Hi Jmot,

I am thinking about money management. Below is the seed. Work it out and post an article. And I will call you Dr Jmot.

Money Management
There are 2 main areas of money management for a simple directional trading system using straight calls and puts or long/short stock.

Risk management
1R(Minimum Risk Amount Per Trade)
1R is called the Minimum Risk Amount you risked per trade.
Trading literature and most trader sets it at 2% of capital.
Instills discipline and prevent trader from taking too large positions due to emotions, indiscipline, hope. And prevent account blow-up(Risk of Ruin)

Portfolio Risk
Portfolio Risk is the Minimum Risk Amount for the whole portfolio at a given time. Thus this sets the number of maximum trade ongoing at a time.

So for a trading system of other options strategy e.g Iron Condor. I do not know how to apply.

Capital Optimisation
One main thing we can observe if 1R is too small, so is the reward.
If 1R is too big e.g 50% of capital, Risk of Ruin(losing all your capital) is just around the corner.
Second Risk:Reward Ratio, for a positive expectancy system(winning in trading over the long term) Trades must have greater than 1:1 Risk to Reward Ratio. Most traders set it at 2:1 or 3:1.

This has been covered at
http://www.seykota.com/tribe/risk/index.htm

Where the Expected Value vs Bet Fraction Graph shows the optimal
risk to take for the greatest expected return.
One rule of thumb is to take the left side of the curve of the optimal bet fraction(25% in the graph) as it is symmetrical on the right side(>25%-50%)

Should the bet fraction be 1R or Portfolio Risk.
How to relate Return to Risk. E.g assuming my trades are 2:1.
If I risk 10% of my capital(Portfolio Risk), I can expect my capital to grow 50% in a certain time(what time?)

I believe the above is the model of money management for aspiring traders.
A one million dollar question.

Mike

Hi Jmot,

1) So from the above theory, if I have an account of 30,000. There is no need to risk no more than 25%-30% 7500-10000 of the capital each time for optimal capital for straight trading.

2) To find the practical amount of starting capital to trade safely.

3) For a trader to know how much to risk to get the return he wants. E.g if I trade 10 trades per month(as per the web site plotting 10 bets of consecutive alternating head and tail). To get 15,000 out of 30,000. I have to risk 3000 each time for consecutive 10 trades.

4) The rest of the capital can be put into other strategies e.g iron condor, but that I cannot account for portfolio risk.

Mike

Hi Jmot,

So the rough idea.
Capital : 30,000
Expected Return : 5000 per month
Trades : 10 trades per month.
Risk Per Trade : 1000
Trades : Either Risk 1000 per trade or 500 per trade for 2 simultaneous trades.
For 10 Consecutive Trades, assume Reward/Risk 2:1,
One pair of winning/losing trade 2000-1000=1000
5 pairs of trade : 1000*5=5000

Theory is theory can you do it is another story

Mike

Yo Jmot,

Now I understand why all experienced traders say money management is more important than the trading system itself. You can take random bets in trading like a coin toss with 50% probability and as long as your trades can fulfil the risk/reward ratio e.g 2:1 you can make money and most important have the confidence to trade.

Capital : 30,000
Expected Return : 5000 per month
Trades : 10 trades per month.
Risk Per Trade : 1000
Trades : Either Risk 1000 per trade or 500 per trade for 2 simultaneous trades.
For 10 Consecutive Trades, assume Reward/Risk 2:1,
One pair of winning/losing trade 2000-1000=1000
5 pairs of trade : 1000*5=5000

Further Thoughts
Profit Range of 10 trades :5000-20000.
Risk can be tuned with trading skill(Probability of Win) to get the expected returns.

Thanks for allowing me to think aloud.

Mike

Expanding on Pt 2 and 3

2) Know that your account will not go down(your risks are controlled) but go up with time

3) Have the confidence to enter trades. How many times we fear to enter as we must be certain the market will go that way. We can win some here lose some there but in the end like a series of coin toss we will make money in the end.

In the simulation of coin-toss
win-lose-win-lose-win-lose-win-lose-win-lose
Our trading can be
win-win-lose-lose-lose-win-win-lose-win-lose
But we made money according to our money management plan!

(We need not be right all the time. It’s not about one trade. But a series of trades.)

hi Ray, my pleasure! do chk out other useful stuff under the “free tools” category as well

Jmot don’t call me Dr Michael as I don’t have a PhD from Preston University(Haha..). I am just a asipring trader not a guru. Thinking about money management over the weekend. Let me know your thoughts about money management. If you have time, post about Capital Allocation too.