Money management

The phrase covers the size and exposure side of a trading approach rather than the analysis side. Where analysis addresses which instrument and which direction, money management addresses how large, how many positions at a time, and how the answer changes as the account changes. The two are independent: the same analysis at two different sizes produces two entirely different sequences of account balances, and the arithmetic of that is not a matter of opinion.

The conventions in common use are few and each is a bounded rule rather than a finding. Fixed fractional sizing takes the distance between an entry and a stop level, and sets position size so that the loss at that stop equals a small stated fraction of account equity, which makes the size fall as the account falls. Fixed size does the opposite and leaves it constant. Exposure caps limit how much of the account can be committed at one time, and correlation caps limit how much of it can sit in instruments that move together, which is what a portfolio heat measure counts. Formal sizing rules such as the Kelly criterion derive an optimal fraction from an assumed win rate and payoff, and are sensitive enough to errors in those assumptions that practitioners who use them usually apply a fraction of the result.

Two things are widely misstated about the whole subject. The first is that a sizing rule limits a loss: a stop level is an instruction that becomes an order when a price is reached, so in a gapping market the resulting fill can sit beyond it, and in a margined position losses are calculated on the full contract value and are not limited to the amount deposited. The second is that the arithmetic of recovery is symmetric. A given percentage loss requires a larger percentage gain to return to the starting figure, and the gap between the two widens as the loss grows, which is the reason drawdown is measured as a percentage rather than in currency.