In this article we would like to draw your attention to the money management part of trading.
Most probably, the technique you will have heard most authors mentioning is the so-called "Fixed Fractional" position size. This technique basically risks a fixed percentage (hence the name Fixed Fractional) of the account's equity (although some authors also apply it to the account's balance). In order to explain the reasons why we do not use this technique we will start by listing its pros and contras:
- One interesting artifact of the Fixed Fraction model is that, since the size of the trade stays proportional to the equity, it is theoretically impossible to go entirely broke so the official risk of total ruin is zero. As an anti-martingale technique, it is designed to accomplish the preservation of one’s capital for as long as possible.
- The compounding effect kicks in every time you have a winner. By using this method the position's size is gradually increased when winning and decreased when losing. Increasing the size of positions during a winning streak allows a geometric growth of the account (also known as profit compounding); decreasing the size of the trades during a losing streak minimizes the damage to the trader's equity.
- At lower percentages of equity risked, a winning or a losing streak simply does not have a spectacular impact on the equity curve. This results in smoother capital appreciation (and much less stress for the trader or the investor). This is because, when you risk small fractions of your equity (up to 3%), each losing trade is given less "power" to affect the shape of your equity curve which leads to smaller Drawdowns and consequently greater ability to capitalize on the winning signals in the future. In other words, the size of Drawdowns is directly proportional to the risked percent.
- By risking the same proportion with any strategy, you can end up winning even if some strategies on higher time frames lose money. This has been our case last month. The Spread Reversion 30M strategy kept winning, but it was not able to compensate the losses from the more longer-term Extreme Volatility 4H. Because those losses exceeded in pips, the absolut result was a loss.
- If you have a small account balance you are forced to work with a lot size which doesn't help in fine sizing the positions.
- If a large loss exceeds a certain amount and the risked percentage is now less than the smaller lot size, the trader is forced to break the risk rules just to trade the minimum allowed lot size.
- This model will require unequal achievement at different size position levels. This means that every time you want to increase the position size it may require you to produce a high return before you can increase the trade size from one lot to two lots- otherwise you would be risking too much. So for smaller account sizes it will take a long time for this money management to actually kick in.
- The pip value is not the same among FX pairs. To be accurate with this technique you need to perform several calculations per each trade.
- Related to the above is the fact that when the system being used is applied on different timeframes- and therefore different stop loss distances which are needed in the formula-, you can end up having a positive pip amount, but a loss in absolute USD or EUR terms. In other words, a 200 pip win in a 4H strategy, could have the same absolute value as a -20 pip loss with a 30M strategy.
The FXStreet Signals service uses more than 40 currency pairs and multiple strategies with different time horizons. Because of this distinctive characteristic, the chosen money management model is a so-called "Fixed Lot" positioning. With the Fixed Lot model, you set the number of lots you would like to trade per position. No matter how much your account balance or equity curve oscillates, you will still trade a fixed number of lots per position.
These are the advantages and disadvantages to consider:
- It's easy to manage and understand because of the consistent lot size.
- It allows profits to grow arithmetically - that is, by a constant amount per time period. It is useful, for instance, if you withdraw your profits after each month of trading, starting anew with the same capital. Some traders perform poorly if their accounts start to grow exponentially - finding in this model an ally for their trading style. Others just prefer to trade with a large account and withdraw profits regularly - not aiming at growing the account.
- For smaller account sizes it can take a shorter time for this money management to actually kick in, just by setting up a fixed lot size accordingly to your risk profile.
- It does not provide an ability to maintain a constant leverage as account balance shrinks and rises. This can lead to big Drawdowns since during a string of losses the leverage increases with each new trade.
- Another drawback of this model is that by trading the same position size on any given trade, you will soon find out that the trading results are very much dependent on the system's profitability, while the purpose of adopting a money management technique is to control the risk during consecutive losses and take the most of a system during winning strings.
- Each withdrawal from the account puts the system a fixed number of profitable trades back in time. Therefore, this may not be the best model to trade if you pursue efficient growth in your trading account.
Summarizing: when trading with multiple pairs and different time horizons you need to simplify the position size calculation. For this reason, the Fixed Fractional model is not the easiest of the techniques available. On the contrary, the Fixed Lot model, simplifies the process a lot but it lacks some dynamism to take the best off your system's run ups. In a future article we will see other variations of these money management models to work with.