Optimal f is the optimal % risk that can be applied to a fixed fractional money management scheme that will yield the greatest net profit. Of course for the net profit of optimal f to be positive the expectancy of the strategy must be positive. This method is also known as the Kelly criterion.
The primary disadvantage of optimizing our risk parameters in this fashion is the high degree of volatility that this will incur in your account. As such, this method utilizes no limiting factors to account for things such as margin calls. Also, it fails to keep risk within human psychological boundaries as when a trader experiences an 95% draw down (which could occur in 5% of all trade sequences) it is unlikely they will be able to keep trading in this fashion. Lastly, and if the above reasons were not sufficient, this methodology assumes a constant statistically verifiable expectancy. In other words - in the real world where trading expectancy is not constant, optimal f is not constant either. Which in layman's terms means that you are constantly trying to catch a falling dagger - drunk, blindfolded, and missing 3 fingers. Hence, it is an interesting theory but of little practical relevance.
Monday, September 1, 2008
Posted by Lord Tedders at 7:13 PM