Money management is the most important aspects of trading but unfortunately the one aspect traders spend the least time thinking about when trading. The choice for the right indicator or chart pattern or the right system seems to be more important then the choice about the right amount to invest and the right amount to risk. Money management decides about the performance of two identical systems or trading approaches and the difference between those trading with a proper money management and those trading without can be huge. The decision to implement a money management systematic has to be made before entering a trade.

All of the money management strategies that can be applied to trading are anti-martingale methods – as an account increases the amount at risk placed on trades also increases. As the account decreases the amount at risk will also be decreased. Using an anti-martingale risk management scheme will increase profits during time periods when a trading approach is working well, while automatically decreasing exposure during portions of the cycle where trading is unprofitable.

I will illustrate the use of two different money management strategies and the absence of a money management strategy based on our GBP Daily trading systems with a beginning balance of 25,000 USD.

No Money Management

Every signal of the trading system will be traded with 1 lot only. Therefore the risk reduces with an increasing account balance. This strategy obviously produced the smallest net profit and with -6.19% the smallest drawdown as percentage of net profits.

Fixed Fractional Trading

Out of the many money management strategies under the fixed fractional methods available, like optimal f, 1 contract per 5,000 USD net profit or 2 percent risk per trade, I have chosen a more common method in forex trading – a fixed leverage of 10:1 based on the account balance adjusted for the GBPUSD exchange rate. Only full lots are traded with a minimum of 1 lot, a lot size of 100,000 and rounded down to the next full number. The formula to calculate the appropriate lots size is as follows:

N = Account Balance x Leverage / Exchange Rate x Lot Size

A 100,000 USD account based on a GBPUSD exchange rate of 1.99 would therefore trade 5.03 = 5 lots.

This method produces a much larger gain and with a -12.87% drawdown as percentage of net profits the highest proportional risk.   

The problem with a fixed fractional approach is that the first increase in the amount of lots occurs relatively late as only one lot needs to produce the additional profits whereby towards the end the same amount of profit is generated by a much larger amount of lots traded, reducing the required amount per lot.    

Fixed Ratio Trading

The fixed ratio method was first published by Ryan Jones in his book The Trading Game. This methodology uses an approach whereby the amount required for the next increase in contracts increases exactly proportionally to the number of contracts. The formula to calculate the amount of lots is as follows:

N = 0.5 [1 + (1 + 8 x Net Profit / Delta) ^ 0.5]

Delta is the constant that defines how much additional profit per lot traded is required for the next increase. In our example we used a delta of 5,000 USD. Again only full lots are traded and the results are rounded down with a minimum of 1 lot.

This money management approach produced the highest net profit with a smaller drawdown as percentage of net profits. All results can be seen in the table below and the individual performance reports can be downloaded here.