Monthly Archives:June 2013

No Money Management = Gambling

littl121 post on June 20th, 2013
Posted in Trading Tags: , , , , ,

Money management. Most people have heard but care little to implement this wisdom correctly. A stop loss is not money management. Position sizing is not money management. These two are merely arms and legs of money management.

Ralph Vince conducted an experiment with 40 Phd students using a computer trading game that gave 60% winning odds to the player (which incidentally was better than Las Vegas’ casinos). Each player attempted 100 trials winning or losing whatever amount he bet. At the end of the experiment, 38 of them (95%) lost money – and only 2 were profitable. The scenario set was essentially the same for each player – what differed was how much each player decided to bet on each trial – ie. money management.

The lesson is obvious – WE CAN FAIL EVEN IF WE ARE TRADING A WINNING SYSTEM WHEN WE DO NOT USE PROPER MONEY MANAGEMENT

Money management sets the tone for

  • reward risk ratio selection,
  • edge selection (to some traders – set up selection)
  • growing our equity account efficiently and
  • serves as a warning system if the trader is losing touch with the market.

The greatest pleasure it gives me is peace of mind – that is an important trading edge.

There is much material on money management on the internet. Three authors worth noting are Van Tharp, Tushar S Chande and Ralph Vince.

3 of the most important money management pointers are:

  1. Realistically test and know clearly the expected returns (or range of returns) and losses your edge gives you. Understanding these payoffs, the win rate and how they affect your equity under different scenarios (eg. 5 continuous drawdowns) will better shape your money management goals and rules than with wishful thinking. Knowing them impact your choice of strategies and how hard you need to work to achieve your goal. For me, my daily targeted expected returns are small, but consistent – so I make sure my potential losses are also very small with proper position sizing, and I take note of the market conditions that give me the best chance of achieving my target returns with little risks. Some Forex traders, who wisely use leverage and limit losses according to their money management rules and trading edge, can with 20 pips profits per day easily translate to more than 100% return on equity per year.
  2. Knowing how much to risk on each trade is vital. Note the word is risk – ie. what you are potentially able to lose. Many traders simply place a regular amount eg. 1 lot of S&P futures with potential cut loss at negative US$250.  This is very unwise.  Even if he has a trading edge, he  is going to lose on some occasions. If those losing trades happen consecutively, it becomes harder and harder for him to recover his account.

Assuming he started with $100 in his account, and risked $10 a trade as a hard stop. If he lost 4 trades in a row, he would have lost $40.  He would then need to achieve a 66.7% return on his remaining $60 to just restore $100 in his account (ie. 1.667 X $60 = $100).  Would that be easy or hard to achieve? Perhaps if he had reduced his bet size to say – $5, – a continuous string of 4 losses would cost him $20. Would his chances of recovery at 25% return more realistic?

But would risking only$5  per trade help him achieve his targetted profit objective?  If the average return for each winning trade was 10%, a $5 bet would only yield $0.50 profit, whilst a $10 bet would double  profits to $1. So what is that magical compromise between risk management and profitability?

A good trick is not to use a fixed dollar amount for each trade, but to use a percentage figure instead. For example, if we have $10,000 as trading equity, our risk may be 2% of the equity ie. $$200 potential loss for each trade. If our risk reward ratio is 1:1, then we potentially win $200 or lose $200. If we are profitable, our next trade will risk 2% of $10,200 ie. $204 and if we had lost on the first trade, our next trade will risk 2% of $9,800 ie. $196.

Why is this important?

If you run a simulation using a fixed risk amount versus a percentage risk amount, you will realize that with a percentage risk value –

  • Your equity will increase faster and higher when you are continuously profitable (because you are able to risk more when you are winning)
  • Your equity will drawdown less quickly when you are continuously losing (actually significantly less because you risk less when you are losing).
  • You prevent Gambler’s Fallacy (ie. some traders think if they had lost the last 3 trades, the next one will definitely be a winner – so they risk a large significant amount in the next trade – that is gambling and not an exercise on probability. This especially hits those using “70% system or 80% winning systems”. Did the inventor get 80% after losing 2 continuous trades out of 10, or losing 20 continuous trades out of 100?

There are other money management strategies – the more aggressive ones can be seen from Ed Thorpe’s or Ralph Vince’s work. But I prefer this simple, straightforward percentage method.

3.     Risk of ruin. That means the probability of losing all your equity.  Should our risk percentage be 2%, 1%, or 10% for each trade?  Did you know statistically, if a trader risks 2% of equity as a hard stop for each trade, in 1,000 simulated trades, with a payoff ratio of 1.5 times, and a winning probability of less than 35% – he will almost certainly face complete ruin? So if a trader wants to risk more than 2% of equity per trade continuously, then his payoff ratio or winning percentage must be improved dramatically.

The table shows why many traders risk only 2% maximum for each trade.

Risk of ruin with 2% of capital at risk. A 0 probability means the total loss of equity is unlikely, but not impossible
Payoff Ratio

Probability of Winning

1

1.5

2

2.5

3

25%

100

100

100

94.3

19.7

30%

100

100

87.4

3

0

35%

100

98.7

16

0

0

40%

100

9.2

0

0

0

45%

93.6

0

0

0

0

50%

5.4

0

0

0

0

Table reproduced from Chande’s “Beyond Technical Analysis 2nd Edition”

This is not to say a trader cannot size more than 2% of equity as a hard stop for ad hoc trades, but the trade opportunity should be one with conditions highly favorable to the trader.

Be mindful, position sizing a potential trade to a 2% equity hard stop should also carefully consider the volatility of the market space and the extent of losses typically experienced by a particular edge or set up.

Thence, taking the time to develop a money management system suited to a trader’s profile will help the trader minimize the pain of mistakes and hasten his progress towards profitable goals.

Two good articles to refer to for further reading :  http://www.futuresmag.com/2011/12/31/simple-money-management-wins-over-time  and http://www.investopedia.com/articles/forex/06/fxmoneymgmt.asp

 

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