Position Sizing Part 2: Kelly Formula and Drawdown-Based Money Management

Summary: Part 2 of a 10-part series. Move beyond fixed lot sizes. Learn percentage risk, the Kelly Formula adapted for forex, and how to scale position sizes based on drawdown.




Title: Position Sizing Part 2: Kelly Formula and Drawdown-Based Money Management

Fixed lot sizing is the #1 amateur mistake. A trader with a $10,000 account using 0.1 lots permanently is mismanaging risk. This guide provides three concrete money management methods, from conservative to aggressive.

1. Method 1 – Percentage Risk Model (Beginner-Intermediate)
Risk a fixed percentage of account equity per trade, not fixed lots.

Formula: `Position Size = (Account Balance × Risk%) / (Stop Loss in Pips × Pip Value per Lot)`

Example: $10,000 account, risk 1%, stop loss 20 pips on EURUSD (pip value $1 per 0.1 lot)

- Risk amount = $10,000 × 0.01 = $100
- Position size = $100 / (20 × $1) = 0.5 lots

Rule: Never risk more than 1-2% per trade. After 3 consecutive losses, reduce risk to 0.5%.

2. Method 2 – Kelly Formula Adaptation for Forex (Advanced)
The original Kelly Formula is for gambling with known odds. For forex, use the modified version:

`Kelly % = W - [(1-W) / R]`

- W = Win rate (as decimal, e.g., 0.55 for 55%)
- R = Win/Loss ratio (average win divided by average loss)

Example: Win rate 50%, average win 100 pips, average loss 50 pips → R = 2.0

- Kelly % = 0.50 - [(1-0.50) / 2.0] = 0.50 - 0.25 = 0.25 (25%)

Forex adaptation: Use full Kelly × 0.2 (20% of Kelly) because forex markets have unknown tail risks. So 25% × 0.2 = 5% risk per trade maximum.

3. Method 3 – Drawdown-Based Position Scaling (Advanced)
This method adjusts position size based on current drawdown from peak equity.
```python
# Drawdown-based position sizing logic
peak_equity = 10000
current_equity = 9200
drawdown_percent = (peak_equity - current_equity) / peak_equity # 8%

def get_risk_percent(drawdown_pct):
if drawdown_pct < 5:
return 1.0 # normal risk
elif drawdown_pct < 10:
return 0.75 # reduce to 75%
elif drawdown_pct < 15:
return 0.50 # reduce to 50%
else:
return 0.25 # halve again, or stop trading
```

Psychology note: Reducing size during drawdown protects your account and your trading psychology from revenge trading.

4. Maximum Drawdown Hard Rule
Set a maximum drawdown limit for your entire account:

Yellow line (warning): 10% drawdown → reduce risk by 50%

Red line (stop): 20% drawdown → stop all trading for 2 weeks. Review every trade.

Black line (kill switch): 30% drawdown → stop trading for 1 month. Re-verify your trading system on demo.

5. The "1% Rule" Table – Pre-Calculated for Common Stop Losses

| Account Balance | Stop 10 pips (risk 1%) | Stop 20 pips (risk 1%) | Stop 30 pips (risk 1%) |
|----------------|------------------------|------------------------|------------------------|
| $2,000 | 0.20 lots | 0.10 lots | 0.07 lots |
| $5,000 | 0.50 lots | 0.25 lots | 0.17 lots |
| $10,000 | 1.00 lots | 0.50 lots | 0.33 lots |
| $25,000 | 2.50 lots | 1.25 lots | 0.83 lots |

*Formula used: Lots = (Balance × 0.01) / (Stop × $1 per 0.1 lot)*

6. Next Step
Part 3 covers trading psychology – how to handle losing streaks, the post-loss cooldown timer, and the pre-commitment contract.

Reference:

Thorp, E. O. (2017). *A Man for All Markets*. Random House.

Vince, R. (2007). *The Handbook of Portfolio Mathematics*. Wiley.