Money Management

Discussion in 'Risk Management' started by cnms2, Nov 22, 2005.

  1. cnms2


    I wonder if there are ET forumities interested in discussing Money Management and related topics. Are you practicing it? Why? Is it the Holy Grail of trading? Why? What do you mean by Money Management? Great experiences? Ugly experiences? Money Management applied to options trading. Optimal F? ...
  2. cnms2


    A tricky choice:
    • flip a coin:
      - tail: you win an amount equal to your bet
      - head: you lose your bet
    • throw a dice:
      - 5: you win an amount 5 times your bet
      - 1,2,3,4 or 6: you lose your bet
    What would you play?
  3. not sure what you are attempting to prove? If you have enough funds to sustain short-term fluctuations, both would have a long term expectancy of zero...

    I wouldn't play either:p
  4. cnms2


    Correct, RunTrade!

    I was leading toward using Money Management to calculate the optimum size of the bet. Using Kelly's formula:
    • F = ((R + 1)*P - 1)/ R
    where: F is your optimum bet as % of your money, P is the probability of winning, R is the ratio (winning amount / bet)

    Plugging in the data results in F = 0 for both games:
    • coin flip: F = ((1+1)*(1/2)-1)/1 = 0
    • dice: F = ((5+1)*(1/6)-1)/5 = 0
    Now I'm hoping for opinions on the optimum risk assumed by a trader.
  5. cnms2


    Probably many of you know Niederhoffer's story. I submit to you: was it poor Money Management? I learned from it to respect the "black swan". I learned that very low probability means "it will happen". I learned not to sell naked options, especially puts. But you have to risk money in order to make money ...

    Here there are the last paragraphs of an article on Niederhoffer and Taleb: Blowing Up
  6. Using Kelly ratio for bet size is absurd for stocks and questionable for commodities. If your daytrading, you can use it, because risk is somewhat more controlled during the day. But its still very risky because of losing streaks. Your system can have 50/50% chance of winning over the long wrong, say thousands of trades, but you can have streaks as long as 30 where you lose , lose , lose. Its during this time youll end up taken out of the game. I stick to a fixed position size - for long term positions, no more than 5% of capital is parked in any one stock. Ive also backtested using % based risk, and 5% allocation in my system beats % based risk. Wheras, the kelly ratio would risk up to 25% of capital in one trade. Just my opinion.
  7. ktm


    I believe Vic's issue was more deviating from his knitting, although better money mgmt would have improved his situation. His expertise was not the Thai Bhat and he got stung. Then he tried to make it up using his bread and butter methods and got stung again. Either event would have just contributed to Vic's normal high volatility and been another bump in the road. Both together combined with some smaller events (the broker liquidating him etc...) brought him down.

    Have you read "Fortune's Formula"? I reviewed it here on ET. It's the story of John Kelly and those around him. I am a strong supporter of the Kelly formula and believe in the merits of the method.
  8. I think Victor, obsessed with greatness and perfection, was too concentrated in asian currency before the "crisis" hit. Only Victor knows and can tell you about what led him to do so but feel free to speculate. His book may shed light on this...

    Money management in basic form is protection against one or several instruments taking you out of the market for good while maintaining the highest possible return and lowest risk. You start with basic notions and a premise, say 2% rule, and then work and craft it to your style of trading. It can be simple or extensive formulas that depend on what it is you do and what you are trying to accomplish in the markets.

    cnms2, you are a pretty smart guy.
  9. Q

    "However, comparing a coin-flipping game to trading is worse than comparing oranges and apples, it is more like comparing potatoes and moldy tangerines." --- The Trading Game (Ryan Jones)


  10. cnms2


    Kelly's formula used by traders:
    • F = ((R + 1)*P - 1)/ R
    where: F is your optimum bet as % of your money, P is the probability of winning, R is the ratio (winning amount / bet)

    was originally developed in 1956 in the paper "A New Interpretation of Information Rate", then applied to blackjack. It provides more hints than you can see at first glance.

    Solving it for F>0, we get:
    • (1) R > 1/P - 1
      (2) P > 1/(R + 1)
    (1) shows that for a given P probability of winning you need a minimum R winning/loss ratio, in order to have a profitable trading system. I.e.:
    • if P=50% you need R>1
      if P=33% you need R>2 (your average win has to be at least twice your average loss)
      if P=67% you need R>0.5 (your average win has to be at half your average loss)
    (2) shows that for a given R winning/loss ratio you need a minimum P probability of winning, in order for your trading to be profitable. I.e.:
    • if R=1 you need P>50%
      if R=2 you need P>33% (if your average win is twice your average loss your trading has to have at least 1 win for every 2 losses)
      if R=0.5 you need P>67% (if your average win is half your average loss your trading needs at least twice more wins than losses)
    #10     Nov 23, 2005