In everyday life, and in the discipline of active trading ten-fold, "money management" plays a pivotal role in a large portion of all decisions. As a term, money management is defined as the process of knowing where money is going, how it is being spent and having a well-drawn-out plan to facilitate a specific end. Whether one is shopping for food at a grocery store or actively trading an equities market, implementing a money management strategy is a key part of realising a desirable outcome.
Identifying Risk And Selecting An Appropriate Money Management Strategy
Risk is exposure to danger. In the financial markets, the peril afforded by risk to the market participant is the loss of capital. Applied leverage, potential profitability and the cost of trade are all factors that contribute to the risk present in a specific trading situation. Trading on margin can result in losses that exceed deposited funds.
The principles of money management address risk from the perspective of the trader, relating the marketplace to both the adopted trading methodology and the trading capital. It is important to remember that the result of a specific trade is dependent upon many variables and remains an uncertainty until its end. In any trade, the element of risk is very real and nobody can guarantee profit or guarantee against loss. The risks can be mitigated, but not eradicated, through the use of a well-designed money management strategy.
Selecting a comprehensive money management strategy for one's trading operation can be a challenging endeavour. Strategies vary greatly and are dependent upon the adopted trading system or methodology, market being traded and available capital inputs. However, no matter the circumstances surrounding the trading operation, the money management strategy must clearly address the following questions:
- What percentage of the trading account balance may be allocated for a specific trade?
- In the event of a loss, how much capital is available to resume trading activities?
- What degree of leverage is to be used on a specific trade?
Each of these three questions speaks to the main objective of a comprehensive money management strategy: utilise available capital in an efficient manner promoting longevity in the marketplace while minimising any undue capital risk. An effective money management strategy preserves the integrity of the adopted trading methodology, giving the trading operation its best possible chance at success.
Leverage is a double-edged sword as it can significantly increase profits as well as losses.
Basic Money Management Strategies
It has been said that there is "nothing new under the sun." That is certainly accurate when attempting to maximise returns on a trading system through the implementation of a money management strategy. Strategies range from aggressive to passive depending on the primary focus of the approach. Aggressive strategies often employ greater leverage with the goal of large periodic profits, and passive strategies are conservative in nature with capital preservation being the primary objective.
Various ideas and guidelines are associated with prudent money management. One such concept is the notion of consistently trading using a positive risk to reward ratio. A risk to reward ratio (R:R) is the amount of capital initially risked in proportion to the potential profit of a successful trade.
Selecting trades with reward greater than or equal to risk is a common practice among active traders. As risk grows larger than reward, a higher rate of successful trades is required to sustain profitability. Conversely, if the potential payoff on a successful trade is several times the initial risk, a trader does not have post a high rate of winning trades in order to generate profit.
Exercising proper money management is no small undertaking and remains one of the greatest challenges an active trader or investor will face. However, through the development of realistic objectives, and the consistent application of concepts such as positive risk vs reward, a wide variety of strategies can be effective.
Flat Risk Method
The "flat" or "constant" risk method is the most basic type of money management strategy. Under flat risk, the strategy is just as it sounds: One risks a constant, predetermined portion of capital on each and every trade in pursuit of an acceptable profit.
Flat risk parameters vary depending upon trading account capitalisation, market being traded, profit objectives and the overall risk appetite of the individual trader or investor. A commonly used risk value in the investment and trading arena is an aggregate amount of no more than 1-3% of the initial account balance per trade.
The mechanics of the flat risk method are relatively simple. If a trading account has a balance of US$25,000 and a risk tolerance of 3%, then the maximum amount to be risked on any given trade is US$750. The result of a given trade has no bearing upon the next trade's risk value. It remains the constant 3% of the initial account balance.
Flat risk can be adapted to reflect the amount of leverage placed upon the trading account at any one time instead of on a per trade basis. In active markets, trading opportunities often arise quickly, forcing a trader to act immediately or miss out. A byproduct of multiple, simultaneously occurring trades is an increasing of risk.
Given the US$25,000 trading account, and a risk tolerance of 3%, three concurrently open trades yield a total exposure of US$2250. If the flat risk parameters are adapted to reflect 3% of the trading account to be placed at risk at any one time, the initial capital risk remains at US$750. The US$750 can then be relegated to one trade, or spread among the three trades with adjusted trade management parameters.
Advantages of flat risk:
- Avoids catastrophic loss
- Promotes longevity in the marketplace
- Reduces short-term variance in account value
Disadvantages of flat risk:
- Limits potential profits
- Lengthy durations to account recovery after periods of sustained drawdown
- Places impetus on defining proper risk parameters
Numerous variations of flat risk are used by traders and investors in the marketplace. One of the most common is known as "compounding" or "reinvesting." Simple compounding applies the predefined risk percentage to the account balance as it fluctuates. This is a common practice that employs certain parts of flat risk while attempting to increase returns as the account grows and limit losses as it shrinks.
The "Kelly Criterion" is a mathematical formula that originates from statistical work done in the 1950s. As it pertains to trading and investing, the formula attempts to define the optimal amount of capital to be risked on a given trade according to the probability of that trade's success.
In contrast to flat risk, the Kelly Criterion promotes the idea that increased capital risk is justified by a greater probability of success. For instance, if a trade has a 90% probability of success, then the appropriate amount of capital to be allocated is much greater than a trade with a much smaller (10%) success rate.
Calculating the Kelly Criterion can be a challenge, thus trading platforms and financial software providers have automated the ability to readily perform the calculation. Many variations of the formula exist, but many traders and investors use this simplified version:
- Kelly % = W - [(1-W) / R]
- W = percentage of winning trades
- R = Average Gain Of Winning Trades / Average Loss of Losing Trades
The mechanics of the Kelly formula for an expected success rate of 60%, gain of 5% and a loss of 4% are performed as follows:
- Kelly % = .60 - [(1-.60) / (.05/.04)] = .28 or 28%
In this situation, according to the Kelly Criterion, the appropriate risk is no more than 28% of the trading account.
Advantages of the Kelly Criterion:
- Large potential returns
- Limited exposure to the trading account
- Ability to maximise returns on high probability trades
Disadvantages of the Kelly Criterion:
- Successive losses lead to disaster
- High probabilities of success equate to huge risk values for single trades
- Large account value variance can inhibit the ability to sustain trading operations
Complex variations of this formula are employed in marketplaces all over the world. The statistical relationships present in the formula are widely used in the areas of hedge fund management and portfolio diversification.
The Martingale strategy is one of the world's oldest speculation systems. Its applications to games of chance in addition to financial markets have been the focus of plentiful academic studies and capitalistic ventures.
In basic terms, the Martingale strategy suggests that a player takes a predefined profit on a win and doubles the risk value after a loss. Assuming the game in question has 50/50 odds towards the player, and the player always "doubles down" after a loss, a profit is guaranteed because the larger bets cover the smaller losses.
In practice, adhering to the Martingale requires a large commitment. The capital needed to double the risk value in the midst of a prolonged losing streak is substantial. Consider the following scenario assuming a 50/50 probability of success, the net gain is equal to the net loss, and the initial risk value is a mere US$5. The risk capital needed after a relatively small number of consecutive losses grows exponentially:
- 5 consecutive losses: US$80
- 8 consecutive losses: US$640
- 10 consecutive losses: US$2,560
- 12 consecutive losses: US$10,240
As the example shows, consecutive losses are devastating to the sustainability of the Martingale and can quickly lead to "gambler's ruin."
In the world of finance, the Martingale system has been practiced for years. Because markets are dynamic and the trading of financial instruments does not exist as a simple binary system, the opportunity is present to increase exposure on a negative position in attempt at profit.
For example, consider a trade scenario pertaining to WTI Crude Oil on the CME Globex futures exchange. Assuming trade parameters of a 1:1 risk vs reward ratio and an imaginary stop loss value of US$.10, the following sequence of events provides an illustration of the Martingale strategy in action:
- The trader enters a market order to buy on contract of crude oil at US$40 and is filled at the desired price.
- The market immediately moves against the position and price retreats to US$39.90.
- As price hits the imaginary stop at US$39.90, another contract is purchased. There is no need to close out the current position and enter a new order for twice the contract size. Simply doubling the number of active contracts as the imaginary stop is hit accomplishes the same function.
- The trader's current position is long two contracts from a net price of US$39.95.
- The current breakeven point for the trade is now US$39.95. The profit target is US$40.00.
- The current liability to the trading account is US$100 (US$10 per US$.01 of market price) as current market price sits at US$39.90.
- From here, the active trade management is dynamic. If price moves in favour of the new position, then the profit can be realised. If price continues to move against the position, then the number of contracts purchased by the trader is doubled at each imaginary stop loss point.
In theory, the addition of leverage increases the chance of capitalising on a market reversal. In practice, the capital required to carry large negative positions can be overwhelming. One trade management strategy that can be used to limit the risk assumed by implementing a Martingale strategy is the trailing stop. In the case of a Martingale scenario as outlined above, a trailing stop can be used to limit the total liability of a trade as price moves tick by tick in the trade's favour.
The advantages of Martingale in trading:
- Range-bound markets provide higher probabilities of successful trades
- Enhances the possibility of sustaining short-run profitability
- Profit targets are predefined, and returns are quantifiable
The disadvantages of Martingale in trading:
- Trending markets can lead to financial ruin
- Leverage needed to double exposure can multiply quickly
- Potential huge capital reserves are needed to sustain an open position
The question of what type of money management strategy to employ depends greatly upon the personality of the trader and the overall scope of the trading operation. Conservative strategies, such as flat risk, may suit some trading operations well. Conversely, well-capitalised traders may have the purchasing power and ability to employ more aggressive approaches, such as the Kelly Criterion or the Martingale system, to their trading enterprises.
No matter what style of money management is adopted, it is imperative that it fits the trading methodology, capital inputs and goals of the trading operation as a whole. Money management cannot guarantee profits or against losses, but it can help optimise the effect of winning trades and reduce the impact of losses.
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FXCM Research Team
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