Proportional Betting in Trading
Proportional betting, also known as percentage betting, is a risk management strategy used in trading.
This approach involves sizing your bets or trades based on a fixed percentage of your current capital, rather than using a fixed monetary amount.
In trading, proportional betting can help manage risk, optimize returns, and provide longevity in the markets.
Key Takeaways – Proportional Betting in Trading
- Risk Management
- Proportional betting limits risk by sizing trades based on a fixed percentage of your current capital, typically 0.5% to 2% per trade.
- This protects your account during losing streaks and allows for growth during winning periods.
- Position Sizing
- Calculate position sizes based on your account balance, risk percentage, and stop-loss distance.
- This gives consistent risk across trades regardless of price or volatility.
- Compound Growth
- As your account grows, trade sizes increase automatically, potentially leading to better growth over time while maintaining the same risk percentage.
- Psychological Benefits
- Having a predetermined risk percentage can reduce emotional decision-making.
- Helps traders stick to their strategy during both winning and losing periods.
- Flexibility
- Proportional betting can be applied across various markets (stocks, currencies, futures) but may require adjustments for contract/lot/share sizes or market liquidity constraints.
The Concept of Proportional Betting
Definition and Basic Principles
Proportional betting is a method where the size of each bet or trade is determined by a predetermined percentage of the trader’s current capital.
For example, a trader might decide to risk 1% or 2% of their total account balance on each trade.
As the account balance fluctuates, so does the size of each subsequent trade.
Contrast with Fixed-Size Betting
Unlike fixed-size betting, where a trader might always risk $100 per trade regardless of their account balance, proportional betting adjusts the trade size based on the current capital.
This approach helps to protect the trader during losing streaks and allows for increased position sizes during winning streaks.
Advantages of Proportional Betting in Trading
Risk Management
Improved risk management is one of the primary benefits of proportional betting.
Risking a fixed percentage of capital on each trade means traders can avoid the pitfall of risking too much on a single trade, which could potentially wipe out a significant portion of their account.
Account Longevity
Proportional betting helps traders stay in the game longer.
Even after a series of losses, the trade size automatically adjusts downward.
This reduces the risk of ruin and gives the trader more opportunities to recover.
Compound Growth
During winning streaks, proportional betting allows for accelerated growth.
As the account balance increases, so does the size of each trade – potentially leading to more exponential growth over time.
Psychological Benefits
This approach can help reduce emotional decision-making.
By having a predetermined risk percentage, traders are less likely to make impulsive decisions based on recent wins or losses.
Implementing Proportional Betting in Trading
Determining the Optimal Percentage
The ideal percentage to risk per trade varies depending on factors such as trading style, risk tolerance, and market conditions.
Many traders use between 0.5% and 2% of their account balance per trade.
It’s important to find a balance between growth potential and risk management.
It’s different than traditional position trading or investing where position sizes – especially for ETFs and index funds – may be larger because of the intention to hold over longer time horizons.
Calculating Position Sizes
To use proportional betting, traders need to calculate their position size for:
- each trade based on their current account balance
- the chosen risk percentage, and
- the potential loss on the trade (often determined by the distance to the stop-loss order)
Adjusting for Market Volatility
In more volatile markets or during high-impact news events, traders might choose to reduce their risk percentage temporarily to account for increased market unknowns.
Also, in such environments, bid-ask spreads tend to widen, which can eat into the profit margin of each individual trade.
Example of Proportional Betting
Say a trader has a $10,000 account and wants to risk 2% of their account on each trade.
This means they’re willing to lose $200 per trade.
If they identify a trade setup with a stop-loss 50 points away, they need to determine the position size that’ll keep their risk within the $200 limit.
To calculate, they divide the risk amount by the distance to the stop-loss:
$200 / 50 points = $4 per point
So, they would take a position size where each point movement equals $4.
In this case, if the market moves against them by 50 points, they will lose $200, which is exactly 2% of their account balance.
Calculation
Let’s say we have a $50/share stock and use a $49.50 stop-loss.
How many shares would be bought?
Here’s how to calculate the position size:
- Account balance = $10,000
- Risk per trade = 2% of $10,000 = $200
- Entry price = $50 per share
- Stop-loss = $49.50 per share
- Distance to stop-loss = $50.00 – $49.50 = $0.50 (50 cents)
Now, calculate the position size:
- Position size = Risk per trade / Distance to stop-loss
- Position size = $200 / $0.50 = 400 shares
So, you would buy 400 shares of the stock.
If you wanted a $1 stop-loss, you buy 200 shares instead.
Advanced Concepts in Proportional Betting
Kelly Criterion
The Kelly Criterion is a mathematical formula used to determine the optimal size of a series of bets.
In trading, it can be used to optimize the percentage of capital risked on each trade based on the probability of success and the potential payoff.
Fractional Kelly
Some traders use a fractional Kelly approach, which involves betting a fraction of the amount suggested by the Kelly Criterion.
This more conservative approach can provide added protection against estimation errors and market volatility.
And by and large, the Kelly approach simply gives trade sizes that are too large, as it was developed for gambling approaches before being adopted by some traders.
An example would be taking the value suggested by the Kelly Criterion and dividing by 10.
The Kelly Criterion also involves estimating probabilities, which isn’t easy to do.
Dynamic Adjustment of Risk Percentage
Advanced traders might adjust their risk percentage based on recent performance or the current market environment.
For example, they might increase their risk percentage slightly during periods of strong performance or decrease it during drawdowns.
Challenges & Limitations of Proportional Betting
Execution Difficulties
In fast-moving markets, it can be challenging to execute trades at the exact calculated position size, especially when dealing with less liquid assets.
Psychological Hurdles
Some traders may find it difficult to increase their position sizes during winning streaks, potentially limiting their growth potential.
Conversely, others might struggle to reduce position sizes after losses.
Commission Considerations
Proportional betting can result in higher commission costs as a percentage of the account balance for small accounts because each trade represents a smaller portion of the account.
Yet it incurs the same fixed commission and potential losses from large bid-ask spreads, increasing the relative impact on the overall account balance.
Market Impact
For large accounts, strictly adhering to a proportional betting system might lead to position sizes that are too large for the market to absorb without significant price impact.
Larger traders and institutions have to break up orders over the course of enough volume and time to avoid market impact (e.g., VWAP, TWAP, and other strategies).
Proportional Betting in Different Trading Instruments
Stocks and ETFs
When trading stocks or ETFs, proportional betting can be straightforward to implement.
Position sizes can be adjusted precisely by trading different numbers of shares.
Currency Trading
In the foreign exchange (forex) market, traders can easily adjust their position sizes using different lot sizes, making proportional betting a popular strategy among currency traders.
Futures and Options
Proportional betting in futures and options trading can be more challenging due to the standardized contract sizes.
Traders may need to use multiple contracts or explore mini or micro contracts to achieve the desired risk exposure.
Cryptocurrencies
The high volatility in cryptocurrency markets makes proportional betting particularly relevant.
Traders can adjust their position sizes easily, but must be cautious of the increased risk associated with these markets.
Technologies for Proportional Betting
Position Size Calculators
Many trading platforms and third-party software offer position size calculators that can help traders quickly determine the appropriate trade size based on their account balance and risk parameters.
Spreadsheets are also useful so it’s easy to run the calculation just by changing the inputs without having to deal with working the operations of calculators repeatedly.
Automated Trading Systems
Some algorithmic trading systems incorporate proportional betting principles.
These automatically adjust position sizes based on the account balance and predefined risk parameters.
Risk Management Software
Advanced risk management software can help traders monitor their overall risk exposure and make sure they’re adhering to their proportional betting strategy across multiple positions and asset classes.
Conclusion
Proportional betting is a risk management approach that can help traders optimize their performance and longevity in the markets.
Automatically adjusting position sizes based on current capital provides a simple and systematic method for managing risk.
But it’s important to recognize that proportional betting is just one component of a trading strategy and plan.
Betting strategies can help with risk management but won’t turn a faulty strategy into a good one.
Traders must also consider factors such as market analysis, entry and exit criteria, diversification, and overall portfolio management (e.g., liquidity, collateral).
Ultimately, the success of a proportional betting approach depends on:
- the trader’s discipline in adhering to the system
- their ability to accurately assess probabilities and potential returns, and
- their skill in combining this risk management technique with other aspects of their trading strategy
Understanding the principles of proportional betting can potentially help traders improve their risk-adjusted returns and build a better and sustainable trading career.