In this article we will discuss some of the most popular techniques of money management
applied in trading. Although the topic can get complicated and also there are many techniques, we will focus on the most important.
Fixed Capital Percent Technique
This technique determines that we should risk the same percentage amount over the size of our trading account in every operation we perform. It has several advantages, for example, when we win, we will gradually increase the size of our position, thus harnessing the power of compound interest, while when we lose, we will reduce the position size, protecting our account from further losses.
It is probably the most widespread money management technique among traders, because a priori, is the one that offers more advantages.
Personally I find two negative aspects in this technique. The first is the need to recalculate the position size constantly, although this is a very bearable problem considering the number of orders managers that will do this for you.
The second problem I find is that while the technique protects the account when there are losses, it also means a greater difficulty in recovering from a slump. That is, in a bad streak if I accumulate six consecutive losing trades, for example, these losses will not recover with 6 consecutive gains and I will have to earn some more to reach break even.
Fixed Amount Per Trade Technique
In this case, we always risk the same monetary amount in each transaction. Many traders say it has the disadvantage of risk porcentually a higher amount in each trade as we lose, but the truth is that it eliminates the second problem present in the above method (a run of losing trades is not recovered with the same amount of winning trades), because to recover from a bad losing streak, a trader just need the same amount of winning trades to reach break even.
Personally is the system I use, because although it is true that when you lose you are risking a greater amount, I think that if I have a winning system sooner or later the benefits will come. For this reason I prefer to recover with the same number of trades that have led me to lose, than rely on the random succession of gains/losses to reach the starting point.
Moreover, the normal thing would be “to reset” the amount to risk when the account grows to harness the power of compound interest and not to risk less a lower percentage amount as the account grows. In that sense, it would be best to recalculate a fixed percentage of the account every X percent growth.
For example, if I have an account of 10,000 euros and risk 150 euros for each trade (1.5%), when I reach a balance of 11,000 euros, I will risk 165 euros for each trade, and will not change this value until the account balance reach the mark of 12,000 euros.
Fixed trade size (Lots) per trade technique
This technique involves always enter the market with the same number of lots. It is a convenient system for traders who perform many transactions, specially in scalping systems
, because it is easy and quick to perform, even without orders manager.
I think this kind of monetary management is only possible for short-term trading with fixed stops, because otherwise, we will be risking different amounts on each trade.
Given that in a medium/long term trading there are times when we have a stop-loss at 40 pips and over 120 pips, it would not make sense to apply this method because it would have no consistency. Otherwise, if we trade very often and we know that when the market its moving against us the exit should be made with discipline at a predetermined distance, then we can use this technique, and it is only here when it makes sense to count the pips we are winning.
Optimal F technique
The optimal F was devised by Ralph Vince, who developed a mathematical formula to determine the optimal amount to risk on each trade for a system with positive mathematical expectation.
In this case you have to apply a considerable reduction coefficient, because depending on the ratios of our system, it is easy that this formula determines that we must risk up to 15% or 20% of our capital in one trade, something that sounds too risky even for those who like strong emotions in trading.
It is an aggressive money management technique that is basically double your position every time you lose. We might even say that a martingale system open new positions when a position goes against you, improving the “average price” of your position, but exponentially increasing the risk.
The idea behind this technique is that when the market made a small correction, while you have been improving your entry price with new trades at better prices than the original price, you get out of the losing position with no losses or even benefits.
There are variations to this trading method, such as increasing the position size according to a smaller multiplier, but in any case, is the surest way to end up breaking a trading account.
There are many systems that use this money management technique (including automatic trading systems), and although they can give excellent results sooner or later end up destroying an account. So I recommend that you understand the concept and know it, but run away from this type of trading.