The money management plan balances the risk of ruin with maximization of profitability. In other words, it seeks to give us the biggest bang for our investment dollar with the greatest measure of safety: the name of the game is to survive a series of consecutive losses.
The Money Management plan seeks to answer:
- What risk shall I take on this trade?
- Given my stop loss, and my risk assessment of the trade, what is the maximum size I can place? If you have different levels of size, then the questions are: What is the maximum normal size and what size shall I have for this trade?
- If you trade more than one instrument, what is the maximum portfolio risk?
- What maximum loss will I incur before I take a rest from trading?
- At what point do I make my profits available to my position sizing?
To answer the questions, you have two components to consider:
- A psychological component: the dollar amount we risk needs to be within our risk profile’s comfort level; otherwise the probability is we’ll not follow our trading plan. If your current level of risk is above your comfort zone, increase your size incrementally – slowly boil the frog technique. Raise the size so slowly that your increased size doesn’t cause your subconscious to send out distress signals.
- A technical component: the inputs to your money management algorithm. There is your trade results: your win/loss rate, your Avg$win/Avg$loss, your avg$win for longs, your avg$win for shorts, the mean and standard deviation of possible consecutive losses, your maximum drawdown, the means and standard deviation of possible consecutive wins, your high water mark, your maximum adverse excursion, your maximum favourable excursion. There is also the market volatility: I use ATR to measure volatility.
All these factors impact the amount of risk you take. If you want a ‘quick and dirty algorithm’, there is the Turtle formulation that considers only the volatility of the market and the amount you want to risk – however you decide that:
(% Capital to risk x Capital)/(S value of ATR) = # of contracts. For example, let’s say you have US$20k and you want to risk 2% and trade the ES. Let’s take a 45 day – the ES has an ATR of about 25. The $ value is 25 x 50 = $1250. So the number of contracts you can trade is:
(2% x 20,000) = 400/1250 = 0
That’s right, a US$20k is not enough to trade 1 contract in the ES. The formula can be applied to any timeframe.
Money Management is one of those subjects that can be as simple or as complicated as you want to make it. I recommend you start with the Turtle formulation and move on from there.