Let’s continue talking about money management and it’s importance for trader.
In the previous post on this topic I’ve mentioned that fixed fraction and fixed proportion methods are simpliest methods for a trader. In the first case you define fixed amount of money you are willing to put at risk, in the second – you calculate it every time basing on your current cash size on your account.
Now let’s continue:

Optimal «f» method

This method is quite sophisticated and was developed by Ralph Vince and popularized by Larry Williams. Ralph Vince has written many books on mathematical approach to money management – you can find them easily on the web.
The main idea of this method is that trader should define ideal fraction for each trade according to some formula. Ideal fraction means that if formula tells you to put at risk 15% of your entire account, you have to do this.
For example, if you want to determine number of lots (shares) that should be traded for your position, formula will look like this:

N = (F * equity/risk)/price

F parameter is defined upon historical data. I will not talk too much about it. In my personal opinion, this method can’t be applied for practical purposes.
Putting 15-20% of account at risk assumes that we rely too much on historical performance of the market, but we know that too often it is not that easy. Current market conditions change and if you rely too much on the past, you might find accept too much risks.
But I’ve decided to include this money management method in my review for your education. If you want to know more about this, you can search the web for books of Ralph Vince.

Fixed ratio

As for me, much more interesting method is «Fixed ratio» money management method designed by Ryan Jones. We have been talking about methods that are not too complicated – «fixed fraction» and «fixed proportion». Fixed ratio is a bit more complicated but not too much.
In a nutshell, we are allowed to increase size of the position as our account grows, but not too quickly.
For example, if we earn 10% on our account, we may increase our lot size by 10%. If we then add another 10% and earn 20% to our initial deposit, we don’t raise our lot. We do it only when our deposit will grow 30%, then 60%, 120% and et cetera.
This is very brief explanation of the principle, but it makes sence because the more we trade, the more we increase probability of getting into drawdown, and if you simply increase our lot size in sync with our account size, we may experience large relative drawdown (lot size is increased and any losing streak will affect our account greater than before)

In other words, this method tell us not to be in hurry – to raise our lot size slowly. But of course, there is mathematical background beyond those words. If you want to know more about it, you can find book of Ryan Jones «The trading game. Playing by the Numbers to make millions»