Re: [TheOptionClub.com] Re: Money Management

 

Sorry for the delay but I just caught up with email.

To paraphrase Bennet A. McDowell's "A Traders Money Management System";

Optimal f formula calculated the optimal fraction of capital to be risked.
The formula was originally developed by John L. Kelly Jr.  of Bell Labs in the early 1940's. Edward O. Thorpe in "The mathematics of Gambling" modified the fixed fraction formula to account for the average payoff ratio, A, in addition to the average probability of success .
This was further defined by Professor Nauzer J. Balsara for determining the Optimal fraction f, of capital to be risked on a trade.

f = Optimal fraction (%) to be risked on one trade
A = average payoff ( $ earned to $ lost)
p = average win ratio

My current belief is that the market is random but like chaos, the underlying structure can be observed. Our job as traders to to overlay structure unto the unpredictable market. The better the structure, the more uniform and consistent our effort the better. Its not much different from highly diciplined approach to training professional athletes. Unfortunatly we can't just use a stop watch and count sets to measure trading performance. The brokers don't make it easy as they don't want to make their fees to obvious or demonstrate how quickly capital can be lost. So I try to keep it simple utilize very few strategies and limit them to few equities. I am not where I want to be in measuring performance nor yet at my goal but I am on track to getting there. Understanding what worked and why provides immediate feedback to optimize & refine strategies / methods.

I am looking for someone skilled at software programing to assist in co-developing a performance tracker and other tools supporting option trading, if your interested please email directly.

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From: derry_nz <derryb@gmail.com>
To: OptionClub@yahoogroups.com
Sent: Mon, March 1, 2010 5:34:00 PM
Subject: [TheOptionClub.com] Re: Money Management

 

@Migo1

It would be a lot kinder for the other readers to provide an explanation for the formula rather than suggest a mediocre education as a result of not understanding it. I don't understand the formula you have presented but this fact is yet to hinder my trading.

The common way to calculate expectancy is as follows:

Expectancy = (Probability of Win * Average Win) - (Probability of Loss * Average Loss)

There are two big problems with trying to calculate expectancy however:

1. Statistics for the formula

Statistics to calculate expectancy must be taken from only one strategy at a time and the strategy must have clearly defined rules. Most people trade several different options and stock strategies in their account making it difficult to separate them out. Furthermore very few people have clearly defined rules for their trading strategies and those that do usually lack the emotional intelligence to adhere to those rules making the statistics irrelevant.

2. Market action does not fit into a bell curve

Even with a long track record or success in back testing through extreme market conditions the market has a tendency to break the mold far more often that would be reasonably expected. Many Quant funds discovered this the hard way in 2007 during the subprime meltdown. Prices began to ‘misbehave’ and events that models predicted would happen once in 10,000 years happened every day for three days. Despite having a 'positive expectancy' many Quants were brought to their knees.

There are options strategies that have a high probability profit but on rare occasions suffer big losses that can claim back several years of profits. Unfortunately these rare occasions tend to be uncomfortably frequent.

The most important consideration when it comes to money management in my opinion is to ensure that you have the ability to endure a STRING of 'Worst-Case- Scenario' trades and still recover your account.

Cheers
Derry
http://etfhq. com/

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