I promised to write something on Money Management and Position Sizing.
Money Management cannot make a losing system/method profitable. However, money management can keep you in the game long enough to figure out how to become profitable. A losing method and no money management = impending demise.
Anybody who has been involved in systematic trading understands the importance of position sizing. Take a decent system and backtest it over say 5 or 10 years using a number of different position sizing methods and you get dramatically different outcomes, both in terms of returns and the volatility of returns.
In addition to very popular fixed position sizing techniques (fixed lot size or fixed risk), many discretionary traders extend that discretion to bet size. Usually based upon how they feel about the trade, what sort of week they're having, how many cups of coffee they've had, market volatility, or how they did on the last trade. I know a guy who used a hangover inverse method. These are all bad ideas. By implication these methods are all suggesting that position sizing is an unimportant consideration and can be managed subjectively.
Your trading method will determine whether you are profitable, but it is money management that will determine your level of success. An average method with good money management will ultimately outperform a great method with poor or no money management. Period!
Here's a few things to get you started on MM - you'll need to do your own homework. There is also plenty of decent material on the web â gotta sift through the crap though.
This is a decent recent thread on MM hosted by cnms2.
http://www.elitetrader.com/vb/showthread.php?s=&threadid=59325&highlight=cnms2. Do a search for other MM threads on ET.
I think the guy that has been doing the most interesting things with MM in recent years is Van Tharp. His concepts of expectancy and r-multiples I use extensively. It is very simple and pragmatic approach (just my style) and can easily be done in Excel. His book "Trade Your Way To Financial Freedom" is excellent, and I believe he has another one on the way. He has a website that is called the Institute of Trading â¦â¦. or something equally pretentious, but I recommend you start with his discussion group.
http://www.mastermindforum.com/phorum/list.php?f=9. There is a lot of stuff here â use the search function.
I mentioned the importance of understanding the Risk of Ruin formula previously. It was developed by Ralph Vince. He has written three books, the first two are excellent for understanding the math behind MM. You don't need a PhD to understand it. Recommended for the more hardcore among you.
As far as position sizing techniques is concerned there are a myriad of different approaches. You've probably heard of some like Optimal-f, the Kelly criterion, Martingales, anti-Martingalesâ¦.. interesting to understand them if you're a real MM aficionado but of little practical use.
There are 3 position sizing techniques that are reasonably sensible and I believe all traders should be conversant with.
1. Fixed fraction â this is absolutely the best all-round position sizing strategy. You bet (risk) a fixed % of your capital on each and every trade. Usually in the order of 1 to 2%. If you are winning you increase your bet size, if you a losing decrease it. Simple right? If you can't devise a better strategy this is what you should use. If you studied your risk of ruin formula you would know that the risk of ruination using fixed fraction is minimal. Much much lower than if you were using a fixed position size.
2. Fixed ratio â this technique was developed by Ryan Jones. It has it's critics but it does work well for people starting with a small account size AND who have a proven and profitable method. It is based on the premise that you are prepared to take on more risk initially in order to grow your account, but as your account grows you become more risk averse. Now this may or may not be sensible. The real risk with this strategy is when you increase position size the first time. If your method goes into a drawdown you can get wiped out quickly. Only recommended for experienced traders. A google should turn up the formula.
3. Variable fraction â this is a more aggressive version of fixed fraction. It works like this. In addition to your standard fraction (say 1%) you add a scaling factor based on recent performance. A simple example is to add say half your return from yesterday (assuming it was posetive) to your 1%. For example, 1% + 3%/2 = 2.5%. I like to use my average return for the last 5 days as the scaling factor. The theory here is that you are ramping up your betsize rapidly when you're having a good run, but quickly falling back to your conservative fraction when you hit a rough patch. If you are an experienced trader and have a proven method this will increase your returns exponentially with only an arithmetic growth in volatility.
This should be enough to get you started on MM. Focus on position sizing initially before moving on to the more complicated stuff. If you are serious about trading then you need to very serious about MM.
bolter
