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Stocks & Commodities V. 18:5 (38-46): Designing A Money Management Strategy by Ray Overholser, O.D.
MONEY MANAGEMENT
Designing A Money
Management Strategy
Using Volatility-Based Stops And The Kelly Criterion
Sorting out the criteria for a coherent money management
plan is a complex, detailed job. Using a spreadsheet to keep
track of the logic helps ensure nothing has been omitted.
by Ray Overholser, O.D.
ith a little planning, you can de-
velop a logically sound money
W management system. Historically,
too much emphasis has been
placed on the development of
profitable entry and exit rules,
whereas the determination of the
proper number of contracts or
shares to trade has been treated as
a distant afterthought.
An individualized money management algorithm (using a
spreadsheet program such as Microsoft Excel) will control
the equity growth of any positive-expectancy system as a
direct function of using correct position sizing. Risking too
large a portion of trading capital per position will eventually
cause even the most profitable trading system to fail.
The second advantage to developing your own position-
sizing strategy is to preserve trading capital during periods of
extended drawdown or losing trades. This saves you the
money to trade when things finally turn around. Unfortu-
nately, many traders inadvertently lose their hard-earned
trading capital as a result of improper position sizing. This
becomes painfully obvious when they have risked too much
capital over an extended series of losing trades.
I developed an effective money management algorithm
using Excel 5.0. It is based on the theory of using volatility-
derived stop-losses as a logical method to allocate capital.
The logic behind using a volatility-based stop compared with
a fixed-dollar stop is that the volatility-based stop can dy-
namically adjust to changes in a stock’s recent price noise.
This contrasts to trading with a fixed-dollar stop, which
ignores volatility by forcing the placement of an externally
derived, subjective stop without considering the underlying
trade’s true character.
As an example, assume stock XYZ has traded within a
range of $10 to $12 per share over the last 14 days, with an
average price during that time of $11 per share and a standard
deviation of $2. A stop-loss could be placed at the time of
Copyright (c) Technical Analysis Inc.
entry, representing twice the standard deviation of $2 per
share. Setting the stop at this $4 per share risk acts as a useful
proxy of the stock’s recent two-week normal price fluctua-
tions. A stop-loss placed at this level is now less likely to
suffer whipsaw losses solely because of a stock’s normal
price volatility.
My algorithm allows a portfolio to grow at an above-
average rate of return while consistently controlling risk. You
should examine the
assumptions inher- TRADER-DEFINED CRITERIA
ent in my model Max. Number of open positions allowed
and make changes Historical Kelly value
7
0.45
in the values to re- Max. % of closed equity to risk per trade 0.10
Max. % of transaction costs to anticipated profit 0.20
flect your own Max % loss permitted per month 0.05
overall risk toler- Max. % to risk if closed equity drops 5% 0.02
ance and trading Max. % to risk if closed equity drops 10% 0.01
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
gorithm is based on FIGURE 1: PERSONAL ASSUMPTIONS. In this spreadsheet, a
the following per- number of values limit the size of positions. The values shown
sonal assumptions can be altered to reflect your own.
(Figure 1):
1 The maximum number of open positions is limited to 7.
2 The maximum risk per position is limited to 2% of
closed equity plus 80% of the Kelly value multiplied
by open profits, the sum divided by maximum num-
ber of allowed positions less number of current posi-
tions open.
The Kelly criterion arose from the work of John L. Kelly
Jr. at Bell Systems in the early 1940s. His original formulas
dealt with long-distance telephone transmission signal noise.
However, gamblers quickly recognized the value of his work
and adapted the original formula to help determine optimal
betting sizes. The Kelly criterion continues to be a useful
method to calculate the optimal fraction of trading equity to
risk in maximizing account growth. The formula is:
%Y = W – [(1 – W)/R]
where:
%Y = Percentage of equity to trade (that is, the
Kelly value)
 Stocks & Commodities V. 18:5 (38-46): Designing A Money Management Strategy by Ray Overholser, O.D.

DOMINICK RAPONE

W = Historical winning percentage of a trading
system
R = Ratio of average winning amount to average
loss amount
3 Maximum total risk to portfolio is limited to 10% of
closed equity and 80% of the Kelly value multiplied by
the amount of open position profits. The term closed
equity is the starting trading capital plus all closed
position profits and losses.
I risk open position profits more aggressively than closed
equity. This is determined by using the Kelly criterion:
Percent to risk per trade = (winning %) - [(1-winning %)/R],
where R = Average winning trade divided by the average
Copyright (c) Technical Analysis Inc.
losing trade. I use a multiple of 80% of the calculated Kelly
value, because the original value often results in unaccept-
ably large drawdowns.
In addition, my position sizing algorithm uses the lesser
value of 0.25 or 80% of the Kelly value. If the Kelly value is
greater than or equal to 31.25%, then I limit it to 25%. If the
Kelly value is less than 31.25%, then multiplying by 0.80 will
result in a maximum allocation percentage below 25%.
Thus, no more than 25% of open position profits is ever
risked on additional positions. The modified Kelly value is
then divided by the maximum number of positions allowed
open simultaneously less the number of positions currently
open. This result gives the percentage of open profits to risk
on the next trade.
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
20% or less, allowing for a 10% slippage factor.
5 Maximum allowable loss per month limited to 5% of
previous month’s closed equity.
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
down 10% to 15%.
8 Percent risk per trade reduced to 3/4% if closed equity is
down 15%.
9 Percent risk per trade reduced to 0.5% if closed equity
is down more than 15%.
There are other limitations hardwired into the spreadsheet:
10 Total cost of all positions not to exceed the amount of
closed equity. This prevents margin trading.
11 All stock trades in round lots (that is, 100-share
multiples).
of experiencing a decrease in equity of 20% or more per year.
13 The volatility stop-loss is determined by using the value
of a Bollinger Band with a two–standard deviation
interval over a 14-day lookback period.
The volatility stop–based method is a
practical compromise between the desire to
allocate risk capital to achieve optimal
growth and the essential need to protect
trading capital from the risk of ruin.
HOW THE SPREADSHEET MODEL WORKS
First, enter the nine key variables in the Trader-Defined
Criteria (Figure 1) section of the spreadsheet. These inputs
help define each individual trader’s risk tolerance and level
of aggressiveness in
managing trading capi- TRADING POSITION SIZE ALGORITHM
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.

HOW TO USE THE ALGORITHM

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:/
/technical.traders.com/sub/sublogin.asp. —R.O.

Copyright (c) Technical Analysis Inc.

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

MICROSOFT EXCEL 5.0 CODE USER INPUTS

{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
at http://technical.traders.com/sub/sublogin.asp.—R.O.

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.
http://technical.traders.com/sub/sublogin.asp. 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
POSITION SIZING VS. FIXED-SHARE levels of:
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

in actual trading. FIXED-SHARE MODEL VOLATILITY-STOP METHOD
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
FIXED SHARE METHOD VOLATILITY-STOP METHOD
EQUITY

EQUITY

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
TRADE TRADE
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
VOLATILITY-STOP METHOD FIXED SHARE METHOD
290,000 290,000

280,000 280,000

270,000 270,000

260,000 260,000
EQUITY

EQUITY

250,000 250,000

240,000 240,000

230,000 230,000

220,000 220,000

210,000 210,000

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
TRADE
FIGURE 7: NEGATIVE EXPECTANCY. A losing system doesn’t tap out the trader with
Overholser’s approach because the “shares to trade” goes to zero as losses continue.
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
TRADE
FIGURE 8: FIXED SHARE. Here, a losing system traded with a fixed-share money
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.

CONCLUSION
The volatility-adjusted position-sizing method is useful
because it helps to achieve two important goals: first, to
roughly equalize the risk between independent trades, and
second, to allow each position an equal weighting in the
quest for optimal return on trading capital. This methodol-
ogy gives each position the same chance of adding profit to
a trading portfolio in contrast to the fixed-share methodol-
ogy in which the returns generated by individual trade
positions fluctuate greatly.
The volatility stop–based method is a practical compro-
mise between the desire to allocate risk capital to achieve
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.
REFERENCES
Kaufman, Perry J. [1995]. Smarter Trading: Improving Per-
formance In Changing Markets, McGraw-Hill Publish-
ing.
Tharp, Van K. [1997]. Special Report On Money Manage-
ment, International Institute of Trading Mastery.
_____ [1999]. Trade Your Way To Financial Freedom,
McGraw-Hill Publishing.
Vince, Ralph [1995]. Portfolio Management Formulas:
Mathematical Trading Methods For The Futures, Op-
tions, And Stock Markets, John Wiley & Sons.
†See Traders’ Glossary for definitions S&C

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
www.WealthByStrategy.com.

Copyright (c) Technical Analysis Inc.

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