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Thursday, February 5, 2015

Things to Consider in Setting Money Management Rules – Part 2: RISK TOLERANCE

In setting a suitable money management, you should also consider the maximum drawdown you are willing to accept, which depend on your risk tolerance.
In this case, do take into account the reasonable percent return required to recover to breakeven when you experience a certain percent of losses (drawdown), as discussed in the previous post.
Then, set money management rules based on your risk tolerance (expressed in terms of percentage of the total account/capital).

Just a simple example:
If you are willing to suffer from losses of maximum of 25% of your total capital, this means your risk tolerance is minus 25%. In this case, you should set money management rules and/or choose trading strategy that has a maximum drawdown statistics of 25% or less.

Consider two options of the following money management rules:
Option 1: Maximum of 2% risk (of the remaining account balance) in each trade
Option 2: Maximum of 5% risk (of the remaining account balance) in each trade

As can be seen from the above table, using Option 1 (max 2% risk for each trade), your account will drop to a level that is close to your risk tolerance of maximum 25% drawdown only after 14 consecutive losing trades.
In contrast, using Option 2 (max 5% risk for each trade), your account will even exceed that level only after 6 losing trades in a row.

Looking at another perspective, Option 1 will suffer 26.1% loss in the case of 15 consecutive losing trades, which would require 35.4% gain in order to be back to breakeven.
On the other hand, with the same scenario of 15 successive losing trades, Option 2 suffers 53.7% drawdown and will need 115.8% gain, which is much harder to achieve, to be breakeven. Although losing 15 times in a row is quite an extreme case, in reality it is still possible to happen.

Remember that although you might have implemented strict money management rules, losing streaks and drawdowns are inevitable.
Hence, you should set a sound money management strategy that aims to avoid risk of ruin at all cost, can survive a period of losing streaks, and also still reasonable to rebound to at least break even.

Continue to: Things to Consider in Setting Money Management Rules – Part 3: HOW LONG YOUR CAPITAL CAN LAST

Go back to: Things To Consider in Setting Money Management Rules - Part 1: DRAW DOWN

To view the list of all the series on this topic, please refer to:
Money Management / Position Sizing

Other Learning Resources:
* FREE Trading Educational Videos from Trading Experts

Related Topics:
* Understanding Implied Volatility (IV)
* Understanding Option Greek
* Understanding Option’s Time Value
* Learning Candlestick Charts
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2