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Money Management Techniques

By Dan Blystone

The Kelly Criterion

The Kelly Criterion was originally developed by John Kelly while working for AT&T’s Bell Laboratory. When the method was published in 1956 it was embraced at first by the gambling community, and was then discovered as an effective money monagement tool by the investing world.

The Kelly Criterion looks at two major inputs:

W – The probability that a given trader/system will be a winner.

R – The Win/Loss Ratio – amount gained from winning trades divided by amount lost from losing trades.

These inputs are used to calculate the Kelly percentage in the following equation:

Kelly % = W – [(1 – W) / R]

The Kelly percentage is interpreted as reflecting the size of positions you should be taking. For example a Kelly percentage of 0.08 suggests that you should take an 8% position in the securities in your portfolio.

The formula specifies the percentage of the current portfolio to be used in a given system.

Interpreting the Results

The Kelly percentage is interpreted as reflecting the size of positions you should be taking. For example a Kelly percentage of 0.08 suggests that you should risk 8% of your portfolio using that system. The formula specifies the percentage of the current portfolio to be used in a given system. In gambling the formula specifies the percentage of the current bankroll to be bet at each iteration of the game. Kelly’s formula was applied by Edward O. Thorp, both in blackjack and in the stock market.

Optimal F

Ralph Vince’s optimal-f method is one method of finding the optimal amount to risk on each trade to maximize profits. It is used to find the fraction of equity to risk on the next trade. Optimal f is a money management scheme that assists in determining the correct position size at a given time. Ralph Vince analyzed many systems as computer programmer for Larry Williams, winner of the 1987 World Cup Championship of Futures Trading.

Optimal f Formula

Number_of_shares = (Optimal_F * Current_Capital / starting_risk_per_unity_of_assets)/Security_Price where starting risk = maximal loss at trade(in %).

The Martingale System

A money management system where the dollar values of investments continually increase after losses, or the position size increases with lowering portfolio size. The principle behind the Martingale system is that statistically you cannot lose all the time, and therefore you should increase the amount allocated in investments, even if they are declining in value, in anticipation of a future increase.

The Martingale system is commonly compared to betting in a casino. When a gambler using this method loses, he or she doubles his or her bet. By repeatedly doubling the bet when he or she loses, the gambler will (in theory) eventually even out with a win. Of course, this is assuming the gambler has an unlimited supply of money to bet with.

Anti Martingale System

A system of position sizing that correlates the levels of investment with the risk and portfolio size. Contrary to the Martingale system, the anti-Martingale accepts greater risks during periods of expansive growth, and an increasing market exposure, with larger equity.

2% Rule

The 2 percent rule is a basic tenet of money management. Even if the odds are stacked in your favor, it is inadvisable to risk a large portion of your capital on a single trade. The 2% rule states that you should never risk more than 2% of your account equity on a single trade. Market Wizard Larry Hite “Never risk more than 1% of total equity on any trade. By only risking 1%, I am indifferent to any individual trade.”

6% Rule

The 6% rule, outlined by Alexander Elder in ‘Come into my Trading Room’ states that if the value of your account falls 6% below it’s closing value the prior month you should stop trading for the rest of the month.

Recovering Lost Equity

Consider the following percentages required to recover from significant percentage losses in your account: 25% Equity Loss requires a 33% return to recover former equity value. 50% Equity loss requires a 100% return to recover former equity value. 75% Equity loss requires a 400% return to recover former equity value.

The table above reflects how difficult it is to recover from large percentage losses of your equity.

Stop Loss Strategies

Equity Stop. In this scenario the trader risks a fixed percentage of their equity on a trade and uses this to determine the placement of the stop loss order. Chart Stop. This technique uses technical analyis such as support and resistance levels to determine the position of the stop loss order. Volatility Stop. This method uses volatility as a measure of where to place the stop loss order – in a highly volatile setting the loss should be wider and in a lower volatility setting the stop should be tighter. Average True Range and Bollinger Bands are two indicators that can be used in determining the postion of the volatility stop loss order.

Position Sizing Turtle Style

The Turtles used a volatility based constant percentage risk position sizing algorithm. See: Trading Forum and Blogs

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