Bad Money Management

In my last post I said I was going to talk today about win/loss ratio and risk/reward ratio. However, I started thinking about something that ties in with the last post which talks about the emotions of greed and fear in connection with money management. (You can read the last post here: Trading Money Management Greed And Fear). It has to do with 2 bad money management strategies I do not recommend: Martingale System and Kelly Formula.

When you are creating your trading system, you should be thinking logically and methodically plan out how you want to trade. Since we are human, emotions like fear and greed cannot be eliminated completely. But when calmly creating your system, you should not let emotions like fear and greed dictate your decisions.

I know a lot of people reading this blog are interested in automating their trading strategy with the hopes of eliminating emotional trading. After all, an expert advisor does not have emotions and will trade exactly as programmed. Just make sure you are not programming in strategies based on the emotions of fear and greed.

Don’t program fear and greed into your automated trading system.

2 Bad Money Management Strategies I Don’t Recommend

Since money management is arguably the most important part of your trading system, I want to go over strategies to avoid. Besides being risky, these strategies are based on the emotions of fear and greed.

The Martingale System

The Martingale System is derived from a betting system where you double your bet after each loss. The theory is when you eventually win, you win back all your losses plus a small gain. Here is an example…

Let’s say I place a bet for $1 and lose. The next bet would be for $2. If I lose again, the next bet would be for $4. If I win this bet I make $4, which covers the $3 in previous losses and makes me $1. Sounds great, right?

The problem is, an eventual losing streak puts more and more of your money at risk for very little reward. Since your trading account is not infinite, it is only a matter of time before you are risking a large part of your account on one trade. This is not a smart way to trade.

In my opinion, the Martingale System is based on fear. People do not like to lose and have a hard time handling loss emotionally. In theory, using the Martingale System is a way to alleviate the fear of loss by quickly recovering your losses and going into positive again. (Basically, you only have to feel the pain of loss until the next trade where you win back all your losses and make a small profit).

But what happens when you have a string of losses? The fear and pain of loss is magnified with each new loss. So, instead of reducing the fear of loss, the emotions involved in your trading increase with each new trade. In the end, your trading is dominated by emotions, which is not a smart or healthy way to trade.

The Kelly Formula

The Kelly Formula is a statistical, mathematical formula developed by Bell Laboratories in the 1950’s. That’s right, this formula had to do with long distance telephone calls. However, any formula that can be applied to gambling or trading soon will be.

old-telephone

The Kelly formula came from engineering work at Bell Labs.

To use the formula there is some statistical information you need to know about your trading system.

  • Percentage of winning trades (W).
  • Ratio of average gain of winning trades in relation to average loss of losing trades (R).

Here is the shorthand of the formula: Kelly % = W – [(1 – W) / R]

Now, I’m going to be honest with you. This is already too complex for me to even consider using as my money management strategy. But the real problem is, depending on the numbers you plug into the formula, it is very easy to get percentages of over 20%.

There is no way I would ever recommend risking 20% or more on any given trade. And the only reason I can see to do such a thing would be greed. People using this formula want to figure out the maximum they can risk on a trade so they get maximum returns.

In my opinion, focusing on maximizing your winnings is not the way to survive as a trader. A good rule of thumb is to focus on minimizing your losses instead. I don’t care how mathematically sound the Kelly Formula might be… trading from the standpoint of greed is asking for trouble. Even if using 20% of an ever decreasing account balance never blows out your account completely, this is not smart trading.

Here is the point…

I think money management strategies like Martingale and Kelly are based on emotions. Martingale wants to lessen the fear of loss by quickly allowing you to recoup your losses and go into positive. Kelly wants to maximize your profits specific to past performance so you don’t leave profits on the table. The problem is, real trading is unpredictable and in both cases the wrong circumstances can lead to substantial and quick losses. Plan for the worst and hope for the best.

If you automate your trading and program in money management strategies based on emotions like fear and greed, you entire trading will be corrupted by emotion. The expert advisor will trade as programmed, bad money management included.

If you have any experience with either the Martingale System or Kelly Formula, please leave your comments below.

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