Money Management


I am constantly surprised by the expectations of seminar participants. Too many seem to believe that at the end of the two or three days, ‘insto-presto, I’ll be one of the world’s best traders!’ It doesn’t help the newbie that too many educators encourage this belief.

The fact is expertise will take time. The very best we can hope for at the end of a seminar is a foundation and a set of actions upon which we can build habits of success. The end of the seminar is but the first step in a never-ending journey of continuing education and self-improvement.

As a part-time educator, one of my major outcomes is to ensure the student makes the plan his own. By this I mean, he takes what is taught, learns the fundamentals and nuances of the method, and then imposes his own personality. Given that each of us has a unique combination and set of experiences, beliefs and values, it is highly unlikely that any method will fit you perfectly. So your job as a student is to ensure that you internalize the method and then go about making studied changes.

By studied changes I mean changes for which the outcomes are recorded. We then study the outcomes to see if any changes we have made have resulted in improved profitability. The students who have graduated from STC (my mentor course), have all shown this ability.

You have seen Dr. Peter Whitnall’s ‘Wham‘ contribution. It’s an interesting method using exponential moving averages as its main tool.

Pete W graduated from the STC and all graduates know how much I ‘love’ moving averages - well alright, actually I do acknowledge they have a place in identifying the zone and strength of trend. But for me, moving averages suck as trend identifiers. Bearing this ‘love’ of mine in mind and knowing that Pete W was one of the more successful graduates, you see the point I am making. Moving Averages may not suit my personality but they certainly suit Pete W’s. He took my material and blended it with tools and materials that suited him and became a successful trader.

This brings me to the second point of this blog.

In ‘What I Learned Losing a Million Dollars’, Jim Paul makes the valid point that there are as many successful methods to winning in the markets as there are personalities - from Warren Buffett’s ultra long-term, fundamental approach to Marty (Buzz) Schwartz’s day-trading, technical method. Take a look at some of the quotes Jim gathered:

  • “I haven’t met a rich technician” - Jim Rogers.
  • “I always laugh at people who say “I’ve never met a rich technician” I love that! Its such an arrogant, nonsensical response. I used fundamentals for 9 years and got rich as a technician” - Mary Schwartz.
  • “Diversify your investments” - John Templeton.
  • “Diversification is a hedge for ignorance” - William O’Neil.
  • “Don’t bottom fish” - Peter Lynch
  • “I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.” - Paul Tudor Jones.

But all successful traders have one thing in common - they accept and manage risk. Yet, this is one aspect of a newbie’s education that is usually given, at best, a cursory once-over. More often, it is emphasized only by its asbsence - when the account blows up.

Like the trading method, how you manage risk is dependent on your personality. For example: in my case, I prefer partial exits. I know that in strongly trending markets, this method adversely affects my bottom line. But for me, the partial exits smooth out my equity curve. Partial exits are but one application of the first principle of my trading philosophy : Above all, protect your capital. Despite its success for me, my risk management approach is unlikely to suit someone with a higher risk tolerance.

So, over to you: does your trading plan and money management suit your personality?

One of the questions that was repeatedly asked at the CMC presentations was: How do you know when to take profits?

The background to the question was the story I told about a relative whose win rate is 90% over a trading period of 30 years. Impressed? Well, what if I were to tell you that in that period, he has never made any money in any calendar year? Still impressed?

The reason for his net loss can be found in the Expectancy formula:

(Average $ Win x Win Rate) - (Average $ Loss x Loss Rate) MUST Be > 0.

In his case, he grabs small profits and incurs large losses so that the sum of his expectancy produces a negative result.

The question thus arose, to avoid this trap (I call it the Expectancy Trap), when should we take profits? In my view there are two standards:

  1. Mathematical and
  2. Technical

The mathematical relies on the size of the initial stop and the Maximum Adverse Excursion, The initial stop is the profit benchmark; you cannot continually take profits smaller than your initial stop. The lower the win rate, the truer is this statement.

My initial stops are chart based but I do rely on a few statistical studies.

The MAE tells us if the stops are too close. In addition I use another parameter that I read  in Ed Ponsi’s book, Forex Patterns and Probabilities (Forex Patterns and Probabilities). In the work, he suggests we run a simulation of losing trades with a series of higher stops. For example, how would the trade have turned out if we had increased the stop by 10 points (pips), 20, 30 etc to 50.

These technicals and mathematical studies help us determine where to place our initial stop. The first step is avoiding the Expectancy Trap.

You cannot avoid the mathematical certainty of long-term failure if our expectancy is negative. We have less control of our win rate than the Avg $ Win and Avg$Loss; so it behoves us to consciously ensure that we don’t consistently take smaller profits than our initial stop losses.

The technical benchmark tells us when we need create an exception to this general rule i.e when to accept a lower profit. After all, part of the function of a trading plan is to tell us when  the probabilities for a trade no longer favour it or at least, tell us when the probabilities favour a partial exit.

An example of this assessment recently occurred in my Soybean campaign. I had pyramided my Soybeans shorts at 1286 basis September 08. My stop was above 1305.75. The market declined to 1242 and started to stall. My view of the technicals was there was a moderate probability of a bounce returning to 1280 to 1300.

If we compare the stop to the profit target, we see the stop was 21 points. To cover the first third (see Rule of 3), I’d need 42 points i.e. an exit at 1244. But on Tuesday when the market got down to 1243, I was sloppy with the timing of my order to exit at 1244 and as a result missed the 1244s. The question was, now that 1244 was no longer available, what should I do?

Given the technical assessment, I covered 40% of the position at 1256 rather than risk the bounce. Once I exited the 40%, I was on a risk free trade for a target to the Primary Buy Zone 1120 to 1176.25.

Figure 1 shows a chart of the trade.

08-07-2008-s-18d.jpg

FIGURE 1 Soybeans September

At the end of the day our success as traders is based on the equation below returning greater than 1:

(Average $ Win x Win Rate) - (Average $ Loss x Loss Rate) = >0.

To produce the desired result we need to consider three factors:

  1. The Win/Loss Rate. Elsewhere I have postulated why the Win or Loss Rate is largely outside our control. (see Ebb & Flow in Position Sizing 2).
  2. Our Position Sizing (see Position Sizing and Position Sizing 2)
  3. Our entry and exit. These are two factors totally within our control.

In this blog I want to examine entry and exit strategies that will maximize the probability our losses will be less than our profits i.e. our Avg$Win will be greater than our Avg$Loss. In the process, I’ll use my most recent AUDUSD to illustrate the ideas.

We’ve often heard that the key to our trading success lies in the maxims, ‘cut your losses and let your profits run’ and ‘never let a profit run into a loss’. As stated, the advices are next to meaningless. (!)

Let me ask you this, what would constitute ‘profits’? If I entered, say Gold long, at 970 and the market declines to 969, should I cut the position? Or if Gold runs to 995, should I not take profits? Or if Gold first goes to 971 and then declines to 969, have I let a profit turn into a loss?

The key to all these questions lies in our initial stop loss. This is the benchmark for our risk management positions. We cannot consistently take smaller profits than losses and hope to succeed. Here I am not talking about the times when the market tells us our analysis is incorrect and therefore it’s time to exit. So we exit with a small loss or profit. No, here I am talking about a perspective of a large sample size. If on the whole, we find that we take larger losses than profits, we’ll find we fail as traders.

Yet my experience with traders shows that this tendency to consistently grab profits smaller than our stop loss is the strategy employed by most newbies. Oh, there will always be a good excuse: a change of timeframes; a change in the condition of the market etc. But the fact remains that if we examine their data, we’ll see consistently larger losses than profits.

Let’s have a look at the AUDUSD. I sold the AUDUSD at an average price of .9600. My stops was .9768, a risk of 168 points. Figure 1 shows the target to be around .9100 to .8955.

07-09-2008-adus-13w.jpg

FIGURE 1 AUDUSD 13w

Figure 2 shows the support zones on an 18d basis.

07-09-2008-adus-18d.jpg

FIGURE 2 AUDUSD 18-d

Notice too that there is intra-day support at 9493 to 9515. (See Figure 3)

07-09-2008-adus-290.jpg

FIGURE 3 AUDUSD IntraDay

Armed with support zones, let’s see an application of the risk management approach I favour.

My stop is 168 points. As long as I see no evidence that my original analysis is incorrect, I’ll risk the bounce from the intra-day Primary Buy Zone. Of course I’d love for the market to break that support zone at its first attempt but there is nothing in my analysis that says it must; indeed I rate a bounce as a 40% probability.

If the market bounces back up to the .9600 area, I’ll be feeling some heat; so should I exit at the .9500 zone? If I KNEW that the market would bounce, the answer is of course. BUT I DON’T KNOW if it will; it may and then again it may not. If I take an .80 profit and the market proceeds to my target, I’d have risked 168 points for an 80 point when there was much more to gain.

If I do this over a large sample size, I’ll need a Win Rate of around 70% to be profitable and for my trading style that would neigh be impossible. So, I would have to forgo taking profits at this level and run the possibility of being stopped out. I’d have to treat the move to the .9500 as noise.

Note that if I were trading a different timeframe with a different stop structure, I may come to a different conclusion.

The next support level is the Primary Buy Zone at .9365 to .9325. If I took profits at .9370, I’d make 230 for a risk of 168. At this point, I can start thinking of protecting my position.

The stop in this case was a little wider than normal, so I’d amend the normal Rule of Three process (see Risk Management 5). I’d take profits for 1/3 of my position and bring my stop down to 67% retracement area of the zone .9667 to .9327 (Top of Value). I’d bring the stop on the remaining position down to breakeven.

If all goes well, I’d liquidate the rest of the position at my target zone around the .9100 area.

By employing our initial stop as a benchmark we’ll go a long way against mathematically taking premature profits, a step that guarantees long-term failure.

Tomorrow I’ll look at the S&P. The market generated a buy signal today.

Index speculators, a new breed

from http://awanginvest.com/?p=415

It is educational for readers/traders to understand why commodity prices keep rising in spite of ample supply. Please read the testimony and you will be enlightened!

June 10, 2008 – 10:58 am

michael-masters-written-testimony

 

This excerpt of a Testimony by Michael W Masters before the US Senate has been submitted by NicT of HK which I reproduce hereunder:

What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.

These parties, who I call Index Speculators, allocate a portion of their portfolios to “investments” in the commodities futures market, and behave very differently from the traditional speculators that have always existed in this marketplace. I refer to them as “Index” Speculators because of their investing strategy: they distribute their allocation of dollars across the 25 key commodities futures according to the popular indices – the Standard & Poors - Goldman Sachs Commodity Index and the Dow Jones - AIG Commodity Index.

Please read more at link at the top of page.

It is educational for readers/traders to understand why commodity prices keep rising in spite of ample supply.

Here is a bonus to go with the abovementioned article - NUGGET OF TRADING WISDOM: 2% Rule

The 2 % rule is a basic tenet of “risk management” or “capital preservation” as they are more descriptive than “money management”.

Larry Hite, in Jack Schwager’s Market Wizards (1989), mentions two lessons :

  1. Never bet your lifestyle ie never risk a large chunk of your capital on a single trade.
  2. Always know what the worst possible outcome is.

Hite goes on to describe his 1 % rule which he applies to a wide range of markets. This has since been adapted by short-term equity traders as the 2% rule:

The 2 Percent Rule: Never risk more than 2 percent of your capital on any one stock.

This means that a drawdown of 10 consecutive losses would only consume 20% of your capital.

Ana aka IDkit

 

Ag. Moderator

So far we have completed the way I assess position sizing. The next step is to manage the trade.

The first step is to identify the entry, initial stop and core profit exit- this is function of your plan.

The next step is to assess the trade’s risk-reward. Because I use the Rule of Three, I assess the risk-reward based on the core profit contract (usually the opposite Primary Zone) and average profit. The risk-reward must be at least 1:2 (based on the structural exit) and 1:1 (based risk compared to historical average profit).

Let’s look at an example.

Figure 1 shows the 5-d and 18-d swings in the ES. Let’s assume we are trading the 5-d and that the average profit per trade in the ES is 80 points. In Figure 1, the risk to average profit would be 1:2.2. Figure 1 shows that the structural risk-reward is 1:3.2

This trade has a qualified risk-reward.

03-28-2008-es-rr.jpg

FIGURE 1 ES Risk:Reward

So, before I even enter a trade, I first assess whether or not the risk is worth trading.

Once we are in a trade, we need to manage our risk.

The Rule of Three states that we cover the first 1/3 when the profits cover our risk on the remaining contracts. Unlike the core profit exit, this is a guideline rather than a fixed exit.

Figure 1 shows that the risk on two contracts is 66 points. Our entry was 1277; so, we’d exit the 1st third at (1277 + 66) 1343. But if we look at Figure 1, we see that the Point of Control is coming in at 1339.98.

We know that the 18-d is in a downtrend, as is the 13-w. So, we are trading a contra-trend move in the higher timeframes. In this situation, I’d look to exit before 1339.98, say 1335 to 1337. I then move my initial stop on the 2nd third to allow for the lower exit. So, if my exit is 1335, there is a difference of 5 points. I’d move my 2nd third’s stop to 1247 (originally at 1242; plus 5 = 1247). This way if stopped out, I’d preserve my capital.

Once the market has a bar’s range above the top of the Value Area, 1386 (i.e. a Whole Point Count of 1 above 1386), I move the stop on the 2nd contract to under the low of the Value Area. In the case of Figure 1, this area is between 1306 and 1275.

Once I exit the 2nd contract at the Primary Sell Zone, I’d bring the stop on the 3rd contract to breakeven.

On a breakout, to manage the 3rd contract, I use a trailing stop using:

  1. Swing lows or deemed swing lows and
  2. Bring the stops closer as the impulse move’s magnitudes moves to mean +3 standard deviations. At this target, I tend to bring the stops no farther away than breach of the 3-d low.

Of course if I have a Change in Trend Pattern, I’d exit on that even if the trailing stop is not hit.
There you have it.

We have covered the ground from Money Management to Trade Management: the two components of Risk Management. Happy trading guys and gals.