Fixed Ratio Trading

[johenmo]

Reading about this in Ryan's "The Trading Game". I understand the maths but he jumps between contracts and shares like a barefoot man on hot coals (presume women would be too smart to walk on hot coals).

He claims smaller accounts will suffer under fixed fractional and benefit unde fixed ratio.

I understand Fixed Fractional and have my calculator setup in excel. No problem here.

All the examples I can find show contracts. Still learning, I may not know enough about contracts (like corn) to relate it to shares.

Can anyone explain this in simple terms? I searched ASF.
Thanks

 

[howardbandy]

Greetings all --

In the interest of full disclosure -- I know Ryan Jones, have read his book, and have talked with him about Fixed Ratio Trading. (I also have exchanged several emails with Ralph Vince, who will be mentioned in the next paragraph.)

Whether you are considering Ryan's Fixed Ratio or Ralph Vince's Fixed Fraction, you need several things:
1. A trading system that works. No foolishness about having just finished the backtesting and the in-sample results look good. I mean you have actually traded it with real money and you are confident that it makes money and that you understand the characteristics of the system. You must be knowledgeable and confident about the risk you take with each trade and the maximum loss you expect in the worst case.
2. Ability to use leverage. If you are trading shares and using no margin, neither position sizing method will help you. Using margin allows you to increase your leverage to the extent that you can use margin. You can get up to about 12 times leverage in the US if you combine a leveraged ETF with a margin brokerage account. But, most of the examples given are using futures contracts, where you can buy essentially any number of contracts when you get a signal to buy. You could also use options, or CFDs in Australia.

The two methods are quite a lot alike.

Ralph's Fixed Fraction method decides how many contracts / options to buy based on the largest expected drawdown. To decide what that is, you can look at the trading history of closed trades from actually trading the system, or from the results of truly out-of-sample tests. A wise saying about trading is that your worst drawdown is still ahead of you, so be cautious. Based on the Kelly formula, Fixed Fraction computes the amount of your trading account to put at risk on any single trade and converts that into the number of contracts to buy. The fraction to put at risk to end up with the highest value of terminal relative wealth is called "optimal f". But trading at optimal f results in not only the highest terminal relative wealth, but very significant drawdowns in the process. You are essentially guaranteed that you will have your worst drawdown when you have your largest position in place. If you have made an error and underestimated your largest risk, you will be trading at a fraction that is higher than optimal, and you will blow up your account. So many traders compute optimal f, then trade at some proportion of that, say 25% of optimal f. That is called "fractional f".

Traded the way Ryan suggests, Fixed Ratio begins by computing the risk on the trades and trades one contract per signal. Decide ahead of time how much you are risking on each contract and how much you need to have booked to increase your trading size. When profits have built up in the trading account, one additional contract is traded for each "M" dollars (say, $5000) of booked profit. For example, you risk $2000 on each trade and you have built up a $5500 profit in your trading account. Since your have more profit than your M, $5000, when your next buy signal comes, buy 2 contracts. When your booked profit rises to $10,000, add a contract and buy 3 contracts on each signal. Your position size will be such that if you lose, you will lose a portion of, but not all of, your booked profit. Your next trade size is based on the remaining booked profit, and will probably be lower after a loss. You definitely want your M to be larger than your risk.

Both Ralph Vince and Ryan Jones have written books (Ralph four, Ryan one) describing their methods. I recommend reading both authors.

Thanks,
Howard