There are a lot of ways to implement money management (MM) to reduce risk. Some even believe that finding a system that is able to be right 100% of the time means that they can all together forget the MM.
From my own little research I have come up with the following ways to reduce risk…
1. exit strategies (hard stops, trailing stops, etc)
2. trade filtering (trade in direction of trend)
3. position sizing (fixed fractional, optimal f, kelly criterion, etc)
4. diversifying across markets (modern portfolio theory, or ranking on relative strength)
5. diversifying across systems (uncorrelated systems)
Opinions differ in terms of the importance of the above techniques but they all to a certain degree reduce risk significantly if paired correctly with a system.
It is to my realization lately that I have been focusing on too much on the entry side of the market. My excuse being that I am in search of a trading system that will complement my TF system. I have decided to take a step back and improve my existing TF system. The current TF system is a breakout model paired with a common trend filter. The system is good in that it is not curve fitted, but the MAR ratio (CAGR/MAX DD) currently 1 on the dot, can be improved if I focused more on the risk management side.
I have been fortunate to be able to talk to Mr. Bob Spear regarding trading and achieving success in system development. He has many years of experience in the subject and currently a professional money manager. He has time after time suggested that the position sizing is really what I should be gunning for in terms of improving my systems.
Giving more thoughts on the subject in general, I felt that position sizing alone really seems to be more important than many of the risk control measures numbered above. The reason being that it is a holistic approach to controlling risk system wide with the ultimate aim to bet less on losers and bet more on winners / bet more aggressively on strong equity growth compared to periods of mininal growth / betting no more when strategy exposure exceeds x% of equity…etc. When I mean holistic I mean that it achieves risk control by incorporating what the other numbered techniques (above) also try to do.
Having thought about it for a few weeks, I have found that position sizing is most commonly a function of risk. While most traders tend to implement a common % capital risk for each trade, I went on to ask whether it is possible to make position sizing as a function of more variables, ie equity growth rate.
Idea: bet more aggressively when account equity gets bigger and less when its small.
The idea is not new and I came across it in a archive called “purebytes” ( I strongly suggest traders read stuff on there; its got amazing material). Anyways, the above idea seems troubling as your bet sizing does not adjust downwards on equity drawdowns cutting deeply in to your hard earn profits.
Heres my solution….have an equity growth look back period of let say 6 months. If it is greater than some percentage you increase your bet size by half of the mean average return of the last 12 months. On the other hand if the last 6 month return is negative adjust bet size downwards by the mean average return of the last 12 months. With this your bet-sizing algorithm, you bet more while the equity growth is upwards and less when its downwards. This algo can be an addition to a volatility based sizing or others like % capital; its all depends on your creativity.
This is a new idea i think? Enjoy…