MONEY MANAGEMENT
Dangers Of The True Optimal f
Do Equations Tell The Whole Story?
by Gordon Gustafson
Success in systems trading depends on having good trading systems and good money management practices. Optimal f can help you.
Once you have a good trading system, wouldn't it be wonderful if you had an equation you could plug into a system to discover the perfect amount to risk on each trade? All you'd have to do would be to plug the results into a risk calculation and relax, knowing that the chances of ever losing again were practically nil.
It's a nice idea. But the fact of the matter? Such equations could easily lead you astray.
OPTIMAL F
When it comes to money management, one of the most popular topics is optimal f. Based on the historical results of a trading system, optimal f defines the optimal fixed fraction of total trading capital that should be allocated to any particular trade in order to maximize the geometric growth of the account. Dividing this by the largest loss results in the number of contracts that should be traded. According to this rationale, if you bet more you will go broke, and if you bet less, you will stay poor.
Arguments made for the optimal f sound so positive - maximum geometric return! - you feel like a fool if you don't use it. Who doesn't want maximum account growth? Money management means devising a way to stay in the game. If there is a reasonable chance of going bust, then you need to adjust the amount of capital to trade lower. There will always be a chance of losing the account if you trade, but you should work to make sure the chances are small.
Figure 1: True optimal f. A really good system could actually wipe you out completely.
...Continued in the June 2002 issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the June 2002 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2002, Technical Analysis, Inc.