Money management is not about risk and reward management. When you risk nothing you gain nothing, and if you risk everything, one day you might well be left with nothing. Technical analysis shows you how to identify both trends and reversal points. It’s like teaching a batsman when to strike the ball. Money management, on the other hand, is all about taking runs and building an innings where sometimes you have to take singles, sometimes you have to be aggressive and send the ball to the boundary for the maximum, sometimes you have to duck to avoid a bouncer, or to leave a ball, or play a defensive shot to avoid losing your wicket. The basic principle of building an innings is to wait for loose balls to hit and avoid flirting with balls going outside the off stump. In cricket you can score runs only if you remain at the crease and you can continue at the crease only if you take care on two fronts, one, you have to avoid getting out, and second you have to avoid retiring hurt. Similarly in trading if you want to remain in the game, you must protect your capital, keep your position size in tune with your capital and risk, and keep your losses small.

Technical analysis can help you identify the horses which stand a good chance of winning a race. If a horse runs too fast and the jockey is unable to control ir, he will fall off the horse and be out of race. Similarly, in a raging bull market if you are unable to discipline yourself and keep on mindlessly increasing your positions, you can be in for a big loss if the market suddenly turns against you. Most recently we witnessed this in the fall of May 2006 and the gut-wrenching fall of January 2008 where many traders lost huge amounts of money in the Indian markets.

The History 

John Kelly, who worked for AT&T's Bell Laboratory, originally developed the Kelly Criterion to assist AT&T with its long distance telephone signal noise issues. Soon after the method was published as "A New Interpretation Of Information Rate" (1956), however, the gambling community got wind of it and realized its potential as an optimal betting system in horse racing. It enabled gamblers to maximize the size of their bankroll over the long term. Today, many people use it as a general money management system for not only gambling but also investing.

The Basics 
There are two basic components to the Kelly Criterion: 
• Win probability - The probability that any given trade you make will return a positive amount. 
• Win/loss ratio - The total positive trade amounts divided by the total negative trade amounts.

These two factors are then put into Kelly's equation: 
Kelly % = W – [(1 – W) / R]

Where: 
W = Winning probability 
R = Win/loss ratio

The output is the Kelly percentage, which we examine below.

Putting It to Use 
Kelly's system can be put to use by following these simple steps:

1. Access your last 50-60 trades. You can do this by simply asking your broker, or by checking your recent tax returns (if you claimed all your trades). If you are a more advanced trader with a developed trading system, then you can simply back test the system and take those results. The Kelly Criterion assumes, however, that you trade the same way you traded in the past.
2. Calculate "W", the winning probability. To do this, divide the number of trades that returned a positive amount by your total number of trades (positive and negative). This number is better as it gets closer to one. Any number above 0.50 is good.
3. Calculate "R," the win/loss ratio. Do this by dividing the average gain of the positive trades by the average loss of the negative trades. You should have a number greater than 1 if your average gains are greater than your average losses. A result less than one is manageable as long as the number of losing trades remains small.
4. Input these numbers into Kelly's equation: K% = W – [(1 – W) / R].
5. Record the Kelly percentage that the equation returns.

Interpreting the Results 
The percentage (a number less than one) that the equation produces represents the size of the positions you should be taking. For example, if the Kelly percentage is 0.05, then you should take a 5% position in each of the equities in your portfolio. This system, in essence, lets you know how much you should diversify.

DEFINITION OF 'DIVERSIFICATION'

A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securitiesin the portfolio are not perfectly correlated.

BREAKING DOWN 'Diversification'

Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction. Investing in more securities will still yield further diversification benefits, albeit at a drastically smaller rate.

Further diversification benefits can be gained by investing in foreign securities because they tend be less closely correlated with domestic investments. For example, an economic downturn in the U.S. economy may not affect Japan's economy in the same way; therefore, having Japanese investments would allow an investor to have a small cushion of protection against losses due to an American economic downturn.

Most non-institutional investors have a limited investment budget, and may find it difficult to create an adequately diversified portfolio. This fact alone can explain why mutual funds have been increasing in popularity. Buying shares in a mutual fund can provide investors with an inexpensive source of diversification.

The system does require some common sense, however. One rule to keep in mind, regardless of what the Kelly percentage may tell you, is to commit no more than 20-25% of your capital to one equity. Allocating any more than this is carries far more risk than most people should be taking.