Fixed Fractional Betting in Trading
Fixed fractional betting is a popular money management strategy used in trading.
This approach involves risking a fixed percentage of your current account balance on each trade or bet.
The primary goal of this method is to optimize capital growth while managing risk effectively.
Key Takeaways – Fixed Fractional Betting
- Risk Management
- Fixed fractional betting is designed so that you only risk a consistent percentage of your account on each trade.
- Helps avoid large losses.
- It generally involves having a predefined percentage of the account (1%), then buying a quantity that matches up with the difference between the entry price and stop-loss.
- We give an example in the article.
- Automatic Position Sizing
- Your position size adjusts automatically with your account balance, scaling up in good times and reducing risk during drawdowns.
- Keeps things simple.
- Compound Growth
- Increasing position sizes as your account grows can improve the compounding effect of your gains.
- Consistency and Discipline
- It encourages disciplined trading, reducing the emotional impact of wins and losses.
- Adaptability
- The strategy can be tailored to different risk tolerances and trading styles.
The Concept Behind Fixed Fractional Betting
Fixed fractional betting is based on the idea that the size of your positions should be proportional to your account balance.
This means that as your account grows, you’ll be able to take larger positions (by dollar amount), and conversely, if your account shrinks, your position sizes will decrease accordingly.
How Fixed Fractional Betting Works in Trading
Fixed fractional betting typically involves allocating a specific percentage of your trading capital to each trade.
This percentage remains constant, but the actual dollar amount will vary based on your current account balance.
It represents a simplified way to scale and de-scale trades.
Calculating Position Sizes
To determine your position size using fixed fractional betting, you would use the following formula:
Position Size = (Account Balance × Risk Percentage) ÷ (Entry Price – Stop Loss Price)
For example, if you have a $10,000 account and are willing to risk 2% per trade, with an entry price of $50 and a stop loss at $48, your position size would be:
($10,000 × 0.02) ÷ ($50 – $48) = 100 shares
Advantages of Fixed Fractional Betting
Risk management
Risking a fixed percentage of your account on each trade helps make sure that no single loss can wipe out or excessively dent your entire account.
Automatic position sizing
As your account grows or shrinks, your position sizes adjust automatically.
This can help to better optimize your risk-reward ratio.
Compound growth potential
In periods of successful trading, this method allows you to increase your position sizes, potentially leading to faster account growth.
Psychological benefits
Knowing that you’re risking a consistent percentage of your account can help reduce emotional decision-making.
Disadvantages of Fixed Fractional Betting
Potential for slower growth
In comparison to more aggressive strategies, fixed fractional betting may result in slower account growth during winning streaks.
Requires discipline
Sticking to a fixed percentage can be challenging, especially after a series of losses or when presented with seemingly “sure” opportunities.
It’s a natural tendency among many novice traders to want to “double-up” or apply similar aggressive methods during losing streaks, but this almost always goes terribly.
May not suit all trading styles
For some high-frequency trading strategies or those with very tight stop losses, this method may result in impractically small position sizes.
Implementing Fixed Fractional Betting in Your Trading Strategy
To successfully incorporate fixed fractional betting into your trading approach, consider the following steps:
1. Determine Your Risk Tolerance
The first step is to decide what percentage of your account you’re willing to risk on each trade.
This typically ranges from 0.5% to 3%, with 1-2% being common among many traders.
Your risk tolerance should reflect your overall trading goals, experience level, and psychological comfort with potential losses.
2. Establish Clear Entry and Exit Points
For fixed fractional betting to work effectively, you need to have well-defined entry and exit points for each trade.
This includes your entry price, target price, and stop-loss level.
These parameters are important for calculating your position size accurately.
3. Use Technology to Your Advantage
Using a calculator or spreadsheet can help the process of determining your trade size based on your account balance and risk parameters.
This can help with consistency in your approach and reduce the likelihood of errors.
4. Regular Review and Adjustment
While the percentage risk remains fixed, it’s important to regularly review your overall strategy.
As your account size changes or market conditions change, you may need to adjust your risk percentage or other aspects of your trading plan (link includes example plans).
This means writing down your criteria, which includes your position sizing.
Advanced Considerations in Fixed Fractional Betting
As traders become more experienced with fixed fractional betting, they often explore more nuanced applications of the strategy.
Varying Risk Percentages Based on Setup Quality
Some traders choose to vary their risk percentage based on the perceived quality of the trade.
For instance, they might risk 2% on their highest conviction trades but only 1% on more speculative opportunities.
This gets into other betting strategies like value betting, or spreading bets based on perceived probabilities.
Incorporating Win Rate and Risk-Reward Ratio
Advanced practitioners of fixed fractional betting often consider their historical win rate and average risk-reward ratio when determining their optimal risk percentage.
This approach tries to maximize the long-term growth rate of the account.
The Kelly Criterion
The Kelly Criterion is a mathematical formula used to determine the optimal bet size in a series of bets.
While originally developed for gambling, it has applications in trading and investing.
The formula takes into account the probability of winning and the odds received on the bet.
In trading, a modified version of the Kelly Criterion can be used to determine the optimal fraction of the account to risk on each trade, based on the trader’s win rate and average risk-reward ratio.
The Kelly Criterion’s applications in trading have been criticized because it often leads to trade sizes that would be too large and suboptimal due to the variance they would cause.
Also, explicit probabilities of winning are not always easy to gauge and are themselves often unknown.
Common Mistakes to Avoid with Fixed Fractional Betting
Even with a solid understanding of fixed fractional betting, traders can fall into several common pitfalls:
1. Overtrading
Just because you’re risking a small percentage of your account on each trade doesn’t mean you should trade more frequently.
Overtrading can lead to death by a thousand cuts, even with otherwise good risk management.
2. Ignoring Other Forms of Risk
Fixed fractional betting addresses position sizing risk, but it doesn’t account for other forms of risk such as correlation risk.
Examples of this include:
- having too many similar positions (being long various stocks)
- event risk (unexpected news or market events)
3. Failing to Adjust for Volatility
In highly volatile markets, you may need to reduce your risk percentage or adjust your stop loss levels to maintain consistent risk exposure.
4. Neglecting the Importance of a Large Sample Size
Fixed fractional betting is a long-term strategy that relies on the law of large numbers.
It’s not always easy to know the quality of a trading strategy over a short period or number of trials, especially in cases of thin edges being exploited.
Traders sometimes make the mistake of judging its effectiveness over too short a period or too few trades.
Conclusion
Fixed fractional betting can be part of a trader’s risk management arsenal, but it’s not a complete trading strategy on its own.
It’s simply a bet-sizing system.
It should be part of a broader trading plan that includes:
- A well-defined trading strategy with clear entry and exit criteria
- Risk management practices beyond just position sizing
- A system for tracking and analyzing trading performance
- Ongoing education, learning, and adaptation to changing markets
When combined with a sound trading strategy, fixed fractional betting can help traders achieve consistent growth while protecting their capital from excessive drawdowns.
However, like all trading techniques, it requires discipline, patience, and a willingness to learn from both successes and failures.