Optimal f vs. Margin

Discussion in 'Index Futures' started by arold, Jun 17, 2004.

  1. arold


    As part of my trading strategy design, I’ve spent the last month researching specifically Money Management (position sizing, bet size, call it what you will).

    Having read three (very deep) books and countless articles on the web, as well as running numerous simulations myself, I have come to the conclusion that searching for the ‘Optimal f’ (i.e. what is the correct fraction of equity to risk per trade) is a useless endeavour (in my case).

    Why? :- MARGIN

    As an example, if I calculate my optimal fixed fraction of equity per trade to be, say, 2%, this means that on a starting account of $10,000, I should risk $200 per trade.

    OK, so let’s say that I’m trading the mini-sized Dow ($5 per contract), which has an intraday, initial margin requirement of $1,250.

    Let’s say that my strategy calls for a tight-stop loss of just two points. This means that I should open a position with 20 contracts, (200/5)/2

    So if I lose this trade, I will only lose 2% of my equity (20 contracts multiplied by $5 multiplied by 2 points = $200).

    So far so good, I have a fixed fractional risk of 2%, I have a fixed stop-loss, which is based on the dynamics of the market, not how much I can afford to lose and I have calculated how many contracts I should order (20).

    But (and here’s the whole point of my post), because I have $10,000 net liquidity and the intraday initial margin on this contract is $1,250, how many contracts can I order?

    Well, it’s not 20, it is in fact, 8 !!!

    By ordering just 8 contracts against an account with $10,000 liquidity, and a stop-loss of two points, instead of risking my desired 2%, I’m only risking 0.8% (8 contracts multiplied by $5 multiplied by 2 points = $80).

    You might think that this is a good thing because I’m not risking so much. But, the whole point of going through the process to discover the optimal fraction is to MAXIMISE my profit AS WELL AS minimise my risk.

    You might also say that if I can’t order so many contracts because of the margin, then I should widen the stop-loss in order to bring the 0.8% risk up to my desired 2% risk but that would be foolish because the stop-loss should be a calculation of your system (i.e. a reflection on the price/indicator/volatility/support/resistance or whatever you happen to be using) and NOT a reflection of how much you can afford to lose. The market doesn’t care how much you can afford to lose.

    The bottom line here (as I understand it) is that; all of the research and work to find the optimal fraction of equity to risk, isn’t worth a hoot because I can never trade the desired number of contracts as I am limited by MARGIN.

    I’ve also come to the same conclusion with many other contracts that I plan to trade, not just the mini-sized Dow. For example, the FTSE 100 allows a maximum fraction of 1.06%, the DAX is just 0.44% and the EURO FX is 1.54%.

    Of course, it is always possible (some would say probable!) that I have completely misread the situation and have just made a fool of myself with these assumptions.

    Actually, I really hope this is the case and that somebody can tell me that I’ve miscalculated these assumptions.

    Until then, I will have to rethink my money management strategy to take margin into account when calculating the optimal fraction of equity to risk.

    Would anybody care to comment on this?

  2. FredBloggs

    FredBloggs Guest

    i think you are blaming the margin requirement imposed by the exchange for your inability to trade the system.

    i.e. you are undercapitalized to trade this method - as they say most traders are.

    i believe the expression is putting the cart before the horse.


    dear flamer,

    i know this is an old thread - but ive been reading about optimal f & thought id do a search rather than start a new one