I've been experimenting with a Kelly-sized money management strategy for the last month. For most of my positions, I've been using 33% Kelly, which is ultra-aggressive. This meant that my position size ranged from 2.5% up to 10% per trade.
Most of my trades won and I made good, increasing my equity by 10% in a single month. However, one trade made me halt my experiment when I experienced a huge gap on Monday morning.
This was a trade made using pinbars on the weekly chart. The above chart shows a pinbar on the EURUSD that appeared a few weeks ago, and I went short on the break of the pinbar last week. The trade went against me by Friday's close, but it didn't hit my stop loss. I decided to keep the trade open over the weekend in the hope that price movement will "reset" itself on Monday and move downwards.
My hope was crystalised on Monday when price gapped significantly lower, hitting my profit target.
While my trade won, it raised a few critical issues:
1. My risk during this trade was around 10%. That's very high, but my Kelly formula suggested an optimal position size of over 30%. When I say that Kelly money management is ultra-aggressive, I really mean it. But as the trade initially went against me, I realised that trading even at 33% Kelly provides no scope for system failure.
Trading is all about risk management. The failure of a trading system is always a distinct possibility. If you don't account for this, then this particular risk is unmanaged and you're not performing your duty as a trader. If I continually traded at 10% and lost five trades, half of my equity will be wiped before I begin to question my system.
However, even if you wipe out 50% of your equity, if you're trading a portfolio of systems using Kelly money management, you should regain your lost equity relatively quickly. That is the dilemma with Kelly, and why it is so tempting to use it.
2. The gap over the weekend alerted me to another risk. While this particular gap favoured me, the opposite can also happen. Since this gap was huge, if it had went against me instead, I would've faced a 20% hit to my equity as price would've opened way beyond my stop loss.
Keeping trades open over the weekend is another form of unmanaged risk. Supposing you're long on the NZDUSD and a tsunami wipes out New Zealand during the weekend, you'll have no ability to escape your position until Monday, when price will most likely gap down significantly.
All this points to decreasing my position size. I really enjoyed trading at 33% Kelly. Even when I occasionally lost, I still felt good, because it seemed like I was heading somewhere quickly and decisively. My wins made a difference.
At this stage I'm reducing my position size back to a level 2% for all my systems. It's boring, but it'll allow me to detect failing systems and survive, as well as manage my risk over the weekend (losing 4% from a gap is much more managable than 20%) .