In setting money management/position sizing rules, you should also consider:
1) How long
your capital can last, or
2) How long your account balance will drop to the risk tolerance you’re willing to take after going through a series of successive losing steaks.
The answers to these questions will depend on:
* The initial
capital/account balance
* How much to
risk per trade
* The
percentage risk tolerance (for Qtn 2)
Suppose
your initial capital is $10,000.
If
you money management rule
is that you would risk maximum 5% of the initial capital (i.e. 5% x
$10,000 = $500) in each trade, your capital will be all wiped out after 20
successive losing trades.
Suppose
your risk tolerance is
25% (i.e. 25% x $10,000 = $2,500), your balance will reach this level after 5
losing trades in a row.
Notice that the above rule is different from what has been discussed as Option 2 in the previous article.
In
the Option 2, the maximum
risk in each trade is 5% of the remaining account balance.
Hence, with the initial capital of $10,000, after losing 5% (i.e. 5% x $10,000 = $500) in the 1st trade, the balance will be $9,500. Then, the 2nd trade will risk 5% of the remaining balance (i.e. 5% x $9,500 = $475), the balance will be $9,025, and so on.
Using
this rule, to answer the above questions is not that straightforward. However,
this rule is more common to be used by traders.
Hence,
let’s try to formulate it.
Trade 1: $10,000 x (1 – 5%) = $9,500
Trade
2: $10,000 x (1 – 5%) x (1 – 5%) = $10,000 x (1 – 5%)^2 = $9,025
Trade
3: $10,000 x (1 – 5%) x (1 – 5%) x (1 – 5%) = $10,000 x (1 – 5%)^3 = $8,573.75
Trade
n: $10,000 x (1 – 5%) x (1
– 5%) x (1 – 5%) x …… = $10,000 x (1 – 5%)^n
Putting in a formula form:
Where:
C = Initial capital (Initial account balance)
R = % Risk for each trade
n = Number of trades
B = Remaining capital/account balance
To answer the above two questions, we need to solve n, which can be done through the basic principles of logarithm, as follows:
Please note that, to answer Qtn 1, we CANNOT set the remaining account balance as zero, as logarithm function will never touch zero line. Hence, we should assume a certain amount, which is small enough and can be deemed as “no more money for trading”.
For example:
Assume
we deem $100 as small enough to approach a situation of “no more money for
trading”.
Continue
with the above case, the values of each variable are:
C = $10,000
R = 5%
B = $100
To find how long the capital can last, we solve n:
Note: Always round down the result.
Likewise, to answer Qtn 2 where the risk tolerance is 25% (i.e. 25% x $10,000 = $2,500), the values of each variable will be:
C = $10,000
R = 5%
B = $10,000 - $2,500 = $7,500
Solving n:
Alternatively,
we can also use another method to answer the questions, which is using
Tabulation, as what has been done in the previous article:
Using this way, after inputting the formula in MS Excel accordingly, we just need to “drag the row” to copy the formula until we reach the desired account balance.
From
the above table, the answer for Qtn 1 is highlighted in yellow, whereas the
answer for Qtn 2 is in green.
For reference, the following are the formula used for both methods:
Go back to: Things To Consider in Setting
Money Management Rules – Part 2: RISK TOLERANCE
To view the list of all the series on this topic, please refer to: Money Management / Position Sizing
