By Darrell Martin You may have noticed that there are almost as many trading strategies and money management systems as there are traders, if not more. In this article, we will compare three different money and size management systems to help you get a grasp on which one may be best for you.
The first one we’ll look at comes from the article “A New Interpretation of Information Rate”, by J.L. Kelly published in The Bell System Technical Journal, 1956: 917-926. This is known as Kelly’s Ratio.
The formula in simple terms is: Expectancy= (Probability of Winning Trade * Average Win$) – (Probability of Losing Trade * Average Loss$)
Back in the Fifties, the formula actually came from solving a telecom problem regarding noise levels increasing over long distances. Which should make one question the “soundness”, pardon the pun, of this as a risk management model.
To progress, the goal is to find the amount of capital should be allocated or “risked” on any one trade. The formula for this per Kelly is the following: % of Capital to Allocate to Trade = Winning % - (1- Winning %) / (Gross Profit / Gross Loss))
This is where the issue starts as the capital to trade must be reversed into account size and proper risk percent. Even still, if done properly according to this method, you can blow your account within a couple of trades with this model.
For example, let’s suppose the risk of $3000 is the output and the account is $5000. This causes a bit of an issue. A couple of losses or a period of drawdowns and it’s a surefire way to destroy an account using this criterion.
You may choose to be on the 25% or 50% side and use this number consistently, even as your account grows, if this method is going to be used. In addition, the entire model will break if you “cherry” pick your trades and do not follow the system consistently. This would cause you to destroy the probabilities of the system.
This model does not define when to remove the profits from the account. Profit management is something many risk management models are lacking.
The second model comes from the book, Beat the Dealer: A Winning Strategy for the Game of Twenty-one. This was written by Edward O. thorp and published by Random House in 1966. It is the Fixed Ratio Method.
Percent of Capital to Allocate = .5 * (1+ Square Root ((1+8) * ((Gross Profit / Gross Loss) / (Delta (a.k.a. User Defined Profit Level)))
This method uses a simple level of profit (Delta) to be achieved which results in a defining level that will increase or decrease the size of the position. The lower you set this level, the faster and account can grow. The higher you set it, the slower an account will grow. This level is totally subjective. You could use the simple daily, or better yet, the initial margin requirement. The max risk is the most you are willing to risk on a single trade. That could be your User Defined Profit Level.
The lower the Delta, the smaller the account size that is required to place a trade. If you are basing your level for max draw down on the past expectancy according to your historical trades or back testing, and you have a lot of winners up front, then that can quickly put you at risk of a large drawdown that could drop your account size dramatically. This system will actually lower the size on a trade as the system is profitable, which is the opposite of fixed fractional risk management. The following formula can help you see how this works:
Required Account Balance = Previous Required Balance + (Number of Contacts + Delta (a.k.a. user defined profit level))
This does not define when to remove profits from the account. Again, profit management is something many risk management models are lacking.
The last model we will examine is Darrell’s Diagnostic M3 (Money Management Method) Ratio
This model covers not only risk management, and position size, but also profit management as well. After all you are trading to make withdrawals what is your plan for doing so?
In this model, for risk per trade in a single day, you take 5% of your account and divide by 6. Do not exceed a 5% drawdown; if you encounter six net losses, then stop trading for that day. For example profit 3 lose 9 would be 6 net losses if all where a 1 to 1. If you made more than 1:1 on your profits then you would not be down 6 net losses or 5% in a day and could continue trading.
Each month, you then recalculate the 5% dollar amount to divide by six to use for each day that month. This helps prevent you from over and under compounding an account. So, if your account increases, you can increase your position size one time a month. This helps to ensure that you don’t increase your account size too quickly and risk a massive drawdown based on one or two trades if you have a simply stellar week and compound too fast If your account size decreases that month, you can decrease your position size. You have to prove the system over a month to raise it back up. This really helps in the psychological aspects of trading.
The benefit of this method is that you have a consistent risk level day in and day out for a month. This helps to ensure that it would take a month of losing 6 net trades every day to wipe out an entire account. For anyone trading consistently, this is hard to do unless you are just doing something absolutely wrong. This could include buying repeatedly in down trends or buying OTM options that expire in 5 minutes, or selling repeatedly in up trends, etc. Even for a monkey with a dart board, losing 6 net trades in a day 20 days in a row is hard to do!
This method has a big psychological benefit. It is easy for most people to handle the pain threshold of 5% of one’s account size divided by 6. So you could lose 3 trades and still take the fourth one. Losses are not good but when they are small relative to your account size they have minimal impact on you psychologically as a trader. You could lose 5% in a day and not be so messed up that you can trade for 3 days without blowing out your account.
If you have a small account size and you can’t do this, you have three choices:
1.Trade something with lower risk.
This could include:
Micro forex, which is approximately a dime (yes 10 cents) a tick
Nadex spreads with $1 risk per tick
Mini Lots on FX for $1 risk per tick (depending on the forex pair)
CFD’s are often $1.00 per tick as well
Stocks (although this will limit those with less than $25000 to 3 trades max in and out on the same day in a week, so this is
probably not the best choice for day traders. Swing traders have many stock and options that could be traded over a long time frame such as larger bar sizes on the APEX method.)
Spreads, specifically lower leverage ones like NQ, HG or SI which have small profits, but also a small risk.
These ideas allow you to start trading now with live money but with low risk, so you can get better as your account grows. You can also deposit money as you are able to set some aside from your job, savings, etc.
2.Trade a larger percentage but just realize that you could potentially lose your account and have to re-fund it. It isn’t a horrible idea. Many traders do it, but understand that most have to fund their accounts a few times over.
3.Trade demo and save your money until you can get the proper account size for what you want to trade. This method takes a lot of discipline, but it is worth it! It costs you nothing but time, which is cheaper than funding your account over and over and over again.
Doing any of these can keep you in the risk model.
Profit management must be factored in if you are up 5% on a day and then stop trading. If you close a trade and you are up more than 5% (possibly 8%), you may choose to either risk the excess 3% or stop trading. Each time you hit another 5%, you should not give it back! If you get 8% to 10%, then stop. If you go from 8% to 9% to 12%, on the next trade, you may opt to give back the 2%, or stop for the day, but do not give back the 10% or whatever percentage amounts you’ve reached.
Each month you should withdraw your profits. There are many methods for this.
Target: Assuming you have a proper account size at the start and you follow the 5% of your account divided by 6 per trade rule, then you should withdraw 50% of your profits each month before you recalculate the percent. With this goal, 50% of your profits would be the target income you need to live off of trading. This means that the income you need to live off of is the basics: expenses, savings and gifts. This is not for “above and beyond” wants. This is your first goal. From there, the “above and beyond” is what you want to achieve.
Larger Account Growth You may increase the percent that is withdrawn once you are able to make your profit goal for expenses, savings and giving, and some of the “above and beyond”, etc. The goal is not to have a “big account with a broker.” In fact, that is not recommended, (remember MFG and PFG.) The goal is to make sufficient income for your goals, and not leave more in your account than you need. At a certain point, you may choose to have a “Savings Trading Account,” where you keep capital that you consider to be part of you risk capital for trading. You only leave in that account what you need for proper risk for a month. This allows you to not put all of this growing capital in a broker account where it is not needed. You are probably not getting paid much, if anything for having that balance in there. As you account grows larger, consider taking more our for additional types of investments such as futures, forex, stocks, dividend stocks, options, Nadex Binaries, Nadex Spread, physical gold and silver, real estate, municipal bonds, federal bonds, tax liens, that invention you always wanted to make and sell, etc.
What if you don’t have the proper balance?
If you do not have the proper balance for what you want to trade, you may make three choices:
Withdraw half of your profits each month on the first of the month. This will ensure that you are putting some money back and sandbag this into savings . This may also help you if your account blows up because you are trading with a higher percentage risk than 5% / 6.
When you double your account, take out half immediately. This removes your initial risk deposit. This is important psychologically because you have the lower than ideal 5%/6 capital, you have the odds stacked against you to be profitable. You don’t have the capital to work through your losses. By pulling out the initial capital, you will still have capital with which to re-start. From this point, leave all money in until you get the account to the proper account size. Once you are at the proper account size, follow the objectives set forth in the Target portion of this model.
When you double your account, withdraw half of the profits immediately. Repeat this each time you double, without waiting until the end of the month. The goal here is to ensure that you are constantly setting aside “dry powder” as you are risking a higher percentage of your account and also trying to increase your account size incrementally as well. Once you are at the proper account size, follow the objectives set forth in the Target portion of this model. There are multiple methods available to traders. Choose the one that is best for you.