One of the keys to money management in trading is knowing how to size the position correctly. For this, there are a few techniques:
- Martingale
- Antimartingale
- F for Kelly
- Hedging technique
- Drawdown
- Portfolio diversification
Martingale
This method consists of adding money to a losing position, usually by “doubling the bet”, so that if the market turns around, we will come out recovering the previous losses and with some profit.
For example:
We lose u$s10 on a position. Using the martingale method, we will double that initial position, putting u$s20, with the intention of recovering the initial loss and obtaining a profit.
The problem with this method arises when these losses accumulate and we keep doubling bets, as the money in the account is limited and the risk assumed is enormous.
Antimartingale
This method consists of using a fixed percentage of the account per trade. If that percentage is for example 3%, then that 3% will be the size of each trade.
It is the opposite of martingale. In this method, if the money in the account decreases, the money put into each new trade will be smaller. Conversely, if the money in the account increases, the money wagered will be larger.
It is one of the most used methods, as it is easy and simple and it is also excellent for minimising losses and increasing capital in winning streaks.
Continuing with the previous example:
We lose u$s10 in a position and our capital was u$s100, therefore we lost 10%. If we decide to risk 10% of our capital, in each new operation the anti-martingale method will not let us risk u$s10 again, because our capital has been reduced to u$s90.
The maximum percentage we could risk on the next trade would be $9. If we keep accumulating losses, we will put less and less money to trade, and if we win we will put more and more.
The anti-martingale method is ideal for maximising profits (we earn more when trades go in our favour) and managing losses.
Using this method we must adapt the size of the positions, to the total amount that the account is taking: increasing the size of the positions as the account grows, and decreasing it as the account is taking losses, to take care of the capital.
In summary, the martingale and anti-martingale methods are two ways of managing a position in order to try to lose the least amount of money, with the difference that in one the risk increases and in the other it decreases.
Optimal Kelly fraction
Kelly’s optimal fraction is a technique used to define the maximum percentage to allocate in each operation to maximise results.
It applies to both day trading and long-term investment.
Kelly’s optimal fraction studies the evolution of the account, and depending on the winning or losing streak of trades, indicates how much to invest in the next position. Therefore, as the results are better, the formula indicates that you should increase your positions.
To calculate it, you need the following data to extract from your trading log:
- Percentage of winning trades
- Profit/Loss Ratio (or profit/risk ratio as we saw earlier: we divide the total profit by the total loss).
The formula for Kelly’s F is:
(IMAGE)
The percentage is calculated as a percentage of one. In addition, the result is usually diluted by dividing the result by 10 to avoid excessively high results.
However, a problem arises: the formula is only useful when profits and losses are constant. And this is not the case in trading, so if we apply the formula as it is, it can lead to large swings in the value of the capital.
In 1990, Ralph Vince published in his book “Portfolio Management Formulas” a formula based on Kelly’s optimal fraction, partly solving some of the problems of the original formula. It is known as “Optimal-f”. We will see it better in the following example:
Suppose we have extracted the following data from our log:
- Percentage of hits: 60%
- Total winnings: us$ 600
- Total loss: us$ 375
- Total trades: 60
With this information we calculate the profit/loss ratio.
- Average profit per trade: u$s10.
- Average loss per trade: u$s6.25
By dividing the total profit by the total loss, we get the profit/loss ratio which is equal to 1.6.
According to Kelly’s formula in our next trade we must risk 35% of our capital. As this is too much for money management, we dilute the result to 10%, so we should risk 3.5% according to the diluted Kelly F.
Let us now suppose that after 10 operations, our results worsen and look like this:
- Percentage of successes: 50%.
- G/P ratio: 1.25
If we have a losing streak of trades, the calculation is considerably reduced. In this case we must risk, according to Kelly’s F, 10% which, diluted to 10%, would be 1% per trade. The risk is three times lower than the previous one.
Hedging
Hedging is considered a hedging technique as it consists of covering or reducing the risk of an investment with an opposite position by means of a correlated financial instrument or a derivative.
Hedging is done to avoid adverse movements in the asset price of an investment, thus acting as an insurance against loss.
For example, if you believe that a particular stock is likely to rise, you would open a long (bullish) position, i.e. you would buy a certain amount of that stock. Once you have opened the position, you think that there may be events in the short term that could cause the trade to lose, such as some news that could hurt it. You then decide to open a position, for example, by buying put contracts on that stock.
The same example applies to forex if you open a long position in EUR/USD and then, in order to protect it from an event that causes it to fall in price, you open a long position in an inversely correlated currency pair (which has an opposite movement), such as USD/CHF.
This hedging strategy can also be done on the asset itself.
Continuing with the EUR/USD example above, when you open the long position, you can, at a certain point, freeze the losses or the gains by opening the opposite position.
In summary, to perform a hedging strategy you can basically:
- Open a position in a product with inverse correlation, since if one goes up, the other should go down.
- Open a position opposite to the one we already have, to freeze losses.
Regarding correlations, they can work better or worse depending on events beyond our control. On the contrary, if we open the opposite position, it is completely neutralised.
We must not forget that when we open a hedging position, what we are doing is a hedge that protects the investment made, but incurring more expenses and it is a non-winning strategy.
Drawdown
Drawdown tries to foresee the worst case scenario in the global operation of all the assets that a trader has under management.
The “Uncle Point” is the level of drawdown that causes the investor to lose confidence and can lead to withdrawal from the market, i.e., the abandonment of this profession, together with the frustration that this entails. Therefore, this point is important as it helps us to answer ourselves questions such as whether the drawdown is within our expectations, whether it will last long or whether we will be able to withstand the maximum drawdown level before reaching the uncle point, among others.
It is very important to ask yourself these types of questions and answer them honestly before you start trading (if you are not very confident you can test different levels of risk in demo and write down how you feel). Remember that the advantage of money management is to improve the risk/reward ratio which is determined by the net return of the trading system you have and the risk by the maximum drawdown. Therefore, if you increase the position size it is logical that the drawdown also increases, but at the same time the return of the trading system increases (as long as you apply a good money management strategy).
This is related to how much you are willing to lose. You have to get used to losing as it is part of investing in the stock market and that is why money management is so important.
You should set a size for each position, based on the money you have available in your account. If you can’t bear a loss of $100, then you should decrease the position size.
Remember that what really matters is the bottom line, not a particular trade. You should “see the wood, not the tree”, i.e. how much money you have left after a series of trades, or per month, etc. You determine that, no one can do it for you.
Portfolio diversification
Diversifying a portfolio consists of composing it with different types of assets. The aim is to reduce common risks. It is the famous saying: “don’t put all your eggs in one basket”.
If we invest all or a large part of our capital in a single asset, for example in the shares of a single company, it is very likely that in an adverse situation we will lose all or a large part of our money. This is why investors take shelter from these risks by broadening the range of sectors and assets in which they place their money. It is best to diversify with assets that have different degrees of liquidity, complexity, risk, duration and of course different sectors.