MONEY MANAGEMENT & POSITION SIZING
The subject of money management, like discipline is one of the most crucial aspects of any traders technical portfolio.
Money management, although imperative by nature remains largely unspoken of and for a long time had a stigma attached to it that effectively created a, "trading hot potato" Everyone knew of it's importance but almost nobody wanted to talk about it. Most books discussing trading or the development of trading strategies almost never take money management into consideration and in some cases even neglect the topic completely.
Money management, sometimes referred to as position sizing is simply a pre configured formula based on both the size of your bank and your chosen strategy. It tells you "how much" from the entry of the trade right up until the exit.In essence, it will determine how big a position you should have at any moment throughout the duration of the trade.
Allowing yourself to come to terms with how critical an area money management is will provide you with a level of confidence in your trading unparalleled by anything else you will learn. Discipline,research and strategy, while all important in their own right, you will never become a success combining those 3 elements alone. After all, you could be the most disciplined, undertake the most thorough research and employ the best strategy, however, if you risked 100% of your bank every trade then you will inevitably go bust as a consequence of a single losing trade regardless of the previous 10, 100 or even 1000 successful trades.
Practicing good money management provides us with the opportunity to continue trading through the inevitable losing streaks that will occur by limiting the damage to our bank these losses would otherwise cause.
There are many forms of money management models available to us, all with varying results depending on your own strategy. Not all models will suit all strategies. the key is trialling them along with the particular strategy you use and determine which suits you best and provides the best results. In my opinion, such tests should be carried out religiously before adopting any new approach or entering live markets.
So...what type of money management rules could we use, lets look at a couple.
Fixed % of bank (declining balance method)
Using a fixed percentage of your bank gives you the freedom to trade without the worry of incurring large unexpected losses as the minimum loss is predetermined by the initial % risked. The recommended amounts you should ever risk in a single trade range from 1% - 5%.
Should you choose to trade more aggressively, then all you need do is increase the percentage of capital used, however, you must bear in mind that the larger the percentage,the greater the potential profit and also potential loss. This is the very reason 1% - 5% is thoroughly recommended as not only should it easily see you through the harshest of losing streaks but also allows for the steady growth of your account balance because the size of your positions are directly linked to, and grow in relation to your account size.
The following table shows how the size of your risk can have dramatic effects on your account when experiencing 20 successive losing trades using a hypothetical bank of £1000.
You should note from the above table that a row of 20 losses when risking 2% of your bank per trade will leave you with £667.61 - a 33% loss on your original £1000 and requires you to make 50% on your current bank just to return to £1000. However, when suffering the same 20 losses risking 10% the contrast in massive, in these circumstances you would be left with a tiny 12.1% (£121.48) which is a 87.9% loss. a loss of this size would mean you would need to recoup more than 700%, a figure you just aren't going recover from.
So you see, risking a safe percentage of your bank - per trade is a sure way of protecting yourself against such crippling losses and will maintain a healthy balance thus keeping the percentage needed to recover these losses at an achievable level.
Table to show percentage of return required to return to original bank,assuming the trade lost.
Fixed Sum
The fixed sum method of controlling position size is very similar to the previous method as it works on much the same principle. The exception being that unlike your balance, the % of your bank risked is not a variable.
The fixed sum, will as it's name suggests, remain at a constant regardless of any fluctuations in account size. This method does, in my opinion have a couple of drawbacks, one of which being that your account will not grow in relation to it's current size. ie. your balance will not grow any quicker the bigger it becomes.
Another factor of this method is that because your risk doesn't change as your capital decreases, the risk will automatically become a higher percentage after each subsequent losing trade. Due to these facts the losing streaks you may incur could ultimately be devastating.
One advocate of the fixed sum method was, William D Gann - an early 20th century finance trader.
Williams theory was that if you have everything figured out from a strategy and research point of view, the chances of experiencing a considerable losing streak were astronomically high, thus, contained in those losses somewhere would be a winning trade that would cancel out said losses and return a net profit.
Other money management techniques include,
- Optimal f
- Secure f
- Kelly criterion
My final thought.
In the time i have spent so far trading the sports markets and trying to improve my knowledge, there is a solitary book that covers the art of money management and position sizing on a level unparalleled by anything else i have ever read on the subject.
Van K Tharp - Trade your way to financial freedom
I thoroughly recommend this book if you want to take your knowledge on money management to the next level.
I hope this has been helpful
Regards
Fluffnut
