Money Management

I have two basic rules about winning in trading as well as in life: 1. If you don't bet, you can't win. 2. If you lose all your chips, you can't bet - Larry Hite.

Money management is a very overlooked component of a trading system. This is unfortunate because, arguably, it is your money management that can have much more an impact on your results than entries or exits.

It's money management, often referred to as position sizing, which dictates how quickly you will compound your account when you are winning, and how slowly you will kill your account when you are losing.

Van Tharp, in his book Trade your way to financial freedom, tells an analogy of a test given to a number of Ph.D students (It was either 20 or 40). Each student was given $1000 to begin with and were told to play a game where they had a 60% chance of winning each time they played, and the size of each win and the size of each loss was the same. Obviously a positive expectancy system. There was no fee for playing and they could play as many times as they liked. None of the students made money except for two!

Why?
1. Either their position size was too large and/or
2. They followed the Martingale system.

Now, remember how I mentioned how trade frequency was very important in assessing the profitability of a system. A fair coin has a 50% chance of landing on heads and an equal chance of landing on tails when flipped. But if you flip the coin 10 times, there's more than a slim chance that you could get 8 or 9 heads consecutively. But flip it 100 times, and the results are more likely to be closer to 50%.

The Martingale system originates from gambling, and says that, you should double your betting size after you lose. Those that have even a basic understanding of probabilities know that the probability of a win is something that does not change irrespective of whether the previous bet was a win or a loss.

And note that once a trading system is in a period of drawdown, its very hard to even claw back to breakeven. If you lose 50%, you have to double your money, i.e., make 100% to just breakeven.

A common method of position sizing used by those that win are either the:
*Fixed percent risk, or
*Percent of total equity, models.

With these methods, when your account size (closed equity) increases, you position size increased, and when your account is in drawdown, your position size decreases. These methods, in essence, can be considered an anti-Martingale approaches. They work to decrease the risk of ruin.

Remember what Larry Hite said: If you lose all your chips, you can't bet.

To conclude, I just want to demonstrate the effect that money management can have on a system.

Systems 1 and 2 are exactly the same system. The only difference is in their money management (and their results!).

System 1 uses $10k equal dollar units.
System 2 uses 10% of total available capital.

Starting capital is $100k.
5000 Monte Carlo simulations were run.

System 1:
Average Number of Trades Executed: 346
Average Profit: $372,838.43 (372.84%)
Average Absolute Percent Drawdown: 9.4199%

System 2:
Average Number of Trades Executed: 152
Average Profit: $498,482.84 (498.48%)
Average Absolute Percent Drawdown: 8.2077%