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MONEY MANAGEMENT
I recently saw an experiment in which a $100,000 account was traded using
various money management techniques. After 11 years of simulated trading
using the same trade results, the final equity of the account ranged from
$382,000 to over $640 million. That difference shows the power of money
management.
Does higher risk always mean higher return? No. Every trading system has
an optimal risk level that will maximize returns (This number was written
about by Ralph Vince.). Any risk level less than the optimal will
obviously hurt returns; however, any amount over the optimal level will
also HURT returns. You will create a situation in which you are risking
more to make less. In fact a risk level can get high enough that the
expected return becomes negative despite having a mathematically favorable
proposition. (Take a $1,000 bankroll and a 6-5 coin toss proposition. If
you risk more than 16% of your bankroll per toss, you will create a
negative expectancy. Every proposition has a point at which the risk level
gives it a negative expectancy.)
I believe in starting one's risk model with a fixed percentage risk. My
methodology tells me where to enter and where to exit a position, but my
money management tells me how large position the position should be.
Divide the amount risked per trade by the per contract risk as dictated by
the entry and exit points. (I.e. risking 1% on a $25,000 account would be
$250 per trade. If I had to risk 10 points at $5/point with $60/round turn
commission and slippage, I would put on 2 contracts.) I recommend a very
small initial percentage risk that increases as profits grow during the
year (or other time frame) until reaching the area of the optimal number.
Example-I want to increase my risk at five different profit levels (up
10%-20% etc. or whatever). My optimal risk is 6%. Risk less than 1% until
no starting equity is at risk. Then move the risk to 1%. I now have five
jumps to move from 1% to 6%, so I will increase my risk by 43% at each
level until I reach my 6%. My risk level will move like this 1% to 1.43%
to 2.04% to 2.92% to 4.18% to 5.98%. (The equity should be figured as cash
in the account plus LOCKED in profits minus equity at risk in other trades.
You are assuming that every open position is stopped out at its current
stop.) Once the equity drops back below the profit level the lower risk is
re-instated. This is a very aggressive model that is risky with profits
but protective with original capital (A 50% drawdown requires a 100% return
to get even; therefore, we want to be especially careful with original
money.). The increase in risk; however, will geometrically increase the
returns. Once this theory is in place, one can be aggressive or
conservative by changing the various risk levels.
I would rather have a marginally profitable methodology with perfect money
management than a large market edge with poor money management. Improving
one's money management will be more profitable than improving one's system.
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