Money Management In Forex – Position Sizing
Money management in forex is massively important. When you’re starting out, it’s very important to get this part right. We know that losses are going to be inevitable and the traders search for the perfect strategy is going to be futile. So what are some of the ways to deal with the risk of loss and minimalize the chance of ruin? What is money management?
When you are limited to a concentration of a small basket of currencies because you have low levels of capital, you need to think about money management issues to succeed as a small retail trader. A key principal of money management is survival.
Geometric vs. Arithmetic Mean
With survival in mind, the first thing I want to discuss is the geometric versus arithmetic mean. The key for a trader is to not lose too much in one trade. People that lose money typically will violate this rule and it only gets worse during a losing streak when you continue to average and are not objective about what you are doing. As you’ll be well aware, if you lose 50% of your capital then you are going to need a 100% win to get back to where you started. You need to exit at the first sign of trouble or your losses will grow arithmetically. Your profits are required to increase geometrically so you have to do exceptionally well when you’ve lost some of your capital to actually get back to where you started. You need to preserve your funds and make sure you’re not losing money.
Theory of Runs
Assume we have two systems, one with a losing percentage of 45% and the other a losing percentage of 49%. Even on a marginal system such as the one that loses 49% of the time, it’s a very low probability, 2.8% that we’re going to have 5 losses in a row. The probability improves to 1.8% when we have a system that’s losing only 45% of the time. So what can we take from this?
Well, obviously if we have a lower loss rate then we have a lower probability of a run of consecutive losses. We can see that even a marginal system such as the second one has a low probability of a large run of losses. If we can avoid these losses, and know that they are infrequent in our system that we have worked on and proven to ourselves as being effective, we give the market every opportunity to work in our favour. It’s very important to avoid these large losses and give yourself the best chance possible to participate in the market. If you risk large sums of capital eventually you are going to have a poor run which will decimate your account.
Theory of Ruin
Assume a system with a loss rate of 45%, and a 1 for 1 pay-off ratio. If our initial margin (equity) is equal to our payoff then the theoretical probability of infinite wealth is 18.18%. If we increase the margin to 10 units, i.e. 10% of our capital on a given trade and we are winning 55% of the time, then this probability improves to 86.5%. Increasing that margin to 50 units, we are nearly up to 100%.
We can see that if we have a large capital base relative to our loss our chances of success dramatically increases. We can also see that if we increase our bet size relative to our margin that our probability of success will decrease. Increasing the bet size from 1/50th of our margin to equal our margin in this scenario would reduce the chance of success from 99.996% back to 18.18%. So the key is keeping your position size or equity risk on a given trade to a minimum unless you have a system with a very high likelihood of success on each trade (and very few people have them!). It’s very unwise to put too much capital on a given trade.
Optimal Capital Percentage to Trade
The optimal capital percentage to trade can be mathematically identified as:
Optimal % = ([(A+1)*p]-1)/A, where A is the average payoff ratio, and p the win %
Lets look at a system with a 51% winning percentage, and 1:1 payoff ratio. Inputting the values into the formula we get:
Optimal % = ([(1+1)*0.51]-1)/1 = 2%
You will often hear many traders suggest that 2% or there about is the amount that you should risk on any trade. Risk adjusted testing by practitioners in the industry adds weight to the argument that a number of this quantum is the most optimal percentage of capital to allocate to a trade.
There are many people that come into this business wishing to make a lot of money quickly, who take large risks and essentially gamble. When they hear that they should only be risking 2% perhaps 3%, sometimes 4% on a trade (if you’re systems working really well) they’re blown away by this fact. With small equity accounts balances hearing this devastates their expectations. It’s important to remember to be very realistic about what your goals are and what you are likely to make. It is vital for the survival of your account to avoid the temptation of betting large on a single trade.
The Martingale System
Many of you have probably heard about the Martingale system, where for example, you’re in a casino and you bet a dollar on black and if it comes up red you double up. If you lose again you double up, and when you eventually win you’ll end up making your original investment back with a small profit equal to the original bet. This system has a great emotional appeal to a loser. It appears like a no lose proposition but unfortunately an inevitable run of bad trades is going to wipe everyone out. If the initial bet is $1, then after 46 losses in a row you would need to bet 70 Trillion on your 47th bet to cover the loss. This sums up the point that you can’t afford to take on the market and you can’t afford to continue to average your positions to recoup your losses.
The important points to take from this article are to be conscious of your trades, never bet too large on a single trade and have a disciplined plan. Most importantly, it is important to exit the market at the first sign of trouble.