Choosing an effective capital management method

The first question a trader or investor should ask himself before he opens trading platform should read: "what loss can I afford in my next transaction?"

In the following article, I will present a few approaches to this important and often overlooked by beginners trading concept.

What is capital management?

When we think of trading, we always only imagine profitable trades and continuous deposit growth, but never take into account a very important nuance - losses. As you know, losses are inevitable in trading. Any experienced investor can tell you that losses are normal and the best thing we can do is limit them.

Money management is a strategy for managing the size of positions on the investor's account. Simply put, capital management determines the size of the position with which to open the next transaction. MM is usually used to achieve a smooth deposit increase and thus reduce losses as much as possible. Of course, money management cannot affect the success rate of a transaction, but it can significantly reduce potential losses in a series of lossy transactions.

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However, this is only a theory. So what do we have in practice? The answer is that most traders focus mainly on finding market entry and exit points, and the role of capital management is given secondary importance. Basically, they do it well because capital management is not capable of turning a losing strategy into a profitable strategy, but if you do make money - effective and informed money management will be a key part of your investment decisions.

Below is a short presentation of the most popular methods of capital management. Let's try to choose the most effective.

• Fixed position, lot size.
• Fixed deposit percentage.
• Gradual increase in position size.
• Martingale.
• Reverse martingale
• Half martingale.

Fixed size

This is probably the easiest and most popular (not to be confused with the best) MM method.

The thing is simple: we must choose a fixed size for our items. All subsequent transactions that we intend to open will have exactly the same predetermined volume, regardless of size Stop Loss and Take Profit.

The advantage of this method is its simplicity and the fact that it is user-friendly and good for any novice investor.

The disadvantage of this money management method may be the total lack of money management.

Also, when your deposit is increased, you'll enter the market with too little, thus losing the potential of your trading strategy. However, this method is sufficient for most traders, because there is usually no "increase in their deposits." These are sad statistics.

Fixed deposit percentage

This method is slightly more interesting. Every time you open a transaction, you adjust the size of the position in such a way as to lose a certain percentage of the deposit in the event of a wrong decision on the market. The size of the order Stop Loss (SL) must be taken into account when calculating the size of the item.

It is accepted that traders usually accept losses of 1-2% of their deposits during conservative trading and up to 10% during aggressive trading.

The advantage of a fixed percentage is that it takes into account the increase in deposits, as well as the payment of "pillows" as a result of a series of lost transactions.

However, this method has some disadvantages. If the number of profitable and lossy transactions is the same, our account bears a loss. To understand this example, it is a good idea to read the table above. In addition, most traders do not use this method, because they constantly have to calculate the size of the transaction, which is often around 0,7645 lot. You will agree that it is much easier to round to 0,8 and not hinder yourself.

Gradual increase in position size

Corrects defects in two previous money management strategies. The main assumptions of this method can be explained by an example. Let's assume that our deposit is PLN 10 and the initial size of the position from which we intend to trade is 000 lot. Every time our result is PLN 1 "forward", we should increase the size of the position, for example by 2 lot. Therefore, when the deposit amount increases to PLN 000, we will enter the market with a position of 0.2 lots. When our deposit is PLN 12, we will open 000 lot positions, etc. The position size can also be proportionally reduced in the event of a loss of part of the deposit. This method is simple and user-friendly and does not require any mathematical calculations, in addition, it takes into account the increase in the value of our portfolio.

Its disadvantage is that it will cause different losses as a percentage of the deposit when using different Stop Loss and Take Profits (TP) orders.

martingale

The basic assumptions of the method are as follows: each time the transaction is closed at a loss, we open another transaction of the same size as in the previous deal multiplied by a specific factor (the ratio is usually 1,4-2). So, if the transaction is profitable, it will allow you to earn money and recover losses from the previous one. In the example below I used the factor 1.4.

There is another name that reflects the idea of ​​this strategy a bit more - the "deferred loss method". This means that you will still lose money, but worse still, the size of your last martingale loss transaction = 100% of your deposit.

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Its advantages include the high probability of a successful trade (or a series of successful trades) due to the fact that Stop Losses are not applied. In turn, the disadvantages of the above strategy are obvious - high probability of losing the entire deposit.

Reverse martingale

The method is the reverse of a classic martingale. Every time we make a profit, we should increase the size of the position. If we incur a loss, we should return to the originally determined position size.

Using this method, we mainly expect a very successful and profitable series of transactions. The method is likely to succeed, but only if the initial deposit is significant.

The above method, like the previous one, does not show any positive mathematical regularities.

Half martingale

It consists in increasing the size of the position by a certain value each time we post a loss and reducing it for each profitable transaction.

Interesting in this method is that it generates a positive balance using mathematical regularity. Unfortunately, only if the size of the position is close to that of the initial phase of the strategy. If the time comes when most trades lose, the trader simply lacks capital to open a new position. The size will be too small for a profitable series that will significantly "lower" profit.

All presented methods have their pros and cons. We are interested in the most stable Money Management method. A stable MM strategy is one that can be represented using the chart below:

Graph 1, MM curve. Source fxssi.com

In this case, the stability of the strategy is reflected in the smoothed line, and the curve of the line is responsible for capital growth. Therefore, the best MM should be close to this line.

Summation

Lack of capital management understood as a fixed position size is a good choice only in the early stages of trading. If our strategy is profitable and stable in the long term, we should opt for more advanced methods Money Management. All strategies that do not take into account capital growth will lose potential in the long run. All techniques based on martingale are subject to jumping movements, which is a strong sign of instability. Thus, a constant percentage and gradual increase in the size of the position seems to be the best approach in capital management.