A trader\'s money management system

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c09 JWBK182-McDowell April 25, 2008 16:7 Printer: Yet to come

80 A TRADER’S MONEY MANAGEMENT SYSTEM

keep you in the game. (Also use example 4 to recognize when you have

reached the advanced trader level.)

Sometimes getting risk in line is as easy as reducing the percent of risk

you take on each trade and sometimes you need to focus on your win ratio

and the number of winning trades you have. Also, giving attention to your

exit points may enable you to significantly improve your payoff ratio. If you

are a trend trader, just staying in a profitable trend longer can boost your

bottom line. Get creative and let the math create motivation and see where

it leads you.

OPTIMALf FORMULA CALCULATES THE

OPTIMAL FRACTION OF CAPITAL TO BE

RISKED

This formula was originally developed by John L. Kelly Jr. of Bell Labs in

the early 1940s, and is sometimes referred to as theKelly formula. Edward

O. Thorp inThe Mathematics of Gamblingmodified the fixed-fraction for-

mula to account for the average payoff ratio,A, in addition to the average

probability of success,p. The figures you will calculate using this formula

are more aggressive than using the risk of ruin tables.

In his bookMoney Management Strategies for Futures Traders,Pro-

fessor Nauzer J. Balsara defines the formula for determining the optimal

fraction,f, of capital to be risked on a trade as follows:

f=

[(A+1)×p]− 1

A

In this formula, the following definitions apply:


fis the optimal fraction (percentage) to be risked on one trade.


Ais the average payoff ratio. (dollars earned to one dollar lost).


pis the average win ratio (probability in percentage of success).

Here is an example of the formula in use:


fis the unknown quantity (of the optimal percentage to be risked).


Ais an average payoff ratio of 2 to 1.


pis an average win ratio of 35 percent winning trades.

f=

[(2+1)× 0 .35]− 1

2

=

1. 05 − 1

2

=

. 05
2

=. 025

To get a percentage, multiplyfresult by 100.