now here is part 1, of the article.
Part 1 – Chapter 11 – Introduction to Money Management
If you have read Jack Schwager’s book Market Wizards, you will recall that all traders each had their own way of trading; their own experiences; their own philosophies and their own outlook. One common theme among them all however seemed to be their reliance on what they called “money management”.
When I read the first book in 1990, I had no idea what money management actually was. Was it making sure your stops are in place? Was it just being careful with your cash? What was it?
Money management, in this context, refers to what a gambler might call bet sizing. It is how many contracts or shares to trade on a certain strategy given a certain bankroll.
Now in my experience with retail investors, this is normally an arbitrary consideration. One contract, five contracts, ten contracts – whatever you can afford really. I have known traders that spend countless hours per day studying Gann or testing indicators or drawing little lines all over their charts. But when it came to placing the trade, there appeared no consideration to the position size.
I even had someone say to me “it doesn’t matter how much you bet as long as it’s a good trade”.
This article uses a really simple example to help explain why this thinking is incorrect. Suppose you are invited to play a coin toss game. Tossing heads means you win two units and a tails means you lose one unit. Suppose you were given $4 as a starting bank roll and you can bet as much or as little as you like and play the game many times over.
Now it is clear the odds are stacked in your favour. $2 for a win versus $1 for a loss. That’s a “good trade”. But how much do you bet? Well, there are a number of ways to approach this one. We will look at three:
- Fixed dollar
- Percent at risk
- Optimal fixed fraction
Fixed Dollar Amount
This is an arbitrary decision of placing one bet (or trading one contract) for a fixed amount of account equity. It is probably the simplest and for that reason, most common money management technique.
In the coin toss game, we would, for example, place one bet every $2 in the account. So in this case we would win $4 or lose $2 on the first toss. Based on the outcome, we would then adjust the amount bet, but still keep it at one bet per $2 equity.
When trading futures, this is the same as trading one contract per $X in your account. The downside in trading multiple futures markets is this technique does not address the unique characteristics of each market with respect to your system.
For example, trading one contract per $5,000 in Eurodollars is probably rather conservative. In contrast, trading one contract per $5,000 in NASDAQ futures would just be ridiculously risky.
Additionally, this method does not distinguish between a volatile trading system and nice, steady one. A volatile system should trade fewer contracts than a more steady system to reduce the risk of going broke. The Fixed Dollar method does not address this issue.
Percent at risk method
The next most common and quite a sensible approach to money management is to risk only a fixed percentage of your capital on any one bet or trade.
In the coin toss, it would mean picking a percentage loss you are comfortable with and betting that proportion of capital each and every bet. You might, for example, be willing to risk 10% of your capital each and every bet. Given six alternating outcomes, your equity would look like this:
|Win/Lose||Starting Equity||10% Bet||Win/lose Amount|| Ending Equity
The advantage with this method is your bet size and potential equity grows at a steadier pace.
Looking at futures, let’s say you have a trading system in the S&P where you run with $200 stops. Giving a small allowance for slippage and comms, let’s say the worst outcome is a loss of $300 per contract on a trade.
With the percent at risk method you trade a certain number of contracts that would make your maximum loss no more than a fixed percentage. If you are trading with a bankroll of say $100,000 and wish to risk not more than 5% of that value on any one trade, then you take 5% of $100,000 or $5,000. Then divide this by $300 and you get:
(5% * $100,000) / $300 = 16.7 contracts
So with this system and method, you would trade 16 contracts (rounded down from 16.7).
In the Market Wizards book, many of the traders said they would risk anywhere from 1% to 5% of capital on any one trade. So there is some suggestion that this is the method many of them have used.
The first and obvious disadvantage of this method is having to round up or down on contract amounts. This has particular impact on smaller equity amounts.
The real negative of this method is that most people would pick a percentage based on their risk preferences, but that is not necessarily the best percentage of the system being traded.
Think about it. If we have a mechanical system where we can define things like maximum loss and probability or frequency of loss, then surely there must be some type of mathematical method of working out the optimal amount to risk.
Well there is! It is called the Optimal f or Optional Fixed Fraction trading. That article comes next week!