Money management techniques describe how a trader defines the size of his trading positions. There are many different money management techniques that a trader can choose from.
The most important factor here is that the trader chooses a specific approach and does not jump around too much. Consistency in position sizing results in much smoother account development, and a trader can often avoid the wild swings that come from mismanaging position sizing.
The standard position sizing approach is called fixed percentage. Here, the trader determines the percentage level of his total account balance that he is willing to risk per single trade.
Usually, the percentage figures range between 1% and 3%. The larger the account, the lower the percentage risk usually is.
If you trade with a $10.000 account, you would risk $100 per trade if your risk level is 1%. This means that when your stop is hit, you lose $100.
The pros of the fixed percentage approach are that you give the same weight to all your trades. Thus, the account graph usually looks much smoother and has less volatility.
Disclaimer: Of course, stops don’t always get triggered, and there is a substantial additional risk.
Averaging up is also known as ‘adding to a winning position’ or scaling into a trade. Once a trade moves into profits, the trader adds more contracts to the existing position as price advances.
Potential losing trades will be relatively smaller because the initial position is not as big when following the averaging up approach.
Especially for trend-following methods, the averaging up approach could be beneficial because it allows a trader to add more and more size once the trend reinforces itself.
Finding a reasonable and optimal price level to add to a position can pose challenges. Furthermore, once price turns, losers can offset winners fairly quickly. To counteract this effect, traders use larger positions on earlier orders and then reduce their size when they start averaging up, which partially offsets the pro-argument.
This method is often called ‘adding to losing positions, and it is very controversially discussed among traders. It is the opposite of averaging up because once your trade moves against you, you would open new orders to increase your position size.
The idea behind this approach is that losses can potentially be reduced, and the break-even point could be reached faster once a trade that has moved against you turns around again.
This method is often abused, especially by amateur traders, who are in a losing position and are emotionally attached to it. Such traders arbitrarily open new orders on the way down in the hope of lacking a sound trading plan and principles, that price eventually has to turn around. The improper use of cost averaging is a common cause for significant losses among amateur traders.
The cost averaging method is not recommended for amateur traders or traders who lack discipline and are emotional about their trading.
The Martingale position sizing approach is as heatedly discussed as the previously mentioned cost averaging method.
Basically, after a losing trade, the trader would double his position size, hoping to recover losses immediately with the first winning trade because it would offset all previous losses.
All previous losses can be potentially recovered with only one winning trade.
The point where doubling up means risking the whole account comes inevitably. Over the long term, all traders will experience a losing streak, and just one extended losing period is often enough to wipe out a trading account.
Suppose traders tend to revenge-trade and impulsively enter trades after losses. In that case, the Martingale technique poses great challenges and, under such circumstances, can even faster lead to a complete account loss.
Starting with only 1% risk per trade, a trader loses his whole trading account after the 8th losing trade in a row.
The anti-Martingale tries to eliminate the risks of the pure Martingale method.
With this approach, the trader does not double up after a loss and uses his regular risk level. Therefore, a losing streak cannot wipe out the trader as fast.
On the other hand, when a trader has a winning streak, he doubles up and risks twice as much on the next trade. The idea behind this approach is that after a winning trade, you are trading with ‘free’ money.
For example, a trader realizes a profit of $200 on his trade, where he risked 1% on a $10,000 account; now, his new account size is $10,200. On his next trade, he can risk $200, which is 1.96% of $10,200. If his trade is another winner with a reward: risk ratio of 2, he makes $400, and his new account size is now $10,600. On his next trade, he can risk the $600, which is now 5.7% of $10,600.
Traders can potentially make more money during winning streaks and do not fall as easily below their original starting account balance.
Just one loss can wipe out all the previous gains. For this reason, traders should not just double-up their position size but use a smaller factor than 2 to determine the position size after a winner. This way, they will still be left with a profit after realizing a losing trade.
Account swings with the anti-martingale technique can be significant because losses after winning streaks can be huge. If a trader cannot deal with such losses, the anti-Martingale method could lead to further problems. A trader should determine a certain level when he does not double his position size anymore but returns to his original approach, securing his gains.
The fixed ratio approach is based on the profit factor of a trader. Therefore, a trader must determine the amount of profit that allows him to increase his position (also known as ‘Delta’).
For example, a trader can start with trading only one contract, and he chooses his Delta to be $2,000. Every time the trader realizes his profit Delta of $2,000, he can increase his position size by one contract.
Only when the trader is making profits can he increase his position size.
By choosing the Delta, the trader can control the growth of his equity. A higher Delta means that a trader increases his positions slower, whereas a lower Delta means that a trader increases position size faster after making profits.
The Delta value is very subjective, and setting the Delta is more a personal preference than an exact science.
Whereas a high Delta decreases position size with a growing account, a low Delta increases the position account when moving from one profit boundary to the next. The differences can be significant.
The goal of the Kelly Criterion is to maximize the compounded return that can be achieved by reinvesting profits, and the Kelly Criterion uses the win rate and the loss rate to determine the optimal position size. The formula looks as follows:
Position size = Winrat – ( 1- Winrate / RRR)
However, the suggested position size for the Kelly Criterion often underestimates the impact of losses and losing streaks. Here are two examples that illustrate the point:
Position size = 55% – (1 – 55% / 1.5)= 25%
Position size = 60% – ( 1- 60% / 1) = 20%
As you can see, the suggested position sizes of the Kelly Criterion are very high and much higher than should be considered for sound risk management. To counteract this effect, the common approach is to use a fraction of the Kelly Criterion. For example, 1/10 of the Kelly Criterion would lead to 2.5% and 2% position sizes in the example above.
Maximizes the growth rate
Provides a mathematical framework for a structured approach
A full Kelly Criterion can lead to significant drawdowns very fast. Using a fraction of the full Kelly Criterion should be considered.