In this article, we would like to draw your attention to the money management part of trading.
Chances are, the technique you’ve heard most authors mention is the so-called “Fixed Fractional” position size. Basically, this technique risks a fixed percentage (hence the name Fixed Fractional) of the account capital (although some authors also apply it to the account balance). To explain the reasons why we don’t use this technique, we’ll start by listing its pros and cons:
- An interesting artifact of the Fixed Fraction model is that, since the size of the trade remains proportional to the capital, it is theoretically impossible to go bankrupt completely, so the official risk of total ruin is zero. As an anti-martingale technique, it is designed to achieve capital preservation for as long as possible.
- The compound effect is activated every time you have a winner. Using this method, the position size gradually increases when winning and decreases when losing. Increasing the size of positions during a winning streak allows for geometric account growth (also known as capitalization of earnings); Decreasing the size of trades during a losing streak minimizes damage to the trader’s equity.
- At lower percentages of stocks at risk, a winning or losing streak simply does not have a dramatic impact on the equity curve. This results in smoother capital appreciation (and much less stress for the trader or investor). This is because when you risk small fractions of your equity (up to 3%), each losing trade is given less “power” to affect the shape of your equity curve, leading to smaller drawdowns and, consequently, to a greater capacity to capitalize the gains. signs in the future. In other words, the size of the Provisions is directly proportional to the percentage of risk.
- By risking the same proportion with any strategy, you can end up winning even if some strategies in higher time frames lose money. This has been our case last month. The 30M Spread Reversion strategy continued to gain but was unable to offset the losses of the 4H Extreme Volatility in the longer term. Because those losses were exceeded in pips, the absolute result was a loss.
- If you have a small account balance, you are forced to work with a lot size that does not help to size the positions.
- If a large loss exceeds a certain amount and the risk percentage is now less than the smallest lot size, the trader is forced to break the risk rules just to trade the minimum allowed lot size.
- This model will require uneven achievement at different levels of size position. This means that anytime you want to increase the position size, you may need to produce a high return before you can increase the trade size from one lot to two lots; otherwise, you would be risking too much. So for the smaller account sizes, it will take a long time for this money management to kick in.
- The pip value is not the same between the currency pairs. To be accurate with this technique, you must perform multiple calculations for each operation.
- Related to the above is the fact that when the system being used is applied in different time frames and therefore different stop loss distances that are needed in the formula, you can end up having a positive pip amount, but a loss in absolute USD or EUR terms. In other words, a 200 pip profit on a 4H strategy could have the same absolute value as a -20 pip loss with a 30M strategy.
When trading multiple pairs and different time horizons, you need to simplify the position size calculation. For this reason, the fixed fraction model is not the simplest of the available techniques. In contrast, the Fixed Batch model greatly simplifies the process but lacks a certain dynamism to get the best out of your system’s executions. In a future article, we will see other variations of these money management models to work with.