Money Management 101

One common question new traders have is, “how much should I risk?” As with anything like this, there are several different correct answers. We will go over a couple of them, but what it really comes down to is what works best for you.

Kelly Criterion

The Kelly Criterion is popular amongst gamblers where the outcome is able to be estimated with a degree of certainty. However, you might be inclined to brush this off because trading is definitely not the same thing as gambling. You shouldn’t do this, though. Kelly works great when you are able to approximate two different things–both of which are possible with binary options, and to a lesser extent, other types of trading. For this to work, you need to be able to know what kind of returns you stand to earn, and what the likelihood of that happening is. You plug those numbers into a formula, determine how much money you will be setting aside for trading, and then an exact dollar amount will be given to you to risk on a particular trade. It’s perfect for binaries, and a lot more difficult (but still possible) for other types of trading.
Manage and be Safe
Let’s say you are looking at a trade where you know you will earn 76 percent if correct, and you think the trade has a 65 percent chance of going your way. You plug the numbers in to the Kelly Criterion and see that you should risk 18.9 percent of your bankroll. Here’s the math:

((0.76 x 0.65) – (0.35)) / (0.76)

You take your returns–in this case, 76 percent, multiply it by your probability of being correct (65 percent), subtract that number by 100 minus that 65 (35 percent), and finally divide the whole thing by your returns again.

The dollar amount will change depending upon the size of your bankroll. Even if you are wrong several times in a row, you will still stay alive long enough in the markets to recoup your losses, assuming your math and estimates are correct.

Most people find themselves to be a lot more comfortable with what’s come to be referred to as “Half Kelly.” Just take the number that you calculate with the Kelly Criterion and cut it in half. It’s a psychological edge, but in this type of activity, it’s a huge one and will help you keep going even after a few big losses in a row.

Simpler Methods

This is a lot easier, especially if you are just starting out with your trading. Never risk more than 2 percent of your entire trading cash on any one trade. This is extremely easy to figure out and stick to. Just look at your trading account, multiply it by 0.02, and do not ever go above that number for any reason. In fact, this is the high end of things; usually you should stick to 1 percent unless it looks like a very good opportunity.

Methods That Do Not Work

The more you risk, the higher your risk of ruin gets. Risk of ruin basically means your chances of losing all of your money, and it is the financial equivalent of a worse case scenario and should be avoided at all costs. Maybe you’ve just found out about the best trading situation ever and want to risk $2,500 of your $5,000 bankroll on it. DON’T! You are setting yourself up for failure and losing that much will take you a very long time to now double up your bankroll. Be smart and focus on gradual gains and not shooting for the moon. Make smaller, smarter trades over the course of a few years and you will get where you want to be.

Conclusion

Money management is tough, but your end goal should be to be comfortable, and not go broke. There are a lot of ways to accomplish this, and even if it’s not mathematically the “best” way, as long as you are turning a consistent profit with your strategy and not taking on undue risk, you should be fine.