On the subject of money management in trading, Ralph Vince has authored a number of theoretical books. His work is written as an academic proof, for those of you who haven’t had an opportunity to read it. He demonstrates that if you don’t trade consistently, it is mathematically certain that you will lose money.
The term “Optimal f” is introduced by Vince. In a nutshell, optimal f is a money management strategy that helps determine the right number of shares or contracts to purchase or sell (or to own or not to acquire at a given time). Thought-provoking, Vince’s work is also rather theoretical and not applicable to trading in the actual world. The issue with optimal f is that the calculation depends on the biggest trading loss, which is impossible to predict until it actually occurs.
In many ways, his fundamental arguments for why money management is important—which are supported by his views on randomness, odds, and probability—are similar to those of trend following, but his method for implementing it is unnecessarily complicated. Some traders may find the idea of any kind of money management to be too onerous because Optimal F can seem so complex.
On the other hand, trading in the real world can benefit from trend following money management. The trend-following money management is not supported by any scholarly research. The simple, fundamental equations that describe how much to purchase or sell a particular stock or commodity are brought together into a comprehensive trading system.
Day traders have created a variety of methods for managing their finances over the years. The majority of these are based on various statistical probability theories, however some of them have their roots in superstition. The basic tenet is that you shouldn’t invest all of your funds in one trade; instead, invest a sum that is reasonable given the level of volatility. If not, you run the risk of losing everything too quickly.
Optimal F is just one approach. Other approaches exist, but none is consistently appropriate for all markets. Option traders may choose to utilize one method for options transactions and a another one for stock trades. If that applies to you, you have to decide how much money to devote to each market before you start trading.
Ralph Vince developed the Optimal F system of money management, and he has written multiple books about it and other aspects of money management. The concept is that you use prior performance to decide how much of your money to devote per trade. Each trade should be 18 percent of your account, neither more nor less, if your Optimal F is 18 percent. Although there are a few modifications, the methodology is comparable to the fixed fraction and fixed ratio systems.
The equation for determining the number of shares of stock, N, to trade using the Optimal F technique is shown in the following diagram.
The risk is the largest percentage loss you have ever suffered, and F is a factor based on historical data. You may determine the contracts or shares you need to purchase using these figures and the current price. When looking at a stock selling at $25 per share, your account has $25,000, your largest loss was 40%, your F is calculated to be 30%, and you should acquire 750 shares:
The Optimal F number itself is a mean calculated using trade results from the past. One issue with this strategy is that it only works when you have some trade data because the risk value is also reliant on previous returns. The requirement for a spreadsheet to calculate it is a second issue (see Ralph Vince’s book if you want to test it out).
Because the history is altered every time a trade is entered into, and because the history doesn’t always produce meaningful figures, some traders only employ Optimal F during specific market conditions.