Quote from acrary:
droth, I don't use % based stops. I use 1/2% of account for risk per-trade. Ex. If I had a 100k account, then the max. risk per-trade would be $500. If I wanted to trade 5 emini contracts I could only risk 2 pts on each contract for each trade (500/(5*50)).
I use it for my personal account because it's simple to calculate, test, and implement. My expectation is large enough that I don't worry about the drag caused by the % of account allocation.
I retired from a investment bank last year. There, the money management and risk management were decided by the company. It chose a method that doesn't have % of account in the formula to avoid the drag.
Here's something I posted elsewhere that gave a way to avoid the drag of the % of account method while being conservative to avoid the risk of ruin:
A unprofitable trading method can't be improved through any money management strategy, so you must first have a profitable method before going forward.
Once you have a profitable method, you need to know a couple of things about it's characteristics. You need to know the maximum drawdown and the % of losing trades before you can apply money management to your method. You should have a minimum of 100 trades (either real or hypothetical) to base the calculations. Why at least 100? Because we need a stable database. At 100 trades, the standard error is 10% (1/sqrt(# trades)). This is acceptable when getting started.
How often should you hit a new equity high? It can be calculated by using the % losing trades. Here's how, take the % of losing trades and multiply it by itself until the number is approx. .01 (meaning 99% chance of seeing a run of however many times you do the mutiplication). For example, if I have a method that loses 40% of the time, then the number will be (.4*.4*.4*.4*.4 = .0124). This means a method with 40% losers will have no more than 5 losers in a row 99% of the time. Next, take the number of consecutive losses and multiply by 3. In this case, the number will be 15. This is called the trading cycle. The cycle is the maximum number of trades that should happen before a new equity high is achieved. Draw a line every 15 trades on your statements and make sure a new equity high is hit within the 15 trade period.
If not, the % of losers is probably greater than the sample used to caluclate this and is a warning sign of a unstable trading method. Use a higher % of losers and re-calculate until each equity peak is within every cycle.
How many contracts should I initially trade? This is largely dependent on how much pain you can stand. If you don't mind a large % drawdown, then your number's will be higher than someone else. Take the amount of equity in your account and multiply by your maximum acceptable drawdown as a % of your equity. For ex. if you have 20k and you don't mind a 40% drawdown, then 20k * .4 = 8k. Next, divide the max. acceptable drawdown by the observed drawdown. For ex. if the method had a max. drawdown of 2k then 8k/2k = 4. This would be the initial number of contracts to trade in the market.
When do I change the size? First, if the max. drawdown as seen in the past is hit, STOP trading. Once the new drawdown has stopped and a new equity high has been achieved (paper trading), then re-calculate the money management numbers and start over.
As far as compounding goes, take the starting equity + (maximum drawdown * 3). Once the account equity goes above this number, you can safely add another contract. Ex. if I start with 20k and the max. drawdown is 2k then when the account goes above 26k, then I can add another contract. You should also do the initial calculation and make sure it's acceptable before adding to your size. In this case the 26k * .4 = 10.4k. The 10.4k / 2k = 5.1, so it's okay to increase from the 4 contracts to the 5 and stay within the acceptable drawdown.
This method does not have a negative edge (as does all % of equity methods), so it'll let your account grow as you apply your edge to the market without the drag.
