Money Management - The Holy Grail Of Trading

Money management determines how much to risk on each individual trade. This is a vital element of any trading system - risk too much and the chances of going bust are too high, risk too little and the reward for trading is too low.

The main methods for calculating trade size are:

Fixed Fractional

The number of contracts to trade is determined by a fixed percentage of current equity. As only whole futures contracts can be trade this, effectively, means that the trader uses 1 contract per $x of equity. For example 1 contract per $10,000.

Fixed fractional, however, requires unequal achievement at different contract levels. For 1 contract every $10,000 to move from 1 contract to 2 requires a profit of $10,000 from 1 contract. To move from 10 contracts to 11 still requires $10,000 profit but from 10 contracts. So for smaller account sizes it will take a long time for the money management to actually kick in and for larger account sizes the number of contracts traded will jump wildly around.

Using fixed fractional the number of contracts traded would be calculated as equity/x, where x=dollars per contract ($10,000 in the above example).

Contracts - Equity Required $

1 - 10,000

2 - 20,000

3 - 30,000

4 - 40,000

5 - 50,000

6 - 60,000

Fixed Ratio

Fixed ratio adds a variable to the fixed fractional method.

Fixed ratio adds delta to the calculation. The delta is a factor which is required to move to the next contract level. The lower the delta the more aggressive the money management is.

The formula is:

equity required to trade previous contract size + (number of contracts x delta) = Next level.

Eg starting with a base of $10,000 for 1 contract and a delta of $5,000:

Contracts - Equity Required $

1 - 10,000

2 - 15,000

3 - 25,000

4 - 40,000

5 - 60,000

6 - 85,000

Comparing the above table to that for fixed fractional it can be seen that at the lower account levels less equity is required whereas as the account grows the number of contracts traded becomes less aggressive.