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Futures, foreign currency and options trading contains substantial risk and is not for every investor. Only risk
capital should be used for trading and only those with sufficient risk capital should consider trading.
Stocks & Commodities V. 18:5 (38-46): Designing A Money Management Strategy by Ray Overholser, O.D.

Designing A Money
Management Strategy
Using Volatility-Based Stops And The Kelly Criterion

Sorting out the criteria for a coherent money management entry, representing twice the standard deviation of $2 per
plan is a complex, detailed job. Using a spreadsheet to keep share. Setting the stop at this $4 per share risk acts as a useful
track of the logic helps ensure nothing has been omitted. proxy of the stock’s recent two-week normal price fluctua-
tions. A stop-loss placed at this level is now less likely to
by Ray Overholser, O.D. suffer whipsaw losses solely because of a stock’s normal
price volatility.
ith a little planning, you can de- My algorithm allows a portfolio to grow at an above-
velop a logically sound money average rate of return while consistently controlling risk. You

W management system. Historically,

too much emphasis has been
placed on the development of
profitable entry and exit rules,
should examine the
assumptions inher- TRADER-DEFINED CRITERIA
ent in my model Max. Number of open positions allowed
and make changes Historical Kelly value
whereas the determination of the in the values to re- Max. % of closed equity to risk per trade 0.10
Max. % of transaction costs to anticipated profit 0.20
proper number of contracts or flect your own Max % loss permitted per month 0.05
shares to trade has been treated as overall risk toler- Max. % to risk if closed equity drops 5% 0.02
a distant afterthought. ance and trading Max. % to risk if closed equity drops 10% 0.01
An individualized money management algorithm (using a philosophy. My al- Max. % to risk if closed equity drops 15% 0.0075
Max. % to risk if closed equity drops more than 15% 0.0050
spreadsheet program such as Microsoft Excel) will control gorithm is based on FIGURE 1: PERSONAL ASSUMPTIONS. In this spreadsheet, a
the equity growth of any positive-expectancy system as a the following per- number of values limit the size of positions. The values shown
direct function of using correct position sizing. Risking too sonal assumptions can be altered to reflect your own.
large a portion of trading capital per position will eventually (Figure 1):
cause even the most profitable trading system to fail.
The second advantage to developing your own position- 1 The maximum number of open positions is limited to 7.
sizing strategy is to preserve trading capital during periods of 2 The maximum risk per position is limited to 2% of
extended drawdown or losing trades. This saves you the closed equity plus 80% of the Kelly value multiplied
money to trade when things finally turn around. Unfortu- by open profits, the sum divided by maximum num-
nately, many traders inadvertently lose their hard-earned ber of allowed positions less number of current posi-
trading capital as a result of improper position sizing. This tions open.
becomes painfully obvious when they have risked too much
capital over an extended series of losing trades.
I developed an effective money management algorithm The Kelly criterion arose from the work of John L. Kelly
using Excel 5.0. It is based on the theory of using volatility- Jr. at Bell Systems in the early 1940s. His original formulas
derived stop-losses as a logical method to allocate capital. dealt with long-distance telephone transmission signal noise.
The logic behind using a volatility-based stop compared with However, gamblers quickly recognized the value of his work
a fixed-dollar stop is that the volatility-based stop can dy- and adapted the original formula to help determine optimal
namically adjust to changes in a stock’s recent price noise. betting sizes. The Kelly criterion continues to be a useful
This contrasts to trading with a fixed-dollar stop, which method to calculate the optimal fraction of trading equity to
ignores volatility by forcing the placement of an externally risk in maximizing account growth. The formula is:
derived, subjective stop without considering the underlying
trade’s true character. %Y = W – [(1 – W)/R]
As an example, assume stock XYZ has traded within a
range of $10 to $12 per share over the last 14 days, with an where:
average price during that time of $11 per share and a standard %Y = Percentage of equity to trade (that is, the
deviation of $2. A stop-loss could be placed at the time of Kelly value)
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 18:5 (38-46): Designing A Money Management Strategy by Ray Overholser, O.D.


W = Historical winning percentage of a trading losing trade. I use a multiple of 80% of the calculated Kelly
system value, because the original value often results in unaccept-
R = Ratio of average winning amount to average ably large drawdowns.
loss amount In addition, my position sizing algorithm uses the lesser
value of 0.25 or 80% of the Kelly value. If the Kelly value is
3 Maximum total risk to portfolio is limited to 10% of greater than or equal to 31.25%, then I limit it to 25%. If the
closed equity and 80% of the Kelly value multiplied by Kelly value is less than 31.25%, then multiplying by 0.80 will
the amount of open position profits. The term closed result in a maximum allocation percentage below 25%.
equity is the starting trading capital plus all closed Thus, no more than 25% of open position profits is ever
position profits and losses. risked on additional positions. The modified Kelly value is
then divided by the maximum number of positions allowed
I risk open position profits more aggressively than closed open simultaneously less the number of positions currently
equity. This is determined by using the Kelly criterion: open. This result gives the percentage of open profits to risk
Percent to risk per trade = (winning %) - [(1-winning %)/R], on the next trade.
where R = Average winning trade divided by the average
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 18:5 (38-46): Designing A Money Management Strategy by Ray Overholser, O.D.

4 Transaction costs divided by expected profit limited to of experiencing a decrease in equity of 20% or more per year.
20% or less, allowing for a 10% slippage factor.
5 Maximum allowable loss per month limited to 5% of 13 The volatility stop-loss is determined by using the value
previous month’s closed equity. of a Bollinger Band with a two–standard deviation
interval over a 14-day lookback period.
6 Percent risk per trade reduced to 1% if closed equity is
down 5% to 10%.
7 Percent risk per trade reduced to 1% if closed equity is The volatility stop–based method is a
down 10% to 15%. practical compromise between the desire to
8 Percent risk per trade reduced to 3/4% if closed equity is allocate risk capital to achieve optimal
down 15%. growth and the essential need to protect
9 Percent risk per trade reduced to 0.5% if closed equity trading capital from the risk of ruin.
is down more than 15%.
There are other limitations hardwired into the spreadsheet:
First, enter the nine key variables in the Trader-Defined
Criteria (Figure 1) section of the spreadsheet. These inputs
10 Total cost of all positions not to exceed the amount of
help define each individual trader’s risk tolerance and level
closed equity. This prevents margin trading.
of aggressiveness in
11 All stock trades in round lots (that is, 100-share managing trading capi- TRADING POSITION SIZE ALGORITHM
multiples). tal. The spreadsheet it- Annual (%) std. dev. of returns 12

12 A percentage of the initial available equity is set self is available at the Current closed equity 277,157
Total open position dollars at risk 7,613
STOCKS & COMMODI- Last month’s closing equity 277,157
aside in an interest-bearing account to deleverage the TIES Website. See Beginning potential trading capital 360,000
trading portfolio to a specific level of risk. This risk sidebars, “Excel code” Percentage of beginning capital to risk 83.33
level is calculated using the technique presented by and “How to use the Actual starting trading capital 300,000
Current trading capital 271,542
Perry J. Kaufman in Smarter Trading. algorithm.” Current number of trades open 4
Next, enter 16 vari- Initial stop loss ($$) per share 12.750
Kaufman suggests a four-step procedure for deleveraging ables in the Trading Entry price per share 75.000
Expected percentage gain per trade 0.24
a trading account to achieve the desired level of risk. Step 1 position size algorithm
Transaction commission cost 32.50
involves determination of the historical trading system risk section of the spread- 80% of system’s historical Kelly 0.25
level. Step 2 requires the trader to subjectively choose an sheet (Figure 2). This or 25%, whichever is less 0.25
acceptable system risk level. Step 3 entails the determination may seem like a lot, Total purchase price of all positions 88,100
Maximum tolerable annual drawdown 20
of the amount of capital to be traded based on the risk level but after you use it Number of shares to trade 100
set by the trader in step 2. Finally, step 4 involves the once, many of the val-
FIGURE 2: CURRENT SITUATION. This second set of
determination of an appropriate stop-loss level. In my case, ues are saved and re- inputs reflects the situation facing the trader. It responds
the trading account is deleveraged, so there is a 2.5% chance used. For subscribers, to both open and closed equity positions.


Enter the following information: B9 Last month’s ending account balance
B11 Potential starting capital
CELL DESCRIPTION B17 Current trading capital (i.e. current trading
account balance)
L3 Maximum number of open positions B19 Current number of trades open
L5 System’s historical Kelly value B25 Expected percentage gain per trade
L7 Maximum percentage of closed equity to trade B27 Commission dollar amount for proposed trade
L9 Max. percentage of transaction costs as a percentage B32 Total purchase price of all open positions
of expected profit B34 Maximum tolerable annual percentage drawdown
L11 Max. percentage trading capital loss “allowable” in any B23 Entry price of proposed trade
one month B21 Stop-loss dollar amount of proposed trade
L13 Percentage of capital to trade if down 0% to 5%
L15 Percentage of capital to trade if down 5% to 10% Entering the information will result in a recommended
L17 Percentage of capital to trade if down 10% to 15% position size of 1,200 shares. This number will be located in
L19 Percentage of capital to trade if down more than 15%
{cell B36} of the spreadsheet final.xls. For more examples,
B3 Annual standard deviation of returns
B5 Current closed equity
subscribers should refer to the downloadable file readme.txt,
B7 Total open risk available from the STOCKS & COMMODITIES Website at http:/
/ —R.O.

Copyright (c) Technical Analysis Inc.

Stocks & Commodities V. 18:5 (38-46): Designing A Money Management Strategy by Ray Overholser, O.D.


{Cell A40} = $B$17/$B$15 {Cell B3} = Annual standard deviation of returns
{Cell A41} = G39*F39 {Cell B5} = Current Closed Equity
{Cell A42} = 1 – (B19*0.02) {Cell B7} = Total open risk (i.e. sum of all shares*stop-loss
{Cell A43} = A41*A42 value for each open position)
{Cell A44} = IF(B17>B5,(B17 – B5) * (B29/(L3 – B19)),0) {Cell B9} = Last month’s ending account balance
{Cell A45} = IF((A43+A44+B7)<=B57,(A43+A44)/B21,B55/ {Cell B11} = Potential starting capital (see readme.txt file for
B21) further explanation)
{Cell A46} = A45/100 {Cell B13} = Percentage of potential starting capital to risk
{Cell A47} = INT(A46) trading
{Cell A48} = A47*100 {Cell B17} = Current trading capital (i.e. current trading
{Cell A52} = IF(B17/B9 >= 1 – L11,A48,0) account balance)
{Cell A53} = IF(B19 <= L3,A48,0) {Cell B19} = Current number of trades open
{Cell A54} = IF(((A48)*(B23)) + B32 <= B5,A48,C54) {Cell B21} = Stop-loss dollar amount for proposed trade
{Cell A55} = IF(B56<=L9,A48,0) {Cell B23} = Entry-price of proposed trade
{Cell A56} = IF(B23*A48>0.25*B5,INT(C56/100)*100,A48) {Cell B25} = Expected percentage gain per trade
{Cell B39} = L13 {Cell B27} = Commission dollar amount for proposed trade
{Cell C39} = L15 {Cell B32} = Total purchase price of all open positions (i.e.
{Cell D39} = L17 sum of all shares* purchase price)
{Cell E39} = L19 {Cell B34} = Maximum tolerable annual percent drawdown
{Cell F39} = {Cell L3} = Maximum allowable open positions
IF(A40>=0.95,B39,IF(A40>=0.90,C39,IF(A40>=0.85,D39, {Cell L5} = System’s historical Kelly value
IF(A40<0.85,E39,0)))) {Cell L7} = Maximum percentage of closed equity to trade
{Cell G39}= IF(B15<B5,B15,B5) {Cell L9} = Maximum percentage of transaction costs as a
{Cell B54} = (B5 – B32)/B23 percentage of expected profit
{Cell B55} = B57 – B7 {Cell L11} = Maximum percentage trading capital loss
{Cell B56} = IF(A48>0,B27/(A48*B25*B23*0.9),0) “allowable” in any one month
{Cell B57} = (L7*B5) + ((B17 – B5)*B29) {Cell L13} = Percentage of capital to trade if down 0% to 5%
{Cell C54} = (INT(B54/100)) * 100 {Cell L15} = Percentage of capital to trade if down 5% to 10%
{Cell C56} = (B5*0.25)/B23 {Cell L17} = Percentage of capital to trade if down 10% to
{Cell B13} = MIN((B34/(2*B3) *100),100) 15%
{Cell B15} = B11*B13/100 {Cell L19} = Percentage of capital to trade if down more
{Cell B29} = MIN(0.25,0.8*L5) than 15%
{Cell B36} = MIN(A48,A52,A53,A54,A55,A56) This code is available for subscribers at the S&C Website

a readme.txt file is available to explain user inputs used in SPREADSHEET LOGIC

the spreadsheet, also available on the S&C Website at DETERMINE AMOUNT OF AVAILABLE CAPITAL TO USE AS TRADING RISK CAPITAL. Determine percentage of trading capital to risk on next trade based on the following factors:
Finally, after all inputs have been entered, the spread- 1) Price volatility
2) Number of positions open
sheet will generate the recommended number of shares to 3) Percentage of open profits to risk
trade. Figure 3 summarizes the spreadsheet’s logic. 4) Percentage of closed equity to risk
Determine whether trading the suggested initial number of shares will exceed the accepted
1) Total open position risk
To evaluate the effectiveness of using my position-sizing 2) Transaction costs as a percentage of anticipated profits
algorithm, I tested a 42-trade simulation of a hypothetical 3) Maximum loss permitted per month
4) Maximum number of trades allowed simultaneously
trading system with a positive mathematical expectancy. 5) Available closed equity needed to trade potential position
This simulated a profitable trend-following system, tak- Determine the exact number of shares recommended based on the above criteria.
ing seven trades each month and holding each trade for FIGURE 3: SPREADSHEET JOBS. The spreadsheet computes a proposed position size
approximately 30 days. The test was conducted, utilizing based on the equity in your account, the volatility of the issue being considered, and the
a starting equity of $300,000 for each method. I measured constraints you impose.
my volatility-adjusted method against a simple fixed-
share strategy that utilized a constant position size of 100 The results of the comparison test (Figure 4) demonstrate
shares per trade — doubling to 200 shares per position only significantly greater expansion of account equity when the
if initial account equity doubled. The testing procedure used simulated trades were sized using the volatility-stop method
the same stop-loss exits for both methods. The test data used (the equity curves of both methods can be viewed in Figures
in this study is available in the file “Testdata.xls,” also 5 and 6). In addition, these results were achieved with a
available on the S&C Website. superior return/risk ratio (23.87 vs. 18.84), a favorable indi-
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 18:5 (38-46): Designing A Money Management Strategy by Ray Overholser, O.D.

cation of the feasibility of implementing such a strategy SYSTEM COMPARISON SUMMARY

I also tested my method on a negative expectancy Total profit $61,053 $197,653
system. The fixed-share method assumes a constant Average profit $2,881 $10,474
100-share trade size, whereas the volatility-adjusted Average loss $866 $4,667
Compounded annual rate of return 44.84% 175.18%
method varies trade size in 100-share increments. Monthly std. dev. of returns 2.38% 7.34%
I wanted to demonstrate how a well-designed money Peak to valley drawdown 0.67% 3.75%
management strategy could help traders preserve trad- Return/risk ratio 18.84 23.87
ing capital in the event the trading strategy begins FIGURE 4: COMPARISON. Compared to the typical fixed-share model, the volatility-adjusted model
producing negative returns. A trader using my money outperformed nearly every measure when using a system with a winning expectancy.
management algorithm (Figure 7) would be forced to
quit trading when the recommended trade size eventually fell more robust return characteristics.
to zero. At this point, a wise trader confronted with this A trader using a fixed-share strategy (Figure 8) or even
situation would cease all trading of the system and walk away. worse, no money management strategy, will need to make a
Traders may then wish to paper-trade the current system, subjective decision at some point about when to stop trading.
modify the current system, or attempt to design a system with

500,000 500,000


400,000 400,000

300,000 300,000
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41
FIGURE 5: POSITIVE EXPECTANCY. Here, a fixed-share money management system FIGURE 6: VOLATILITY-ADJUSTED STOP. Using the same winning trading system used
produces steady growth using a winning trading system. However, compare this to Figure in Figure 5, the volatility-adjusted money management system produces far better equity
6, and you’ll find some surprising results. growth.

300,000 300,000
290,000 290,000

280,000 280,000

270,000 270,000

260,000 260,000


250,000 250,000

240,000 240,000

230,000 230,000

220,000 220,000

210,000 210,000

200,000 200,000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28
FIGURE 7: NEGATIVE EXPECTANCY. A losing system doesn’t tap out the trader with FIGURE 8: FIXED SHARE. Here, a losing system traded with a fixed-share money
Overholser’s approach because the “shares to trade” goes to zero as losses continue. management system eventually taps out. See Figure 7 for the comparable result using a
volatility-adjusted approach.

Copyright (c) Technical Analysis Inc.

Stocks & Commodities V. 18:5 (38-46): Designing A Money Management Strategy by Ray Overholser, O.D.

The volatility-adjusted position-sizing method is useful Kaufman, Perry J. [1995]. Smarter Trading: Improving Per-
because it helps to achieve two important goals: first, to formance In Changing Markets, McGraw-Hill Publish-
roughly equalize the risk between independent trades, and ing.
second, to allow each position an equal weighting in the Tharp, Van K. [1997]. Special Report On Money Manage-
quest for optimal return on trading capital. This methodol- ment, International Institute of Trading Mastery.
ogy gives each position the same chance of adding profit to _____ [1999]. Trade Your Way To Financial Freedom,
a trading portfolio in contrast to the fixed-share methodol- McGraw-Hill Publishing.
ogy in which the returns generated by individual trade Vince, Ralph [1995]. Portfolio Management Formulas:
positions fluctuate greatly. Mathematical Trading Methods For The Futures, Op-
The volatility stop–based method is a practical compro- tions, And Stock Markets, John Wiley & Sons.
mise between the desire to allocate risk capital to achieve
†See Traders’ Glossary for definitions S&C
optimal growth and the essential need to protect trading
capital from the risk of ruin. The adage “No pay, no play”
is an apt reminder of the importance of a good money
management strategy. Those traders implementing such
strategies will have a distinct edge over their less sophisti-
cated counterparts.

Ray Overholser, O.D., is a private trader in Gainesville, FL.

He is completing a graduate business degree at the Univer-
sity of Florida, with the goal of opening a hedge fund based
on his research in technical analysis and money manage-
ment. He plans to launch an online newsletter at

Copyright (c) Technical Analysis Inc.

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