Money Management 8

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Money Management 7

Money Management

An essential element to success in trading is ignored in almost all trading or market timing books or articles. It's surprising given its importance that very few writers devote any time to the discussion of money management practices and principles. This chapter will present one approach to money management that is general and could be easily supplemented by other methods if you desire. The goal here is to provide recommendations for a simple, viable approach to allocating funds and managing your portfolio.
This book is not intended to include a course on money management. However, if there is one subject within the realm of trading that is vital to a trader's financial survival and at the same time totally overlooked as critical, it is the discipline of money management as it applies to trading success. If market indicators and systems were always precise in identifying tops and bottoms, the necessity for prudent money management skills would not exist.
Unfortunately, such is not the case. Even if a system were 99 percent accurate, the 1 percent failure rate could conceivably wipe out a trader who did not apply money management methodology. The following techniques for your consideration in designing a prudent and viable money management program may appear simplistic upon first glance. However, making procedures complex serves only to obfuscate the obvious, easy, and straightforward approach to sound money management. These recommendations regarding the design of a money management methodology are a compilation of various techniques I have developed and employed successfully throughout the years.
Before you enter any trade, you should be convinced that the trading event will prove to be profitable. Otherwise, why even attempt the trade? Obviously, no decision in life is always correct and this applies invariably to the markets. In the case of the markets, however, you are not able to undo a bad decision and recover your losses from a trade.
This lesson came early in my career. Discretionary decisions or trading hunches or guesses may prove profitable on occasion, but how do you quantify and duplicate this decisionmaking process in the future? Consequently, the following suggestions are directed not only toward developing -a series of mechanical, objective approaches to trading decisions and money management but also to enable you to replicate your decision-making process regardless of the time period and the number of markets followed. The primary considerations are consistency, objectivity, and portability. Additionally, you need to be sensitive to diversification of market timing techniques, as well as markets monitored. By implementing a number of unrelated methods, you will be able to sufficiently diversify your portfolio and thereby reduce your level of risk. In other words, by applying a combination of market timing approaches, each of which uses a different trading philosophy, you will be able to operate as if you had a number of trading advisors managing your funds. Obviously, these techniques should be applied on paper before introducing them real time into your trading regimen. Once the techniques have been sufficiently tested to ensure performance results and nuances, the money management disciplines must be introduced. The other chapters of the book pertain to the methodologies, so this discussion is devoted to a basic approach of managing trades and your investment.
First, you should allocate percentages of capital equally to various mechanical market timing models. Therefore, if you have developed and decided to use three noncorrelated mechanical approaches, then you should designate the same percentage participation to each. You may choose to vary this approach. For example, if one system is two times more effective than another, then you would double by position size or if the frequency of trading for one method is twice as active as another technique, you may wish to reduce portfolio commitment by 50 percent.
However, for sake of discussion, assume that all systems are equally effective. Assuming a total of 100 percent, you may not wish to allocate in total more than 30 percent to these systems collectively at any one time. Also assume for purposes of simplicity that you have elected to follow 10 individual markets for each system. Consequently, your maximum exposure would be no greater than 30 percent of your beginning equity, and that is only if each model has its maximum investment exposure of 10 markets at any one time and each market is being traded simultaneously at the same time (10 markets times 3 trading methods times 1 percent apiece equals 30 percent exposure).
How are you to measure your investment commitment in terms of number of futures contracts, for example? Rather than subscribe to an esoteric portfolio management methodology with numerous complicated variables connected by advanced statistical formulas, you should rely on the market itself to dictate your level of exposure at any point of time. Specifically, the various futures exchanges determine the margin requirements to trade markets. Typically, as trading activity becomes volatile, the margin requirements increase. At that time, you should reduce your exposure because you would have specifically allocated only a 1 percent commitment to that market for this particular market timing method. Conversely, when price activity becomes inactive and less volatile, you would increase your investment exposure, hopefully, awaiting a breakout and increased volatility. Consequently, margin requirements serve as a barometer for fund allocation.
To clarify this process, the market itself is the best source for dictating market exposure. This measure can easily be determined through simple calculations. The various futures exchanges evaluate the volatility and volume of markets continuously. If for any reason, they believe that the potential exists for wide daily swings in the market and, concurrently, the risk of erosion of a trader's margin, then, typically, they will be inclined to raise margin requirements. Therefore, whenever margin requirements are raised, market exposure as measured by the number of contracts traded should be adjusted accordingly. In other words, say you assume a portfolio size of $1 million, the use of three trading systems, and the limitation of trading only 10 markets in each. The maximum exposure can be no greater than $300,000 dollars, since that amount accounts for 30 percent of $1 million, the maximum account size defined above. It is unrealistic to assume that positions will exist in each and every market at any one period of time, however. In any case, this allocates $100,000 to each of three markets. In turn, this would imply that for each method, each market would represent $10,000 dollars. Now suppose the margin requirement in one market is $ 1,000. Then 10 contracts could be traded at any one time. If volatility increases, the exchange may decide to raise margin requirements by an additional $1,000 to $2,000, thereby forcing you to reduce your position size to five contracts (5 x 2,000 = $10,000 and 10 x $1,000 = $10,000). What has effectively occurred is a portfolio contract-size adjustment of 50 percent due to a 100 percent increase in margin requirements. If the volatility has increased sufficiently that the exchange is compelled to raise margin requirements, and you are still positioned in the market and have not been stopped out of the trade, then it is likely that the market has moved in your favor. In that case, the money management discipline and methodology described here requires closing out profitable positions, and prudent trading would also dictate profit taking. The initial exposure was a function of margin requirements, and the change was made as a result of market volatility and potential risk as defined by the increase in margin requirements.
Once in a trade, stop losses must be introduced. Generally, you should apply a standard stop loss and not risk any more than 1 percent of your portfolio on any one trade. Should you desire to increase this stop loss, you should reduce accordingly the size of the position or exposure you have in that market and at that method at that particular time.
For example, you should always maintain a 1 percent risk level, but if you wanted to increase the dollar stop loss to double that amount, you should reduce your market exposure by 50 percent. All other increases in stops would be adjusted accordingly as well.
As the portfolio size in one method and in one market increases, you should adjust your stop loss and profit-taking levels and make certain that your exposure does not constitute an undue weighting in the portfolio. In fact, as the profit in a position increases, you should reduce the position size to maintain a maximum portfolio exposure and, ideally, in effect you will be investing only the profits generated in the trade.
The approach described here is simplistic but effective. High-tech mathematical modeling and sophisticated statistical techniques can be introduced, but experience indicates that minimal improvements will be produced.
Although this approach to money management is devoted to high-margin futures, a similar approach can be easily applied to stock portfolios.
In conclusion, it is critical that a trader design and implement a methodology that is capable of being measured for performance statistics historically. Once confident of the results and comfortable with the implementation, a trader should paper-trade the method and then apply it real time to the markets with funds in small lots or shares. As you gain experience and confidence with the method, the position size can increase. Discipline is a prerequisite. If you conform to the general money management guidelines discussed in this chapter and then add improvements to the schedule to fill in any blanks in procedure, a difficult and critical component of trading success will have been addressed and satisfied.

The Kelly formula


A simple case of the Kelly formula is where you either double your wager (i.e. you get back your bet plus an equal amount) with probability p or else lose it all with probability q = 1-p . The Kelly system says that in this case the optimum fraction of your capital to risk is f=p-q.
For example, if you have a system in which you double your money with a 60% probability and lose it all with a 40% probability then your optimal fraction to bet is
f = p - q = 60% - 40% = 20%.
The mathematical reason that its true is actually quite simple.
In the double or nothing case above, the log of your return per bet after W wins and L losses using this system is:
(W/N) log(1+f) + (L/N) log(1-f) where N=W+L.
If N is large then W/N=p and L/N=q. Maximizing this expression in f using calculus gives f=p-q, as expected.

Thus, if the assumptions are satisfied, your portfolio will grow at the highest rate if you invest the optimal f each time. One problem with the Kelly criterion is that it implies a larger maximum drawdown than most people would be comfortable with. Most people would likely want to choose a fraction to bet which is less than the Kelly fraction even at the expense of optimality. Another problem is that you often don't know what p is.
For purposes of illustration, I have used the same simple double or nothing setup that Kelly uses in his original article but the entire idea generalizes substantially beyond this.
Since you probably don't know what p and q are you could just pick an X% and Y% that are sufficiently small. For example, you could choose X% as 3% or 5%, say. A number of practically oriented books and articles recommend that sort of approach.
William Gallacher's book, Winner Take All, is another source which mentions and critiques Optimal f in the context of futures trading.

Louis Kates
lkates@alumni.princeton.edu

Tips & Hints:

Should you desire to increase this stop loss (1% of cap.), you should reduce accordingly the size of the position or exposure you have in that market and at that method at that particular time. ð adjust stop loss and profit-taking levels
As the profit in a position increases, you should reduce the position size to maintain a maximum portfolio exposure and, ideally, in effect you will be investing only the profits generated in the trade (!).

Random Entry Strategy:

The initial strategy demands that with any trade on, right or wrong, the stop and exit system would either leave you in the good trades or get you out of the bad trades at a small loss and under certain circumstances get you on the other side. The random initial entry perspective forces you to develop a very disciplined trading strategy and trading rules to go along with it. More importantly, it gets you away from looking for all the answers in the various entry systems which were being promoted.
The stop and exit rules for the system were developed with an extreme perversion to optimized values and being very careful to watch the degree of freedom which I allowed the system to have. Once you have a set of profitable stop and exit rules, you can concentrate on developing an entry system that was more intuitive than the random 'flip of the coin' method. This step in the development of a system, by definition, became much less important.

The importance of discipline in your trading regime can not be overstated, especially on exits. This discipline was a welcomed (and badly needed) side effect of developing a trading system with this methodology.


Trailing or multiple contracts:

Enter all contracts on the entry and exit half (or a portion) at the primary exit signal, stop is moved to breakeven on the remainder and we trail the remainder until the secondary target or we get stopped out. Each trade has an associated stop plus a primary and secondary exit ð at the time of entry, all possible exits signals are known and quantified

I use threshold levels to increase my trading size. My formula is:
2x max historical drawdown + margin = equity needed to trade 1 S&P contract.
So a 50% drawdown to me means a real 25% drop in equity.
By drawdown I'm talking about my total net running drawdown. I always use stops on my individual trades which keeps my max. daily net loss around 3% to 5% depending how many systems trade that day (I use 3 systems). The recent volatility in the S&P's has forced me to almost double my stops over the last 6 months which has made the drawdowns deeper.

Turtle System trading signal:

1. Enter a long/short when a tradable (!) exceeds its 20 day highest/lowest close.
2. Exit a long/short when a tradable (!) reverses to inside its 10 day highest/lowest close. (wenn letzter "theoretischer Trade" ein Verlust war, nur eine Position eingehen [theoretischer Trade: wenn weitere Kriterien' nicht erfüllt?])
The second part on money management describes when to increase or decrease the number of contracts traded.
The hint I can give is "volatility". Focus on the volatility of each individual market. Then think of in terms of "units". Derive your starting capital into measureable "units" based on volatility.

The Turtles managed the absolute risk this way:

1. Take the average of the True Range over 10 days
2. If this is rising, trade with FEWER contracts. This allows the stop (=risk) to be
wider and so you risk a constant amount of money but with fewer contracts
3. If average TR is lower, then start trading more contracts

Trailing Stop:

Let's say you buy an S&P at 900 and it rises to 902. If the S&P stays above 902 for a week and then falls below 900, say to 898.40 then you get stopped out at that point, 898.40, assuming no slippage. A Trailing $400.00 trailing stop would get you out at 900.40 assuming that the S&P did not get any higher than 902.

Risk-Reward-Ratio:

10% risk per trade: you may think, that if you have 100000 you could risk/invest no more than 10000 in one stock (e.g. 50 stocks á 200). But consider buying a stock priced at 200 with a 2$ stop loss: risking 10% means, one could buy 5000 stocks ! So risk must be thought of as the percent of equity you are willing to lose on a trade if you are wrong. Risking more than 3% is extremly risky, especially if you have 10-15 positions on at one time.

Limit Orders:
A big advantage to limit orders is maintaining a predetermined Risk-Reward-Ratio for a specific trade. In other words, if you enter a trade with a stop-loss and a target price and you like to maintain a certain ratio, say 3 to 1, then you must pass if you can't enter the trade within the Risk-Reward parameters. For this reason, I like to use stop with limit orders.

Adaptive Moving Average & "Efficiency Ratio":
An exponential moving average in which the smoothing factor varies with the "Efficiency Ratio". Efficiency ratio is the ratio of total price excursion divided by the sum of all individual excursions of each bar. It equals 1 if all moves are in one direction over the lookback period.

Buy & Hold:
Take your system and gauge it against a Jan through Dec against simply buying and holding. This will let you know how much was really your system and how much was just the market.

100000 Account + Stop-Loss: $1500 13 Markets
a) simultaneously active in all markets and stopped out in all markets:
19500 Loss ð 19,5% Drawdown
b) 13 consecutive losses:
19500 Loss ð 19,5% Drawdown
c) simultaneously active in all markets and stopped out in all
markets + 5 consecutive losses:
97500 Loss ð 97,5% Drawdown (!!!)
d) 5 consecutive losses in all 13 markets (65 consecutive losses):
97500 Loss ð 97,5% Drawdown (!!!)
ð check 50% Drawdown (shutdown point) !!!


5 Systems: sum all positions up to arrive at the final trade:
get a net position of 3 contracts long (5 long - 2 short)

Bring the two files into Excel, and add the NetProfit columns together to get the combined equity curve.
weight the equities: for example, if I have equities for BP, DM, JY and SF I may create an equity curve of 2*BP + 1*DM + 1*JY * 1*SF where the coefficients 2,1,1,1 are inputs

15% in margin: 2-5% DM, 2-4% DAX, 2-4% Gold, 1-2% Euro-$
ð so increase number of contracts within these limits

accept a 50% reduction in Return if it comes together with a 30% reduction in Drawdown

Portfolio-Stop: -7-8% monthly: Stop !
Return p.a.: = 3 * Drawdown
Drawdown + Regression-Analysis:
45° + deleverage at a parallel line ABOVE the 45° line (to let room for further losses)


Drawdown 40%
Recovery 100%
Net Return 20,0% =(1-40%)*(1+100%)-1
when using a proportional Trading System, the ratio of recovery should be a constant:
X 2,50
(1-Drawdown)*(1+2X)-1 = 0
D = (X-1) / (2*X)
30,0% optimal Drawdown ð trade 1/4 less (from 40% to 30%)
22,5% new Net Return

Third Of A Series On The Successful Use of Money Manage-ment To Improve Your Trading Results - Tom D'Angelo

http://www.commoditytraders.com/issue/tom.html


This is the third in a series of articles which describe how to construct a professional and disciplined money management plan, designed to allow the trade to manage his trading in the same manner as a successful business. Refer back to my previous articles in Vol 4-1 and Vol 3 8 for a detailed discussion of the Profit Center methodology and calculation of the required money management statistics.

In this article I will discuss the Performance Report. The Performance report is a summary of all the significant money management statistics for each individual Profit Center. Each Profit Center is a business and the Performance Report is a management report which reveals your success or failure in managing that business.

The Trading Plan is the trader's strategy for the next trade based on the information provided by the Performance Report. The Trade Journal is an "after the fact" critique of the Trading Plan after the trade is closed out with a profit or loss. I will discuss the Trading Plan and Trade Journal in my next article.

There appears to be lots of interest in the Real Success trading methodology. I have not purchased this course but I will try to describe a sample Performance Report for Real Success methodology traders.

First, if I was trading the Real Success method, I would set up the following Profit Centers:

RS(M)- All trades taken from the Real Success Methodology

RSDAY - All Real Success day trades. Overnight Real Success trades can be entered into a Center named RSONITE

RSSP500 - Real Success trades segregated by the future traded (RSSWISS, RSBEANS etc)

RS3MIN - All Real Success trades taken off of 3-minute bars RS5MIN - All Real Success trades taken off of 5-minute bars

RS3MINSP500 - All SP500 trades taken off of 3-minute bars (RS3MINSWISS for all Real Success trades taken off of 3-minute bars for Swiss Franc, etc)

Substitute 5MIN for 3MIN to segregate trades taken off of 5-minute bars. Example, RS5MINSP50O for all SP500 trades taken off of 5-minute bars.

Helpful hint - If you are planning to paper trade the Real Success methodology first, simply add a P to the end of all the Profit Center names. The P signifies a paper trading Profit Center. For example, paper trading the Real Success method with 5-minute SP500 bars, you would enter the trades into a Center named RS5MINSP500P. After you have about 20 paper trades in each Center, calculate the statistics I described in Vol 4-1 of CTCN and you will have excellent information as to your performance paper trading the Real Success methodology for each Profit Center.

Results of the paper trades can then be compared with real time results by using the Performance Report.

When you begin real-time trading, create The Profit Centers I have described above (without the P at the end of the name) and enter the real-time trades into those Centers.

After 20 real-time trades have been entered into a Profit Center, you will have a good data base of trading information and can complete your first Performance Report.

The following is a brief description of the items contained in the Performance Report.

Profit Center Name - Name of Profit Center analyzed.

Example, RS5MINSP500 for all trades taken from Real Success methodology trading 5 minute SP5OO bars.

Profit Center Type and Goals - Description of the Profit Center and the financial goals the trader is attempting to achieve.
For Example, Profit Center RS5MINSP500 will contain only SP500 trades taken from the Real Success methodology based on 5-minute bar charts.

After 100 paper trades, the trader has achieved 60 profitable trades (6O%) and 40 unprofitable trades (40%). Average Profitable trade was $600, average unprofitable trade was $400 for a ratio of 1.50. The Profit Factor was calculated to be 1.23. Net profits after 100 hypothetical paper trades are $2000.

Worst drawdown was $1800. Best series of winners was 6 with $1600 in profits. Worst series of losers was 4 with $1550 in losses. The trader will try not to lose more than 3% of capital on any one trade. These statistics of hypothetical paper trades can then be used as goals to be achieved with real-time trades.

The remainder of the Performance Report lists statistics from real-time trading.

Initial Capital - $30,000. This serves as the funding requirement for the business to cover margin requirements and trading losses.

Drawdown - Current drawdown in progress = $1050. Largest actual real-time drawdown = $2300

Series - Worst series of consecutive losers = 4 with a loss of $1300 in the series of 4 trades. Best series of winners = 6 with a profit of $1700 in the series of 6 trades.

Current series in effect - 2 consecutive profitable trades with a profit of $600 in the series of 2 trades.

Largest profitable trade - $ 950 on 3/11/96

Largest unprofitable trade - $1020 on 2/ 5/96

Optimum number of contracts to trade = 3, based on Ralph Vince's formula.

Trading efficiency - 57% winners and 43% losers.

Average profitable trade = $500. Average unprofitable trade = $300. Ratio of profitable to unprofitable = 1.67.

Range of losing trade as % of capital = 2.1% to 4.3%

Profitability - Profit Factor = 1.14. Profit Center is profitable with profitability trending upwards. I use graphs to determine the trend of profitability with the Pro-Graphics module of my MANAGER money management software. I will describe in my next article how I use the trend of profitability to determine how many contracts to trade.

Current net profit after 60 real-time trades $1100. Current Capital = $31,100 which equals $30,000 Initial Capital plus $1100 net profit.

Thus, the trader has established a business named RS5MINSP500 which is producing revenues (profitable trades) and expenses (losing trades + commissions). The Performance Report informs him of his trading performance in the RS5MINSP500 business as well as enabling him to compare actual real-time results with goals derived from hypothetical paper trades.

The Performance Report takes the trader out of the dark and into the light. He knows exactly his trading performance for each of his businesses and can instantly explain to anyone his profitability and efficiency as a speculator.

Most traders experience psychological problems due to the fact that they attempt to manage a business (i.e. trade) without any type of organizational structure which can provide them with the information necessary to execute disciplined, informed and educated trading decisions.

Nearly all traders manage their trading using monthly broker's statements which provide a "macro" view of their trading.
These statements only inform you as to your overall profit or loss for all your trading. This type of data is totally inadequate for the professional trader who requires more detailed information such as provided by the Profit Center methodology.

Hopefully, the reader has begun to see why many aspiring traders experience the same psychological problems....fear, greed, anxiety, inability to "pull the trigger" etc. The average trader operates in a fog. He has no money management methodology to provide the structure for successfully managing his trading business. Since he operates in the dark, he inevitably becomes uncertain and anxious. Continually floundering around in the dark makes the situation worse and worse, like a snowball rolling downhill.

You cannot successfully manage any type of business without first organizing your trading performance into a meaningful structure which reveals trading strengths which can be exploited and weak areas which must be eliminated or reduced.

The Performance Report provides the basis for formulating the Trading Plan. The Trading Plan is the strategy for the next trade based on the trader's trading performance as revealed by the Performance Report. I will also explain how the Performance Report is used to formulate the Trading Plan as regards to how many contracts to trade.

After the Trading Plan has been executed and the trade closed out with a profit or loss, the trader completes the Trade Journal. The Trade Journal is the "after the fact" critique of the Trading Plan. These three reports are specifically designed to eliminate the psychological problems which plague most traders and create an environment conducive to executing rapid, informed and educated trading decisions.

The Trading Plan and Trade Journal will be described in my next article as well as how this type of methodology promotes psychological stability and significantly reduces stress.

I will also describe how to file all the reports so that the trader will now be operating in a professional, disciplined and informed trading environment . . . similar to a successful business and structured to engender confident trading decisions.
This type of environment is specifically designed to advance the trader up the learning curves of the three disciplines necessary to achieve successful long-term successful speculation: Trading methodology; psychological discipline and; money management.

For a free booklet describing the reports I use and information on a newly completed book I wrote on money management, feel free to contact me at 800-MONEY30.

System Testing Observation
Adam White

Here is an interesting observation I made while system testing.

Say you run a system test over 10,000 bars of data, then print out a chart of the system's equity line. Then repeat the test, but start 100 bars later. Let's say two trades were included in those 100 bars, so they've been dropped. Now print the second equity line and compare it to the first. You'd get exactly the same equity line, but 100 bars shorter. Right?
- Wrong!

When I do this I get a radically different equity line on the second test, i.e., they are not near mirror images of each other. My hunch is that a form of the chaotician's "butterfly-effect" has arisen: changing any given trade's market position (long, short, flat) will effect in a chain reaction all the subsequent trades in complex and unexpected ways. Here dropping the first two trades could very well change the system's market position when the third trade is calculated, and so on.

I believe this observation has profound and unfortunate implications for the robustness of system testing. It's a second and more subtle problem that lies behind the mere curve fitting/optimization problem.

If dropping a couple of early trades will always effect later trades, then there's no truly "neutral" starting point with any test data. Where your test data starts determines the final test results just as much as your system does.

Editor's Note: Not too many CTCN members are aware of this but I have known about this for some time. The success or failure of many different mechanical systems is predicated to a surprising and varying degree on the sequence of events just prior to the first actual trade generated by the system.

The trade setup and timing of the first trade can have a profound effect on the subsequent trading results. The circumstances and timing of entry into the first trade can sometimes make a huge difference in the overall trading performance.

Max Robinson Has A Unique Way To Use Closing Price To Mimic A Moving Average

Keep up the good work. Anyone that is trying to do something good will be criticized or disliked by someone. But remember, you are helping many, while only a few are unhappy.

I have the System 2000. It does help identify turning points and congestion areas in the market. But then one needs an entry method.

The secret of all financial success is money management. How much can you risk on this trade, and still be financially able to take some losses and still be able to trade when the profitable trade finally comes by. Study Vol 4-1 of CTCN, articles are really enlightening (D'Angelo & ??). Can't read name?

I have two Ken Roberts courses. They have some good ideas in them and one of them convinced me to let go of some old anger.

Every one needs to understand that the constitution may guarantee equality under the law, but we are not born with the same abilities. Some of us just will never become a winning trader, but we might become a successful painter.

Larry Williams latest video had lots of information in it.

I have a mathematical way of using the close of today's market to compute an average that is similar to the 9-day and 40-day average.

My method is much easier and quicker to compute than most averages, since you only deal with today's close. This method picks turning points and acceleration points like any system that I have seen. But like all of the other systems, one has to apply his own entry and money management plan to it.

The big problem I believe we all have is fear and greed. Most of us are so greedy that we can't stand to be wrong 5 or 6 times out of every 10 trades. So we keep searching for the Holy Grail. In order to get over the fear of losing, one has to find a system and run it on old data until you realize that it may work okay!
Call anytime 308-775-3140.

All about Stops
Donald Turnbull

Here are some thoughts that might prove useful to neophyte traders like me. They may duplicate many that you have already published, but I have not had the pleasure of reading.

I do not trade the S&P index because the margin requirements are so high it would take too big a proportion of my account to cover them. I would then have one position with, perhaps a 50% chance of success (and a 50% chance of failure).

Editor's Note: The S&P 500 margin is indeed very high for overnight position trades. The last time I checked it was $12,500 at my brokerage firm. This is one of the main reasons the S&P is not recommended for overnight trades.
However, like most brokers, my broker reduces the margin sharply for daytraders, where it's only $3,500.

In fact, I have heard it said by some of our members that certain brokers do not require any margin providing no trades are carried overnight. I am not sure if that's correct information and have not verified it to be correct, but have heard it said many times.

For similar reasons, I do not trade Japanese Yen, where one full point is worth $1,250. The difference between the high and low in one day can be $6,000. This is too rich for my trading style.
Instead I trade low margin trades like pork bellies, live meats and beans, and have a number of trades going at one time.

Just suppose I have 5 trades going, each with a 50% chance of success (and a 50% chance of failure). The statistical probability of all five failing is .5 x.5 x .5 x .5 x .5 which in .03125 or only 3%.

Editor's Note: Are Don's figures correct? Is it true that five trades involving 50% odds results in only a 3% chance of having five straight losers? If so, why does your editor frequently hear about certain systems or trading advisors having far more than five consecutive losers. Many of those systems are in fact ranked much better than a 50% success ratio by either the developer or Futures Truth Ltd.

In fact, I have heard of some systems or trading advisors that claim perhaps a 60 or 70% (or even better) success rate yet sometimes will have say ten, or even 20 (or more) straight losing trades. How is this possible, if Don's failure possibility is only 3%, or even less than 3% based on profitable trade percentages considerably higher than 50%?

I recall some years ago I read in one of the major trading publications(I believe it was Barrons Newspaper) that Jake Bernstein had (if I remember correctly), 23 straight losing trades. I know Jake and he is perhaps the most respected and most knowledgeable commodity expert there is. Jake has also written 23 books on trading commodities and is incredibly knowledgeable on trading. Jake is also a psychiatrist (or a psychologist . . . I always get the two confused) and no doubt has great discipline and trading skill. I am sure Jake will normally have at least 50% winning trades. So how is it possible someone like Jake could have over 20 consecutive losers? I am not picking on Jake as many other famous traders and experts have also had 20 or more straight losing trades over the years.

What is the chance of this happening, if in fact the profitable trade percentage is 50%, or even higher? If the chance is extremely small, why has your editor heard about this happening numerous times over the years, involving a vast number of popular systems, methods, and well known trading advisors or respected advisory services?

The probability of at least one or more successes is 1-(.5x.5x.5x.5) which is 93.755% . That's a lot better than the 50% mentioned above.

With tight stops, the losses are limited to an average of $300. With 4 losses, this amounts to $1,200. Profits are allowed to run and usually average $2,000. This results in small but virtually certain profits.

In actual practice, by limiting my trades to the recommendations of an advisory service, like Steve Myers on Futures (Summerfield, FL, 1 800-835-0096), probability of success is much higher.

I have heard it is bad practice to order a position "at the market." Before placing an order, I phone my broker's quoteline and get the high, low and last figures. Then I place a limit order at the "last" figure. Is there a better way of doing it?

Editor's Note: I do not necessarily agree it's a "bad practice" to trade with market orders. In fact, our Real Success Methodology uses market orders more frequently than limit orders, especially when entering into a new position. We also use market orders extensively on exits involving targets and stops.

Market orders have several major advantages over limit orders. One major advantage is you occasionally have difficulty verifying you are actually in a trade or out of a trade due to uncertainty involving a limit order being filled. On the contrary, with a market order you always know you are filled and in the trade or out of the trade. Another advantage is a market order will normally have less slippage than a limit order. In fact, as witnessed in CTC's Real Success Videos, sometimes we actually have positive slippage with market orders, rather than the usual negative slippage involving limit orders.

When profits accumulate and my account grows above my target figure, I have my broker send me a check for the difference. That way, I am not tempted to get into larger and larger trades. This may not be the way to become a millionaire, but it suits my risk tolerance level.

Moore Research Center publishes a list of "optimum" stop values, beyond which a commodity rarely recovers, and within which it often recovers. Their "optimum" stops seem to me to be too high. They are all in the range of $1,200 to $1,500.
To go along with my philosophy of having a number of trades going at a time, I think that tight stops are appropriate. This may stop you out of some trades that eventually recover and make a huge profit. But even in these cases, if you have confidence that the market will eventually rise, and you watch the market closely, you can get back in again and lose only one round-turn commission. However, if the commodity doesn't recover, you've saved yourself a lot of money.

Money Management, Optimal f

BALANCING ACT By Mike DeAmicis-Roberts

Comparing optimal f and probability of ruin can give you better insight into the risk-reward parameters of your trading.


As many traders know, success depends as much on money management strategy as it does on a particular trading system. Optimal f and probability of ruin (POR) are two key money management concepts that help you determine how to best allocate capital for maximum growth and minimal risk to your account.

In some cases, however, these formulas conflict. We will overview the meaning and application of optimal f and POR and discuss a method (and offer some free Windows software) for evaluating systems by comparing these two formulas.

See Futures' downloads page for a copy of this software and "Profiling Optimal f And POR" for directions on using it.

Optimal growth Optimal f, popularized by Ralph Vince in his book Portfolio Management Formulas (Wiley 1989), is the ideal percentage of capital to allocate for any particular trade - the amount of equity that will result in the greatest gain to the account (see "Without money management, you don't have a system," Futures, Building a Trading System special issue, October 1994). This amount, which determines how many contracts you can trade, is based on the profit and loss profile of a trading system, rather than a percent of account equity.

Optimal f allows the trader to maximize the profitability of a system. If you trade with a higher or lower percentage of equity, you run the risk of not capitalizing enough on your winning trades or getting hit too hard on your losing trades.

The POR is the likelihood your system will reach a point of success or failure, that is, the chance that you will blow out your account before hitting your financial goal. Ruin is defined as the account level at which a trader stops trading. The POR is calculated using the percentage win, the average win, the average loss, the account size, the account size at ruin and the account size at success.

Because the probability of ruin increases with the amount risked, it's important to limit the amount of capital you commit to each trade. By trading smaller portions of the account equity, there is a greater chance a well-tested system will perform closer to its historical results. Traders who risk a larger percentage of account equity are more susceptible to variation from the expected results because of the small trade sample size.

Unfortunately, finding the optimal f and POR for a system is a computationally intensive process, (although the math involved is not difficult). As a result, few traders know the optimal f or POR for their systems. In most cases, this leads to diminished returns and increased risk.

Optimal f and POR calculations do not always suggest the same risk parameters. By comparing optimal f and POR, you can determine if the amount of capital risked at the optimal f value results in an unacceptably high POR. On the other hand, a trader may wish to increase the POR for the chance of exponentially higher returns. Ultimately this is a decision every trader must make. The optimal f amount suggests how much to risk; the POR value gives you an idea of the relative risk associated with trading this amount.

Application When evaluating a system for the optimal f, you find that the total returns lie on a curve, with the optimal f value at the apex. Moving the same amount to the left or right of the apex curbs the potential returns of a system by approximately the same amount. For example, if the optimal f for a system is 25%, then a trader can expect about the same amount of returns while trading at either 20% or 30% of the account.

The same cannot be said about the POR. In short, the more a trader risks, the greater the POR: It always will be higher when trading more than the optimal f and lower when trading less. Generally, if you don't want to trade at the optimal f value, it's wise to trade at a lower value to decrease your risk of ruin.

In some instances, it might not even be possible to trade a system at optimal f. For example, a trader with a $15,000 account and an optimal f of 5% can only risk $750 on any trade. This may not be an adequate amount in markets like the bonds and S&Ps.

Another problem is when the optimal f amount does not translate evenly into whole contracts. Using the example above, the trader should risk only $750 on each signal. If a single contract position implies a $500 risk to the account, the trader must decide if it is better to trade one or two contracts, which in turn influences the POR for the account.

There are no strict rules - "you should always trade y percent of optimal f" or "x is an acceptable POR." Optimal f and POR analysis does not give a trader any specific guidelines on how to trade. Rather, it shows the risk and reward associated with using a certain money management strategy for a trading system. You can then use this information to better evaluate the prudence of your trading approach.


Mike DeAmicis-Roberts is a researcher-programmer specializing in risk management and neural network technology with Comet Management in Hollister, Calif.
His internet address is: mike@chipx.com



MONEY MANAGEMENT INTRODUCTION
http://www.bhld.com/brochure/money.html

Money management is a part of an over-all investment system. Most people never have a formal money management strategy, yet every investment must address the two basic money management questions "What should I invest in?" and "How much should I invest?"

Your over-all investment system includes your money management strategy and several trading and investment models. You may have a number of investment models which you have never formalized, such as accumulation of savings, purchase of long term bonds and so forth.

The money management information you develop with Behold! cannot utilize information about those parts of your investment system which are not formalized within Behold! yet those other parts will affect the degree of risk which your are willing to accept for the trading and investment models you develop with Behold!

The money management features in Behold! address two main questions:

(A) What is the best way to allocate my money among my formalized trading
models and potential markets?

(B) With the capital on hand how many contracts (shares) should I buy?

This second question is particularly important to commodity traders as the leverage available to them allows carrying more contracts than is wise.

The question concerning capital allocation is vital to any trader who has sufficient capital to allow trading more than one stock or commodity.

Definition of Terms:
The Performance Summary for a single file or for a set of files for a single commodity (a roll-over report) shows two pieces of information at the bottom of the "All Trades" section, Optimal Capital and TWR.

Optimal Capital can be defined as: The amount of capital which you "should" have used to back up each commodity position, in order to achieve the highest rate of gain.

TWR is an acronym for terminal wealth relative. It is the ratio of final capital to initial capital which you would have achieved had you backed each position with the optimal capital.

Both of the above definitions assume that all profits/losses are to be plowed back into trading, and that you have the ability to carry fractional positions. Note that TWR in Behold! is an annualized number to allow comparisons between tests of different lengths.

"q" If you test a portfolio (with more than one stock or commodity) and check the box Calc Optimum Allocation then you will get two other types of data. One is simply labeled as "q" and the other is a list of numbers showing the optimal fraction of capital which should have been allocated to each security. Use of the capital allocation numbers and "q" will allow a commodity trader to obtain a Geometric Optimal Portfolio: that portfolio of the commodities tested which will give the highest growth rate.

For a better description of the terms and an in depth understanding of their derivation you should read the book Portfolio Management Formulas by Ralph Vince. For those with a mathematical bent it would be good to read his second book The Mathematics of Money Management.

Optimal Capital, TWR, the optimal capital allocation in a portfolio and the "q" value are all computed using data taken for trading with a fixed number of positions. They are not effected by the manner in which you vary the number of positions you are trading.

Trade Testing Options in Behold!

There are many ways to do portfolio performance testing, and in order to allow you to get what you want (which is not necessarily what we expect) the money management features in Behold! have been placed under your direct command. Thus we do not determine exactly what is "optimum" and then force you to live with it.

The Test Options dialog is use to set many testing options, of which the following are of interest now.

#Positions:
Single. This selection will require Behold! to always open a single position. This is the way that you should do your initial system development.

by Rules This selection allows you to write rules which control the number of positions opened. Your rules can access trade information such as the amount won or lost on the previous trade, current working capital and Worksheet data such as RSI, ADX and so forth.

Auto Behold! will calculate the number of positions to open as current working capital divided by the capital per position ($Posn) which is set in the same dialog. The initial working capital is set in this dialog in the Capital, Single file test item.

The next items determine how your working capital is changed by your trading results.

None Means no reallocation. All of your wins accrue to your working capital, and all losses are subtracted from working capital.

Percentage A certain percentage of each win will be taken away, to simulate re-capitalizing losses in other markets. A certain percentage of each loss will be replaced, to simulate re-capitalization using profits from other markets.

Dynamic This choice is only applicable to tests on portfolios.

The last item of interest is Monthly Withdrawal. This item allows you to determine how withdrawing a portion of your working capital, to cover expenses and so forth, will effect trading results.

Optimal Capital

The information in this section is mainly of interest to commodity traders, however stock traders should always assure themselves that the Optimal Capital value shown in the main Trade Test report is well above the cost of the stocks they are trading.


Portfolio Capital Allocation

Proper diversification of your investment capital would recognize all of your investments and allocate capital among them in order to obtain the maximum rate of return with the minimum relative risk. Capital Allocation in Behold! can only determine the best way to allocate your capital among the trading models and securities which you have formalized with Behold!

IF you run a Portfolio trade test and check the Calc Optimum Allocation box you will get three new items at the top of the full portfolio report. These are "Q" and the optimal % Capital allocation as determined for the securities tested in your portfolio. See Vince's book for a discussion of "Q."

As an example of the allocation information, see the example below.

Financial.PTF Initial Capital = 100000 "Q"(E/V) = 2.29
IMMEUD Actual %Capital = 100.00 Optimal % 62.55
TBOND Actual %Capital = 100.00 Optimal % 37.45

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Money Management 9

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