Money Management and Discrete Nature of Trading
Realizing what to trade and when to trade is the key to successful trading. Because nobody can know a potential profit strategy in advance, losing money is an inevitable part of trading. It then becomes very important to decide how much money to allocate to each trade. This question addresses the issue of money and risk management and is found in many of the familiar writings of Ralph Vince (1992, 1995), Ryan Jones (1999), and Larry Williams (1979, 1999, 2000). While money and risk management are important for trading any financial instrument, we will continue to focus on trading futures contracts. My particular interest in this chapter is to identify the optimal allocation of money for each trade and to recognize the discrete nature of the allocated amounts.
Let me introduce the notation that will be used throughout this chapter and discuss the underlying concepts.
N, W, and L: N is the total number of trades in a specific sequence. Some of them win (profit and loss [P&L] > 0), others lose (P&L < 0), and some will break even (P&L = 0). W is the number of winning trades. L is the number of losing and breakeven (P&L = 0) trades. By including breakeven trades in the count of losing trades, we avoid thinking that we have a successful system simply by having no losses. Then N = W + L. As N grows because more and more trades are completed, the ratios W/N, L/N, and W/L will become more stable and fluctuate around ...