Compounding and money management

Hi everyone,

I thought I would post up this question to see if anyone else is struggling with this or have some valuable insights to share:

I currently have an automated strategy that I have been back testing and currently tweeking that averages 34-36% win ratio and an average return of ~2.5:1.
While I am working on how to reduce the average loss size I have also been thinking of my money management strategy and namely compounding.

From what I have read any strategy that averages 34% win rate is going to have a ~40% draw down at some stage. If this is the case then it is driven by having a run of losers which means that if we change the risk size per trade to compound, we will ultimately be compounding in the wrong direction when we have a run of losers and as we know a loss of 1% does not equal a win of 1%.

What strategies do people have to minimise the effect of negative compounding when they are having a run of losers?

Thanks in advance.

I believe you are overthinking the problem.
You need to accept that there is a risk in this type of business and use business principles to ameliorate this - not mathematical issues.
If your strategy is that good, start small and keep going till you are happy with your bank balance. Then you can compound based on previous profits.
Repeat above till you are financially secure!
Cheers, H

Hi Aich

I understand what you are saying and your advice is apt however take for example a system with 50% win loss ratio and a 1:1 ROI ratio (I know just stick with me) and $1000 to start to play with.

I win my first trade at 1% risk so I risk $10 to make $10 and my balance is now $1010 (woohoo im going to be rich)
My second trade I again risk 1% and thus this time risk $10.10 but lose and my balance is now $999.90
My third trade is now risking $9.99 to get to $1009.90
My 4th trade losing is now $999.80

I understand that we are talking cents or low level dollars here and 50% win ratio does not mean i win then lose then win, etc. However when looking at an equity curve on a trend following strategy that averages between 30-40% win rate it means you will suffer a 40% drawdown eventually. This occurs by having a run of negative trades with a few winners spread in them over a period of time. In this scenario you will need to win more trades than lose to make it back and at a 30-40% win ratio it will take a substantial amount of time.

In this scenario are people:

1. Accounting for this in their ROI calculations (if not then it means thier calculations are off as its biased based on data they use to test or current market)
2. Can this be minimised using a more advanced compounding technique such as increasing or decreasing risk based on their live equity curve?

kind regards

I thought I would give an update as I have found my answer. Below are two sets of results, one with efficient money management techniques applied and the other with regular old 1%.

Quite simple. When calculating lot size of a trade you want to open according to your risk percentage, use your balance minus SUM of all stop losses of your open trades.

Any smoothing you do will proportionately increase your risk, personally I set my trade size to 1% (or whatever depending on the system I am using) of my cash balance and the beginning of a month and then increase it when I have a new high a the beginning of subsequent month.

On draw down, I think rules of thumb can be misleading, back test your system over loads of data and calculate the draw downs from peak that actually happen, I also recommend looking at RoMad on investopedia.com

Goodday, bro. Sorry, how were you able to deal with the negative impact on compounding? What technique did you use and how were you able to Break Even faster after a series of compounding losses?