Rules of thumb are not derived by definition....They are heuristics...based on experience only... There is no general solution to the position size problem. Kelly and optimal f is for losers... Risk as little as you can and trade as frequently as you can. This is the solution. Listen to someone who trades..
There is a dozen of parameters to consider when it comes to controlling the risk. Account protection should actually come as a first priority in ones trading. Most trading software and platforms already have in place instrument protection like stop loss, trailing stop loss, exit point. I list here some "account money management" questions I think is important to know, before the daily trading session starts. 1. How much am I prepared to lose on a daily basis? 2. When do I move up my daily stop loss, if in profit to break-even? 3. When do I trail my daily stop loss from break-even? 4. How many profit levels should I consider? 4. How much am I willing to give away of my profit on a daily basis? 6. When do I exit and stop trading for the day, when in profit? The answers of the above questions depends on the trading style, how much risk the trader is prepared to take and the funding of the account. The status of the account ( +/- ) is to be taken into consideration as well.
The problem with this is that it's a logical fallacy. There is no difference between capital that you gained from profits, and other capital - they are identical. A 100k account that is $1k profit, $99k initial capital; and an account that is 1k initial capital, and $99k profit, are identical in every respect - they are 100k dollars, they will blow up if you lose 100k, they have the same margin, risk, etc. It is completely irrational to treat numerically identical account capital differently in any way. Assuming you gained them legally, then a dollar is a dollar, regardless of where it came from.
The problem with this is that it's a logical fallacy. There is no difference between capital that you gained from profits, and other capital - they are identical. A 100k account that is $1k profit, $99k initial capital; and an account that is 1k initial capital, and $99k profit, are identical in every respect - they are 100k dollars, they will blow up if you lose 100k, they have the same margin, risk, etc. If you drop $30k then you just lost $30k - that's a 30k loss regardless of whether it is from profit or from 'initial' capital. It is completely irrational to treat numerically identical account capital differently in any way. Assuming you gained them legally, then a dollar is a dollar, regardless of where it came from.
No they don't - what makes you think Kelly or Optimal F are the only valid ways to calculate risk? Kelly is notorious for causing blowups and massively underestimating drawdown risk. In any case, both my rule of thumb and Kelly pay attention to win rate, and I explained why I ignored the payout ratio (because in a bad drawdown of consecutive losers, you get NO payout because you have no winners during the losing streak). Your 2nd claim is silly because I explained the reasoning in this thread - they are based on likely maximum drawdowns, which is the main measure of risk, is it not? If your fund is down 35%, no investor or creditor will care if you were using Kelly or Optimal F for your position sizing - but they will care that you just vapourised over 1/3 of their capital. Ironically your own post, complaining of a lack of reasoning, has no reasoning behind it - it's pure assertion!
So a 30% win rate that pays off 5:1 on winners is not good enough for you? That's your call, but it would be a highly profitable system (if traded small enough). 10% is suicidal. Even with a 75% win rate, you will sometimes lose 2 or 3 in a row, which means you are down enough to have investors closing your fund with withdrawals, or (if trading solo) taking a monster 27% loss. And if your strategy win rate degrades in the future, you will be down 50% before you realise what has happened.
It all depends on your trading style and I agree there is not any difference on money gained, then on money funded the account. Nevertheless some traders do like to compound made profit when trading. They like to take more of a risk on the profit, then on the basic funds of the account. In a trading system this should be included as an option and of course not as an obligation. Let me give an example: The trading account was funded with $10.000. Profit were made and now it's in the amount of $12.500. He still uses the same low risk per trade, 1% on the $12.500 account. Additional he feels he can risk 2% instead of 1%, on the profit of $2.500 made since the account was funded.
Ghost of Cutten, This is essentially what Van Tharp describes in his book "The Definitive Guide to Position Sizing". I encourage you to get a copy. Some people are willing to "risk a little profit" to juice their returns when their system is generating higher win rates than usual. Some may also take the monetary value in their account as "not really their money" or the "markets money" since it was profit. Reasons may be that these gains are not yet realized because the positions are still open or some predetermined time end point has yet to occur (ie end of year, month, or quarter or whatever). Since they have not officially "booked" these profits they are willing to give some up to make more. Others use their stop loss placement to recalculate how much is at risk on open trades and then risk more as per their rules allow when they raise stops on winning positions. The answers as to what risk is "BEST" is a very individual thing. Everyone has a different system with different win rates and different R value profit per winning trade. Van Tharpe would suggest that you determine what is MAX draw down (for me about 15%) and what you would consider "ruin" (for me 25%). These numbers may be considered high by some and low by others so everyone will be able to risk different amounts based off these numbers. Essentially what you want to do is run MULTIPLE MC Sim on your trade data using all sorts of risk per trade and see how that effects your draw down and risk of ruin. The goal is to obviously choose a % capital to risk that will NOT result in ruin or max draw down as you define them. Then give yourself a little wiggle room beyond that as a MC Sim assumes you trade your system exactly as you did when you collected the data. We know that is not always likely. Also you may be interested in my post on page 13 of this thread which is along the same topic. (http://www.elitetrader.com/vb/showthread.php?s=&postid=3389866#post3389866) I PMed you some information about MC analysis. Good Luck.
Thanks for the link & comments. I agree that risk tolerance is subjective, but I don't agree that treating unrealised and realised gains radically differently is at all rational. There is no difference between 'initial' capital and 'profit', at least not on closed positions. Dollar for dollar they are exactly the same thing, and treating them differently for psychological reasons is no more rational than -EV loss aversion, gambling on -EV games like roulette, or other behavioural finance oddities. So, I will call a spade a spade and say that this makes no sense. If the goal of trading is to maximise risk-adjusted return for a given drawdown tolerance, then anything other than treating all dollars the same is going to be an inferior approach. Being reckless with 'open profit', and very cautious with 'initial capital' will result in excessive drawdowns when ahead, and inferior profitability when 'behind', or both. The optimal approach is to take the right amount of risk at all times. Not to mention, after a certain point in a profitable traders career, almost all their capital will be 'open profit'. Or, for people who use calendar years to reset their 'open'/'initial' distinction - why is a trade worth risking 3% on 31st December, and only 1% on Jan 1st? It makes no sense. If a trader's emotions are such that they are tempted to inferior or irrational behaviour, then the trader needs to master their emotions, just like they would do when buying a market panic, or selling a super-profitable stock that everyone is bullish on.