Advanced Money Management Techniques

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 a much smoother account development and a trader can often avoid the wild swings that come from mismanaging position sizing.

Fixed percentage

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 get always triggered and there is a substantial additional risk. 

Averaging up

Averaging up is also known as ‘adding to a winning position’ or scaling into a trade which means that once a trade moves into profits, the trader adds more contracts to the existing position as price advances.

Pros:

• 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.

Cons:

• Finding a reasonable and an 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.

Cost Averaging

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.

Pros:

• The idea behind this approach is that losses can potentially be reduced and the point of break-even could be reached faster once a trade which has moved against you turns around again.

Cons:

• 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, and by 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 for traders who lack discipline and are emotionally about their trading.

Martingale

The Martingale position sizing approach is as heated 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.

Pros:

• All previous losses can be potentially recovered with only one winning trade.

Cons:

• 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.
• If traders tend to revenge-trade and impulsively enter trades after losses, 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.

And, as statistics confirmed, losing streaks will happen no matter how good you are as a trade. Thus, it is just a matter of time until you blow up with the Martingale approach.

Anti-Martingale

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 risk 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 are now 5.7% of $10,600.

Pros:

• Traders can potentially make more money during winning streaks and do not fall as easily below their original starting account balance.

Cons:

• 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 very large. If a trader cannot deal with such losses, the anti-Martingale method could lead to further problems. It is advisable that a trader determines a certain level when he does not double his position size anymore, but goes back to his original approach, securing his gains.

Fixed ratio

The fixed ratio approach is based on the profit factor of a trader. Therefore, a trader has to determine the amount of profit that allows him to increase his position (also known as ‘Delta’).

For example, a trader can start out 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 1 contract.

Pros:

• Only when the trader is actually making profits, he can 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.

Cons:

• The Delta value is very subjective and setting the Delta is more a personal preference, rather 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.

Kelly’s Criterion

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 winrate 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 undererstimate the impact of losses and losing streaks. Here are two examples that illustrate the point:

Example 1:

Position size = 55% – (1 – 55% / 1.5)= 25%

Example 2:

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 a 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.

Pros:

• Maximizes the growth rate
• Provides a mathematical framework for a structured approach

Cons:

• A full Kelly Criterion can lead to significant drawdowns very fast. Using a fraction of the fully Kelly Criterion should be considered.