Capital management is an essential part of the trading system, essentially the part of the system that decides the size of your position. It determines how much profit you can make and how much risk you can take in system trading.
Chapter 1 The Importance of Capital Management
It is often said that successful trading equals psychological control + capital management + analysis system. However, in reality, most people overlook the issue of capital management.
Let's play a capital management game: Let's start with a game with a 60% chance of winning. You have $1,000 and 100 betting opportunities with odds of 1:1. So, how should you place your bets to maximize your returns? Think about this question before you continue reading. Surveys show that people tend to bet more in unfavorable situations and less in favorable ones.
In the market, people often expect a rise after several consecutive declines, or expect a decline after several consecutive rises. But this is just a gambler's fallacy because the chance of winning is still only 60%. At this point, capital management becomes extremely important.
Assuming you start this game with $1,000 and lose three times in a row (which is quite likely from a probability perspective), you are left with $700. Then, most people will think they will win the fourth time and increase their bet to $300 (trying to recover the lost $300), even though the chance of losing four times in a row is small, it is still possible.
Then, you're left with only $400, and to recover your losses in this game, you would need to profit 150%, which is unlikely. If you increase your bet to $250, you are likely to go bankrupt after four games. In either case, it is not possible to profit from this simple game. Without the concept of capital management, the risks taken are too great, failing to achieve a balance between risk and opportunity.
It is believed that 70% of traders lose money, 10% break even, and only 20% make a profit. Therefore, reducing the entry volume to a very small number can shift a trader from the 70% of losers to the 10% who at least break even. If you're eliminated from the game, you can't continue trading. You must ensure you can keep on trading. Yet, most traders are eliminated before they have a chance to succeed.
With a bit of bad luck, they would lose all their efforts. Staying in the game is crucial. Imagine if your method just needs a slight adjustment to turn the situation around, what would you do? You just need to survive, let your capital pass through the inevitable troughs. You need to ensure your tenure is long enough to acquire the skills and information necessary to become a successful trader.
Capital Management and Stop Loss
People always like to take profit quickly while giving losses a bit of leeway, the result being cutting profits short and expanding losses. In the long run, how to achieve capital appreciation? Let's remember these numbers: a 20% loss requires a 25% profit to break even, which is relatively easy; a 40% loss requires a 66.7% profit, which is harder; and a loss of over 50% needs a 100% profit, which is almost impossible to recover from. From my personal experience, a 20% loss should be the limit for losses.
However, this kind of stop loss is not capital management, because it does not tell you how much to sell, thus unable to adjust the position to control risk. Capital management is an essential part of the trading system, essentially the part of the system that determines the size of your position. It determines how much profit you can make and how much risk you can take in system trading. We cannot replace the most important part by simply setting this type of currency management stop loss.
Capital Management and Analysis System
Returning to our previous game, the foundation of profit is the winning rate. That is, your analysis system's buy and sell signals, in the long term, must be able to generate profits. With an effective analysis system in place, the role of capital management is to serve oneself effectively through appropriate position adjustments and capital management. In the aforementioned game, we can assume an analysis system has a 60% winning rate, but that's it.
If used improperly, it could also result in significant losses (as previously mentioned, from this we can also understand why using the same analysis system in trading leads to vastly different investment performances). In this game, if I simply bet $10 each time, eventually my capital would reach $1,200. Of course, there are better betting strategies. Comparing a few example betting strategies, it's clear to see different betting methods produce entirely different outcomes. It can be said, understanding the importance of capital management is also starting to grasp one of the greatest secrets of trading.
Chapter 2 Strategies of Capital Management
There are countless strategies for capital management. Professional gamblers have long claimed that there are two basic capital management strategies: martingale and anti-martingale. In a losing trade, the martingale strategy increases the size of the bet as capital decreases; on the other hand, anti-martingale increases capital in a winning trade or when our capital increases.
If you keep increasing your risk in a string of losses, you will end up with a series of very large losses that could bankrupt you, because the martingale strategy is very risky. Anti-martingale takes more risk after a series of profits. In the investment field, smart investors increase their investments to a certain extent when they are profitable. As many entry methods exist, so do capital management strategies. The following are anti-martingale capital management models.
1. A fixed amount per unit. This model only allows you to buy a position with a certain amount of money, it essentially treats all investments equally and always allows you to hold a position.
2. Equal unit model. This model gives the same weight to all investments in a portfolio based on their intrinsic value.
3. Risk percentage model: Its capital adjustment rule is based on risk as a percentage of capital. Give all trades the same level of risk, allowing for steady portfolio growth. This model is best for those who are long-term trend followers.
4. Percentage of volatility model: Provides a reasonable balance between risk and opportunity. This model is suitable for trades using tight stop losses.
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