Trading totally at random with a 50% winning percentage and an R multiple of 1 yields no advantage, as one naturally expects. Remember that an R multiple is the average win divided by the average loss. Such a system poses neither an advantage or disadvantage. The average outcome should come out extremely close to the starting balance.
Most traders focus on risking a set dollar amount such as $ 1,000 on a given trade. Fixed fractional money management updates that dollar figure after every single trade. It changes the overall outcome after you add up all the winners and all of the losers. Remember that trading is the net outcome of several hundred trades or even thousands of trades. The power of a position sizing or betting strategy comes into play as the number of trades increases.
Fixed fractional money management stretches some portions of the bell curve and compresses other regions. Before we get into that, it's important to remember what fixed fractional money management means. It stands for the idea of risking a set percentage of the current account equity rather than the starting equity.
Consider an example where the account balance starts at $ 100,000 risking 1%. Both methods risk the same amount on the first trade, $ 1,000. The next trade, however, will yield a different risk amount. A win on the previous trade would increase the account equity to $ 101,000. One percent of a 101 grand is $ 1,010 of risk on the next trade. A whopping ten dollar change.
That may seem trivial. It is most certainly not over the long run.
Consider a trader that plays a coin toss game and has a system with the following characteristics:
He starts with a $ 100, 000 account balance
His R multiple is 1.0
He wins 50% of the time with no trading costs
He risks 1%
A flip of heads means that he wins. He loses when the coin lands on tails.
The absolute worst outcome of playing the coin toss with a fixed dollar risk of $ 1,000 is a loss of $ 46,000. Adding fixed fractional money management during that difficult drawdown improves the drawdown to a less substantial loss of $ 37,500. The worst drawdown goes from -46% to -37.5%. The method drags the absolute worst case scenario and pulls it closer to the average. When an unlucky, devastating drawdown kicks in, the technique reduces the losses that the trader experiences.
The best case scenario for fixed dollar risk is a $ 58,000 (58%) return. Adding money management to the system dramatically stretches the best case scenario further to the right. It improves to a $ 76,000 return (76%). The good times get a lot better without changing anything at all about the trading system. The method stretches positive returns away from the average. The trader walks away with more money in his pocket.
The natural instinct is to conclude that fixed fractional money management is the way to …