In my experience, many traders utilize a fixed lot betting strategy. Meaning regardless of their equity, they will trade the same size on every trade.

The problem with this approach is that a profitable trading strategy will only grow linearly. This means that the account would only grow by a fixed $ amount per profitable trade.

A better approach may be to get the laws of mathematics on your side and utilize a fixed fractional betting strategy with every trade. A fixed fractional betting strategy means that you are risking a fixed fraction of your total equity on every trade.

There are 3 advantages to this approach.

1. If your trading strategy yields a positive expectancy, then over time, your trading strategy will grow exponentially. This means that the account would grow by a fixed % amount per profitable trade.

2. Your risk remains in constant proportion to your equity.

3. Many traders get attached to a particular trading size, say 10K, 100K, or 1M. Risk per trade may have been considered at the outset, but a drawdown in equity without a corresponding lower trade size can accelerate losses quickly.

To illustrate this, I have shown the results of 2 profitable backtests where the only difference is the betting strategy. The fixed lot results below trade each position at 25K currency units. The fixed fraction results risk .5% of the total equity on each trade.

Fixed Lot

Risk Management: Fixed Lot vs. Fixed Fractional

Images created using Trading Blox software.

Fixed Fractional

Risk Management: Fixed Lot vs. Fixed Fractional

Images created using Trading Blox software.

As seen, the fixed fractional risk management used in the second chart keeps risk more proportional to your equity at all times and trade size is adjusted automatically.

This is especially important during backtesting as each trade will impact your portfolio less and less on a profitable strategy and accelerate losses on a strategy that has a rough start. If your algorithm includes a fixed lot amount in back-testing, it can be tough to analyze the robustness of the strategy over a long time series.

Now, let’s look at what happens on a losing strategy using the same parameters. With a fixed 25K trade size on every trade, our account quickly goes bust within the first year.

Fixed Lot

Risk Management: Fixed Lot vs. Fixed Fractional

Images created using Trading Blox software.

If we implement the same strategy, but risk a fixed .5% of our total equity on each trade, the strategy still loses over time, but much more slowly. This risk management method does its job by keeping risk proportionate to the account equity as the account continues losing money.

Fixed Fractional

Risk Management: Fixed Lot vs. Fixed Fractional

Images created using Trading Blox software.

Whether your strategy is profitable over the long-run or not, risking a fixed fraction of your total equity on each trade may allow you to conserve capital more precisely than trading a fixed lot amount where your risk per trade may be unknown.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES IS MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION.

OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.