Introduction to Money Management (MM) -Optimizing Position Sizing
Money management can be defined as the process of achieving risk control by avoiding over-leveraged positions. Money management is a key component of every portfolio towards long-term trading success.
The Importance of Position Sizing
The right position sizing is the epitome of an effective Money Management. Deciding how much capital you should risk into each individual trade is very important in order to optimize risk control.
What is Position Sizing?
In general, position sizing refers to the aggregate volume of a trade position.
Position sizing (%) is the volume of a trade position as a percentage (%) of the total available capital.
Selecting Position Sizes
These are some key factors determining and optimizing position sizes:
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The Available Capital
First of all, you should adjust your position sizes based on the availability of direct capital.
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Risk Tolerance
All investors don't have the same risk tolerance, therefore, you should decide how much you can afford to lose, in total, during a certain period.
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Winrate combined with Reward/Risk ratio
The win rate affects the occurrence of losing streaks and the probability that you can lose money. The Reward/Risk ratio refers to the ability to make a lot of money on winning trades {check below for more info about why you should combine the Winrate and the Reward/Risk ratio}.
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Longer-Term Positions
The larger the time Horizon the more vulnerable you are to unexpected news and events, therefore, position trades (lasting a few months) incur more risk than swing trades (lasting a few weeks). The time horizon is even more important when opening positions with highly negative SWAP rates (the interest charges for holding positions overnight).
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Popular vs Unpopular Financial Assets
If you trade in short periods, you must always calculate the trading cost for opening any new position. Less popular assets suffer from limited liquidity and thus they are offered in high spreads between ask/bid. Don't overtrade assets that are offered in very high spreads. In Forex trading, there is a huge difference between the spreads of Major, Minor, and Exotic pairs.
The Reward/Risk Ratio (R/R)
The Reward/Risk ratio can forecast the ability of a trading system to earn money in the long-run.
Setting the Minimum Reward/Risk ratio
Trades with great Reward/Risk are generally better than other trades. As a minimum Reward/Risk Ratio you should consider 2:1. Don't execute trades offering less than 2:1 R/R and prefer trades with more than 3:1 R/R. Some say that this way of thinking is differentiating the sophisticated traders from all the others.
Let's see an example:
You execute 10 trades with R/R=5
(i) If you lose 8 of 10 trades and you have 2 winners, you still get your money back.
(ii) If you lose 6 trades and you have 4 winners, you double your initial trade position.
(iii) If you lose 4 trades and you have 6 winners, you triple your initial trade position.
Overall, selecting highly Reward/Risk trades means you can afford to make mistakes and still make a lot of money.
Reward/Risk Ratio -Tips for Avoiding Mistakes
First of all, calculating the Reward/Risk ratio of a trade position requires two price levels:
(a) A key support level that determines the stop-loss (if you go long, and vice versa if you go short)
(b) A key resistance level that will determine the take-profit (if you go long, and vice versa if you go short)
The Right Attitude
(1) If the above calculations don't match your desired Reward/Risk ratio then simply skip the trade. Tighten your stop-loss or widen your take-profit is the wrong way to trade. In other words, don't manipulate the Support & Resistance levels to achieve the desired Reward/Risk ratio.
(2) Calculate Support & Resistance levels at the right time-frame. For example, if you trade swing, calculate the S&R on the H4 and H1 charts, if you trade longer, calculate the S&R on the H4 and D1 charts.
(3) Don't use Fixed Stops and Fixed Take-Profit orders (many traders use a fixed stop of 50 pips without knowing why)
(4) Use pending orders to enter and exit trades. Professional traders use pending orders much more than market orders (pending orders count 70-90% of all opened positions).
The Win/Loss Ratio and the Win Ratio
The Win/Loss Ratio
The Win/Loss ratio refers to the total number of winning trades to the total number of losing trades. The Win/Loss ratio takes into account only the number of winners and losers and does not take into account how much profit was won or how much loss was lost.
The Win Ratio
The Win Ratio refers to the total number of winning trades to the total number of trades. For example, a 60% win ratio means that a trader won on 6 of 10 trades. The Win Ratio, as in the case of Win/Loss ratio, takes into account only the number of winners and losers and not the actual profit or loss.
Combining the Reward/Risk Ratio and Win Ratio
Combining the Risk/Reward ratio and the Win Ratio can provide a very useful insight to all traders. The Win Ratio indicates the occurrence of winning trades, while the R/R indicates the profit and loss potential of a trade position. The combination of these two variables can offer an objective way to measure the profitability of different trading systems.
For example, let's compare two different systems:
(A) The trading system (A) has a Win Ratio of 50% and trades with Reward/Risk 3:1
(B) The trading system (B) has a Win Ratio of 40% and trades with Reward/Risk 6:1
Although System-(A) has a greater Win Ratio than the System-(B), the System-(B) is considerably more profitable.
Market Correlations and Money Management
Since the financial crisis of 2007-2008, the global financial markets operate more than ever as a unified area of risk and return. Market Correlations refer to relationships between two or more financial assets and measure how similar two different assets move.
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a positive correlation means two assets move in the same direction
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a negative correlation means that two assets move in opposite directions
Correlations are expressed on a scale of -1.0 to +1.0, as follows:
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+1.0, two assets move in an identical direction, 100% of all times
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+0.0, two assets move in random directions
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-1.0, two assets move in the exact opposite direction, 100% of all times
Market Correlations and Money Management
Trading correlated assets in the same direction may lead to extremely high market risk. Therefore, it is wise to avoid trading simultaneously highly correlated assets.
The Strongest Market Correlations
These are the highest market correlations:
(1) EURUSD to GBPUSD (The strongest Forex Market Correlation +0.9)
(2) EURUSD to AUUSD and NZDUSD
(3) AUDUSD to the Gold Price
(4) Crude Oil to USDCAD, CADJPY, USDRUB, and USDNOK
(5) US Bonds Yields to USDCHF (USDCHF is inversely correlated to the US Bond Prices)
(6) US Stock Markets to USDJPY
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■ Money Management and Position Sizing
George Protonotarios
TradingFibonacci.com (c)