The Art of Money Management Part 2: Main Methods

The Art of Money Management Part 2: Main Methods



In the first part of the article, we discussed the idea of money management, its history, and its rules. In part 2, we will look at the most popular models of money management.

Few will argue that one of the most vital elements of a trading system is the one signaling the direction of the opening position. Apart from this, money management helps use for trading the part of your deposit that is most optimal for reaching your goal, according to your trading plan.

Each of the models discussed reflects the most frequent approaches of traders to money management. We will have a look at both the advantages and drawbacks of the systems. The most experienced and skillful traders sometimes mix these models, however, only in compliance with their trading strategies.

Methods of Money Management

Methods of Money Management

Now we will analyze the most popular methods of money management, which are generally accepted. So, first things first.

Trading the whole capital

According to these tactics, each trade is carried out with a maximum possible number of lots (volume of the lot). The trader is counting on the current or soon expected strong movement of the market, entailing a quick increase of the deposit.

Pros

The profit here can be the maximum possible, depending on the deposit. In other words, the bigger the deposit, the larger the volume of the position opened, hence, the bigger the profit made.

Cons

The other side of the medal is an equally high risk. In the case of losses, the deposit reduces as quickly as possible, especially bearing in mind that any trading strategy features a virtually 100% possibility of receiving a loss. With such money management, the very first loss will make null and void any number of "achievements". Thus, such a method applies to strategies with a very high mathematical expectation, a high profit level, and a low risk level.

Fixed lot

This approach is the simplest and most popular method of money management. The idea is to choose a fixed lot volume for your positions. All positions are opened with a constant number of lots, set in advance (i.e., 0.1 or 1, 2, 3, 5 or 10 lots regardless of the income of the previous trader, the current size of the deposit, or other trading characteristics).

Pros

This is a simple and easy-to-use system, in contrast with the previous one (both in the sense of decreasing and increasing the deposit); the larger the deposit, the smaller the risk.

Cons

A drawback (in the basic variant) is a lack of some reactions (by definition) to changes of the deposit size: if it becomes too small, the lot and, thus, the risk may be too high; if the deposit becomes larger, the lot, on the contrary, may become too small, decreasing the profitability. As long as the size of an earned or lost point remains the same, the return on your time and effort spent does not change much (as long as you do not change the settings).

Fixed deposit share

Each time, opening a trade, the trader chooses the size of the lot in such a way, that in the case of a loss, the latter will amount to a certain part of the deposit. The size of the Stop Loss is always taken into account when calculating the lot. The classical way of conservative trading suggests a normal loss of 1-2% of the deposit. In the case of aggressive trading, losses of up to 10% of the deposit are allowed.

For example, before opening another trade:

  • A) the trader calculates a certain sum that they are ready to risk. If our current depo is $25,000 and our fixed percentage is 10%, we can open a position that will risk no more than 10% of $25,000, or $2,500.
  • B) the sum you get in point A) should be divided by the size of the Stop Loss (in money) for the minimal lot (which is 0.1). For example, if for 0.1 lot of the GBP/USD the price of a point is $1 and the initial SL of the trade is, say, 50 points, for this minimal lot the SL will "cost" $50. Dividing $2,500, received earlier, by $50, we get 50 — this means that in the nearest trade we can open a position sized 50 micro- or 5 normal lots. In such a situation, with the price of a point being $50 and the SL 50 points, we cannot lose more than 10% of the depo at once (50 p. * $50 = $2,500).

Pros

This system is rather easy to use. The size of the position is in proportion with the size of the depo. What is more, the profit earned is automatically included in the calculations for the next trade; conversely, in the case of a loss, the lot decreases proportionally. The risk remains the same all the time.

Cons

Having suffered a loss of N points, you will need to make a profit larger than N to compensate for the loss. If the starting depo is rather modest, it may be impossible to work with a small fixed share, which seriously enhances the probability of losing everything. The decrease of the % of risk proportionally decreases the size of the maximal slump, however, several other parameters, including the profitability, decrease not proportionally. Sometimes it turns out to be impossible to open a trade of the very same size that would comply with the maximal acceptable risk.

Gradually increasing the lot

Let us explain the idea on an example. Imagine the trader's deposit is $10,000. The initial lot volume they are going to trade is 1. Earning $2,000 every next day, the trader increases the lot volume by 0.2. Accordingly, when the depo grows to $12,000, the entrance will be with 1.2 lot, when the depo is $14,000 — 1.4 lot, etc. If the depo decreases, the lot volume can be proportionally decreased the same way.

Pros

This method is simple and clear and does not require any mathematical calculations, what is more, it keeps track of the deposit growth.

Cons

In case the SLs are different, the system will give different losses (as the percentage of the deposit), same with different TPs.

Martingale

Martingale

It should be specifically mentioned that Martingale is not a strategy, as beginners usually think, but a money management method; it creates an illusion of a profitable strategy though in most cases it leads to a loss.

The idea is as follows: each time when a trade is closed with a loss, the next trade is opened at the size of the previous one multiplied by a certain coefficient (usually 2). Thus, if the trade is profitable, it will bring a profit and compensate for the previous one.

This method is also known as the method of suspended loss

Pros

The probability of the trade (series of trades) being successful is high as there are no loss limits.

Cons

The probability of losing the whole depo is also high.

Antimartingale

This method is a reversal of the previous one. Each time we make a profit, we increase the lot volume, while when we suffer a loss, we decrease the volume to the initial size.

As with the Martingale method, Antimartingale does not show any positive mathematical regularity.

Half-martingale

The idea is that after each losing trade we increase the lot by a certain value and after each profitable one — we decrease it. This method has a weak point: if the lot volume remains near its initial values, you make money, while if you receive several losing trades in a row, your depo may turn out not enough to open a new trade. In the case of a profitable series, the lot volume becomes too small, which significantly cuts down on the profit.

You can compare the methods of money management when you have a thoroughly tested trading strategy: otherwise, you will simply not know what is malfunctioning - your money management method or your strategy. All methods have their pros and cons, however, we are interested in the most stable one. Under stable here we mean the one that provides conditional smoothness or steepness of the deposit increase line.

Summary

  • A money management system is obligatory in the presence of a profitable trading strategy
  • All methods that do not account for an increase of capital lose efficacy with time
  • All multiplicator models (Martingales) are prone to intermittent movements, which is a sign of instability.

Speaking of the choice of a money management method, if you are working for a perspective, choose the fixed share or gradual increase of the lot volume. However, the former may be tiresome due to the calculations while for the latter you can create a table once and work by it.

Profitable trading to all!



Left unedited for writing style, spelling or punctuation.


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