Bad money management will crush a good system.
A big variable affecting the future performance of any system is money management. It is a major factor in properly implementing any trading system. There are many excellent books devoted just to this subject.
We begin by calculating the risk of ruin for the values you will meet during system testing. The data in the literature do not extend down to the range covered here. The risk-of-ruin calculations assume that your probability of winning and payoff ratio are constant. Since these values change from time to time, the risk-of-ruin calculations are simply for guidance.
We then study an example of the interaction between system design and money-management rules, and the effects of using fixed or variable contracts with a typical breakout system. We then expand on the theme of projecting drawdowns using the standard deviation of monthly equity changes. An out of sample test will convince you that it is reasonable to project future drawdowns with this method. It is very useful to have a reasonable projection of future drawdowns because it helps you pick a suitable equity level for a system.
Lastly, we will see how changing bet size affects the equity curve. For a given system, you can change the smoothness of the equity curve by how you alter your betting strategy.
After reading this chapter, ...