Money Management Strategies . . .

[Airelon]

Curious as to what money management strategies ones employ when it comes to their trading.

I just switched from a pretty basic "fixed % of capital" to using a modified version of Kelly's. Larry Williams may have been able to do it, but I personally could never conceive of just using a straight Kelly's formula to trade with. The risk you open your account up to is just huge during a winning streak. Mind you, the rewards are greater . . . but I'm just not comfortable with the risk.

So I modified it a bit . . . I used a 70% historical for the formula, and then when the whole Kellys subset is done, I multiply that by .3 - and will be risking that much. When I played with the numbers, it seems that it was above just the fixed 3% I was using (and therefore, had greater rewards - which is what Kellys formula gives you), but I wasn't opening my account up to a huge risk, as Kelly's will do to you when you have a winning streak.

In Excel, I keep track of all my trades, accuracy rates, drawdown, risk reward ratio's, etc. Then from some of those cells, I pull out my risk formula, that looks like this:

=Account Size*((Current Trading Accuracy-((1- Current Trading Accuracy)/0.70))*0.35))*0.3

And wala! What I call: Kellys S.

The /.70 ? That's the "historical rate" that I plugged in. Where it says "Current Trading Accuracy" ? That number varies, according to how well my calls are doing, and is pulled from an Excel Column. . .

[aquaswim47]

Cramer lectured about this very fact. He indicated about using strict scales vs wide scales. Strict scales involve buying a stock at equal intervals as the stock price declines. For instance, for every $1 in share price the stock declines, you buy 5% or 10% using your Zecco account. Wide scales involves buying more shares as the stock goes lower. For the first $1 drop in share price, you may buy 1%, second $1 drop, 2%, third $1 drop 3%, fourth $1 drop 4%, and fifth $1 drop 5%. Then if it drops another 10%, you might buy an additional 25% bringing your total to 40% of your intended ownership. Then you try to see if the stock is still worth buying. You look at news, take a look at this year's or this quarter's balance sheet compared to last year or last quarter, cash-flow statement, and financial ratios (from the income statement). Once you reach 25% of your intended ownership, you need to make a decision; either you need to stop buying, sell if you think the Street may have underreacted to a bit of news or the financials have substantially deteriorated, or buy more because you really believe in the company. Likewise, you will need to do this with 50% and 75% of your intended ownership. You might be right or wrong with your analysis as the Street may have already priced in the bit of news or the deteriorating financials.

[Airelon]

Here's a little something I wrote out for a friend of mine, who had started investing and trading. It covers just the basics of Money Management, and is a starting place:

Money Management:

People will hear the words "Money management" and think "Oh, you mean how much to risk?" or "Only risk 2% of your account size" or, "Oh, you mean my stop / loss" order?

The truth is, those are all very small parts of what comprises Money Management. Proper Money management involves analyzing risk. But it should also look for growth. For your money, making you money. Money management is about managing your trades. But managing your individual trade, does not comprise all there is to know about money management.

I would say that Money Management is made up of:

Risk Analysis

Reward Analysis

Trade Management

Drawdown

Accuracy Rate

Performance Analysis

And those factors? Can be split up even further. . .

[Airelon]

Risk Analysis:

Every human on the planet, engages in risk analysis every day. Chrysler offered Joe a job. Should he take the job? Will he be outsourced next year? Will his job move to another country? Will he be unemployed? Will the union help lower that risk?

It’s the same in this business. You have to determine your risk. You have to try to devise ways to try to limit that risk.

Let me say that again.

You have to determine your risk.

You have to devise ways to try to limit that risk.

Determining means – you have to sit down, and at least plan out a reasonable worst case scenario. How much money would you lose. How much of your account would that loss represent? How would that impact your ability to trade further?

You have to figure any methods at your disposal to limit the risk. For example, I recommend never, ever putting more than 3% of your total account size, into one trade. Some people will say 2%, but I raised it to 3% due to what I will talk about next. Reward. Regardless, the number has to be very low. Why?

It helps mitigate your risk. Thus, you become someone engaged in business, rather than gambling on your money in one area. With only 3% of your account towards Ford? If Ford tanked and went out of business tommorrow, that would only represent a 3% loss to account size, which is your business. Your risk is mitigated. You are left to trade another day, and one disaster doesn't sink you.

That means also, that you must do something that most traders fail at. Have an adequately funded account. An underfunded account is one of the FIRST No-no's, when it comes to trading. This is only logical. Let's face it, if you only have $1,200.00? Then 3% of your account is $36.00. And who can initiate a trade with a risk total of $36.00? Commissions would eat that up, and I can't think of a trade vehicle where the risk is TRULY limited to $36.00. Options maybe. But they'd have to be so far out of the money, that your reward would be nill.

So having an adequately funded account, and keeping your risk per trade to 3%, helps your keep the rest of your account available for other trades. You won't miss business opportunities, because you had your money all in one area.

There are other ways to mitigate risk. Options. Options LOCK IN your total loss, at the price you paid for the option. Of course, Options come with their own risk that you have to consider. Part of the value of an option, is the time decay. As well as the volatility of the market. If your strike price is too far away, if the market isn't volatile enough? The market could slowly move in the direction you thought it would . . . but the option theta (time value) ticks away, and volatility remains low. Your option won't rise much in price.

Again, it comes down to determining your total risk. And trying to figure out strategies that mitigate that risk. There are many.

But there is a dark side to risk analysis that I will talk about in my next post . . .

[Airelon]

Reward Analysis:

Now, what of that 'dark side' that I mentioned when it comes to risk analysis. At times, ones will become so concerned with risk control, that they give no thought to the reward. For example, what if a trader was so concerned with limiting risk, that they engaged in buying cheap, severely out of the money options? Is their risk limited? Yes. Let's say that Sugar is trading at $10.00 and we expect it to fall to at least $9.25. Instead of buying a $9.50 put option, what if they were to reason "Well, I can buy a 750 put option, for only $11.00. That way, my risk is limited to $11.00."

The question becomes, how reasonable is this? Will the market move close enough to 7.50 for that option to become worth anything? Honestly? So did the trader limit their risk? Yes. But they didn't sufficiently consider their reward, or analyze for a reasonable reward, for that limited risk. All they end up doing is throwing away money on cheap options, and nickle and diming themselves to death.

Every human on the planet engages in reward analysis. ;D Sound familiar? Well, it's true. We talked about Chrysler offering Joe a job. There were risks, ah, but what about the reward? The money that Chrysler is offering Joe is very nice. So, what does Joe do?

He balances the risks against the reward.

That is key. That is fundamental to good trading. This is something that 99% of small speculators never consider. They never look at a trade, and look at the balance between the risk, and the reward. Which is ironic. Because any good businessman balances those two factors.

You must plan out what a reasonable reward would be. A good rule of thumb, is that any reward should at the very least be twice as much as your risk. Why in the world would you become involved in any business where the risk was greater than the reward? You'd be setting yourself up for failure.

I can't tell you how many traders I've seen consistently risk $3000.00, seeking a $500.00 reward. Mathematically, they are bound to fail. It's a certainty, and is so obvious, it needs very little explanation although mathematically it has been proven again and again, such as in this linked example.

What a trader needs to do, is consider what is termed the risk / reward ratio. 1 risk, to how much of a reward? The ratio should be at least 1:2, and preferably, rest around 1:4.

Now there I do provide caution here. You must plan out a reasonable reward. This means that there should be market conditions, tools, and indicators that provide and seem to signify that the market can reasonably reach your goal. In the above example, we would like Sugar to go to $3.00. However, historic volatility in that market demonstrates that this is not a reasonable conclusion.

So plan out something, that given historic volatility, the market can reasonably reach that will give you a reward 4 times greater, than your total risk.

So what do we have to date? A few rules.

1) Limit your risk. Determine ways to limit your risk. Do not risk more than 3% of your account on any one trade. We'll talk more about how that number can be adjusted later, but for now? That's your baseline. Risk 3% of your total capital on one trade. This leaves you alive to trade another day, in case something horrible happens on your one trade.

2) Also, plan out a reasonable reward given historical volatility that is at least twice as much as what you are risking. Preferably four times.

We will continue with another aspect that needs desperate attention by most traders, and something that relates to our reward. Proper trade management. Because there is another caution. There is nothing saying that the market will make your reward goal. So what are you to do?

[Airelon]

Trade or Investment Management:

Man, if this isn't an area that receives total neglect on the part of even most guru's. It's very, very difficult to find information about it. At most you'll hear this:

"Make sure you have a trading plan, once you are in the trade". Or you might hear "Ride out your profits, cut your losses" or "Always use a stop / loss order"

That's it.

Ok.

What does that mean? I mean let's face it, those are all pretty much common sense factors. "Make sure you have a trading plan" while true? Is about as helpful as "Buy low, sell High"

Well duh.

So yes. You need a trading plan, once you have pulled the trigger, and you are in the investment, or the trade. What should that plan consist of?

TIME: How long are you looking to be in this trade, or this investment. When dealing with the markets, timing is everything when it comes to your entrance right? Well it should be a big part of your exits as well.

I'm a big one for considering seasonality into a market. This gives us not only an entrance clue (notice it's only a clue), but also a clue as to when we might want to start thinking about exiting the trade.

Gann wrote that timing, for the individual investor, is the most important aspect. NOT price. Price is important, but of the two, I agree with him. TIMING is the more important.

What about an investment? Well, perhaps your timing is more concerned with how to add to your position, since I very rarely sell any of my investment stocks or 'take profits'. But you still have to be concerned about time, once you have bought a piece of a company as an investment.

Let's say I bought Ford at 6.55 (Which I did). It rises to $8.90 and I'm making dividends along the way, for each share. Great. Do I buy more Ford at $8.90 on July 20th? Seasonality is telling me that such timing may not be a great idea. That I may want to look for dips in Ford, and buy more of it (thus increasing my dividend income) come November, when the market typically bottoms out from the Autumn doldrums and weakness.

PRICE: What is your profit goal?

Now you must understand that sometimes, you won't make this goal. But it's very important to have a price goal in mind before, and once you are in the trade.

RISK: What are you willing to risk? If you are trading, where is your stop / loss order? How does this risk equate to to your profit goal?

EVOLVING MARKET FACTORS: Your plan must be flexible. And you can't be afraid to reward your winners, if the market calls for it. At the same time, you must realize when a trade has run it's course, and you may not reach your profit goal.

For example. I'm short in Sugar #11 since July 25th. I bought a Sugar #11 950 October Put. My risk is about $125.00 (Actually, a little less, probably around $56.00 since I'm selling the option before expiry). My profit goal is for the market to hit $9.40, which would mean that my option would be almost 4 times my risk. This particular seasonal weakness in Sugar #11 runs until about August 21st.

Now after I initiated the trade, the market hit some support, and couldn't go any lower. So now what? I decided that if the market broke through a certain level of support - to add to my position and buy another put option. That's exactly what happened. The market broke below 9.97, and I bought a 925 October 925 Put for 8 ($87.00). Actually at the moment, that account is looking at two 950 puts, and 1 925 put. The market conditions told me that 9.97 was some key support. I should reward my winners as much as possible, so an entry point was to add to my short position, and buy another put option if the market fell through that support. (Put options are for when you are expecting the market to DECREASE in price. They gain value as the price falls)

Now remember my goal? What happens if the volume starts to decrease around August 17th, the market sinks to 9.50, but not my goal - 9.40? Do I hold out until 9.40? No. I've made a profit. Seasonality is telling me that the market weakness would be ending on the twenty first. Sinking volume on sinking prices The market is technically starting to chop around, and has trouble sinking lower? It just might be time to take my profits as market conditions are telling me that while I was correct as to the markets direction - that direction has run it's course.

* * *

When you use all of the above factors in conjunction with one another and come up with a good trade plan, the result is that you know what you want out of the market, and are not left with questions rattling around in your brain at each tick of the market: Should I take my profit? Should I let it ride? Will I be cutting my profit too soon? What do I do?

Next topic? The dreaded drawdown! Oh noes!

[Airelon]

Drawdown:

Unless you are God, no one has any idea what will happen in the markets tommorow. We cannot predict accurately. The best thing we try to do, is what any business person does. Try to look and see what the current market is telling us, and what might be on the horizon in the future. Then identify low-risk, hi-reward possibilities.

And sometimes. Sometimes we get it wrong.

Our reaction to that can be very interesting. Often, we rail against it. Our ego is bruised. We are convinced that we knew the direction the market was going to take. When in fact, nothing could be further from the truth. We don't know. We never did. Again, what is our business? Try to look and see what the current market is telling us, and what might be on the horizon in the future. Then identify low-risk, high reward possibilities. That's it.

Now, if we have applied the above topics to our trading? Risk Analysis? Reward Analysis? Proper Trade / Investment management? Then our 'bruised' ego will be much less. We won't need that trade to win, because it only represents 3% of our total account. That's all. No biggie. It's only the undercapitalized investor / trader that needs a particular trade to be a winner. Thus, when it's only 3% - we can see the bigger picture. The bigger picture, is the systems performance, not the individual trade.

Having a trade move against you? Or having a series of losing trades? That's drawdown, and it is a fact of life. Drawdown is a reduction in account equity from a trade or series of trades. As I said, it's a fact of trading. Because none of us are god. We may not like the fact that we can't predict market direction correctly 100% of the time, that our trade plan may have been off, etc. But there it is. We're going to have the market turn against us at times while we are within the trade. And we're going to have the market stop us out of trades at times. Fact of life.

What do we do?

DRAWDOWN TRACKING: It is vital that you track your drawdown. There are two types of drawdown we need to track. Inter-trade Drawdown - which means, when we are inside the trade, how much does the market move against us? And there is Multi-trade Drawdown. How many losing trades do we have in a row? What's the maximum?

Why keep track of this information?

First of all . . . because we sometimes err. We make mistakes as to how much our 'total risk' is. When we keep track of both of these types of drawdown. We may have been fooling ourselves with our risk analysis, and when we keep track of all our drawdown, it tells us how accurate our analysis of our risk actually is. Or if we are risking more than 3%.

Secondly, it has to do with something else every trader must engage in. Something I'll mention later . . . performance analysis. In short - how well are we doing overall? Or perhaps our drawdown is so low, that we mathematically figure that we might be able to increase our risk to 3.5% per trade. Or perhaps our drawdown is such that we need to decrease our risk to 2.8% per trade. Keeping track of

INTER-TRADE DRAWDOWN: Let's say we enter a trade. We're going to short Sugar at 10.15. Ok. Let's say we're capitalized enough, to where we can enter an actual futures position, not an option. Ok. So we're short, and in the market at 10.15 October. Great.

Sugar moves to 10. Fantastic. We're up 15, or $168.00. Great.

Then the market moves back to 10.15. No biggie. Then it moves up to 10.20. 10.25. 10.40. 10.50.

That . . . is inter-trade drawdown. We're inside the trade, but it's moving against us. In this case, our drawdown would be 35 points, or $392.00. We better have around $13,500.00 in our account, to handle this sort of drawdown. If so, great. If not, then a) we should have been stopped out earlier due to risk analysis, so that wherever our account is at - we should be stopped out or b) we're trading beyond our means, and are starting failure in the face. We're risking more, to make a little. Not good risk / reward ratio.

But let's say we're still in that trade. We're adequately funded, and we can withstand that sort of drawdown. Then what happens? Ah, Sugar starts to head lower. And lower. And lower. Now we're at 9.75, and quite happy. We're $1,000.00 up. Cool beans. Perhaps (if we are adequately funded) we have even added to our position, and are up more. Great! We have an opportunity to add even further to our position with trade management below 9.75! Great! More profit.

But that doesn't change that we had inter-trade drawdown, and it is vital to understanding our systems performance, that we keep track of that drawdown. It's vital to our future risk analysis, that we keep trade of that inter-trade drawdown.

MULTI-TRADE DRAWDOWN: Let's go back to the above example. Let's say our account is only $10,000.00. We can't stand drawdown (risk) of $392.00. Let's say we're stopped out with a $250.00 loss to our account.

That's a fact of life, and it happens. This is what traders must understand. It is proper to lose from time to time. This doesn't mean you are a bad trader. It means our timing may have been off, or the market just did whatever the market was going to do. That's all. We can possibly short sugar still. A poster once made an interesting statement. He said:

It can be hard at times, but you have to let those winners ride. It has been stated here that you can be profitable with only 30% wins. That is VERY true, but not if you don't let the winners ride much farther than the losers. 30% at a 1:1 risk to reward is NOT a winning system. I've been tempted at times to just close out a winning trade because it was up and I was unsure if it would continue on towards my profit target... but in all honesty, when are you ever completely sure it is going to continue towards profit? If you don't let those winners ride on, and always cut them short, you could very well fall into that scenario of 1:1 at 30%.

human natures is such that we do not like losing

[this is] very true . . . and this makes it more of a reason why a high percentage of people that trade eventually fail. Human emotions can be very distracting and by having such emotions, they cut out their profits too early and start to mess up their odds in the long run..

Keep to your risk analysis. What makes money, is not any individual trade. It's the whole thing together. Maybe you enter a short on Sugar #11 in a couple of days, when another timing tool tells you to enter it again. Then you're short from, say, 10.25, and the market heads down to 9.75. Great! Little drawdown, and you've got your profits. You can't let your ego get bruised to where you just ignore good signals, when the market is telling you to enter it once again. Too many traders become disgusted with themselves, and would walk away from Sugar altogether, only to see that in a few days, the market headed in the direction they thought it would. Instead of entering the market as they should again - they blame what? The stop / loss. I've seen many, many traders do this. And then what happens? They stop trading with a stop loss. They get margins calls, and before they know it, they're out of the markets. Then I've heard them rail on how there is a "them conspiracy" and the market is "out to get" the small trader. Anything. Anything but realizing the truth. Their ego was what got them in trouble, not the stop / loss order.

I say the above, and wanted to take an emotional tack, when discussing mult-trade drawdown. You're going to have periods with losing trades. One after another. If your money management strategy is set correctly, if you have an adequately funded account, and engage in all of the above concepts? When this happens - it will be easier to handle. But if not? It can destroy a perfectly good system, and cause you to become an emotional basketcase when trading the markets.

Keeping track of mult-trade drawdown, can also expose weaknesses and strengths in the trading system overall. For example, lets say you're trading markets, and everything is going well. Little drawdown. Remember this - market conditions change. They change all the time. Not just what the markets are doing overall, but they go from nice trending markets, to extremely volatile ones. Some systems work great in trending markets, but horrible in volatile ones, and vice versa. Your periods of multi-trade drawdown, will give you indications as to what sort of markets you should be trading.

You must keep track of those losses. For the same reasons that you must keep track of inter-trade drawdown. It helps you plan out your future risk analysis better, and is needed later, when analyzing your overall system performance.

[Airelon]

Accuracy:

Accuracy describes just that. How accurate are you with your market calls? 30% accurate? 50% accurate? 80% accurate?

I don't think I have ever seen a more overhyped, yet neccessary part of money management stressed. 'Systems' and knowing ones accuracy rates are vital for proper money management. And let's face it, we'd all like to be right 90% of the time, as to market calls.

Yet small time traders and speculators act as if Accuracy rate is the end all be-all of trading. As if a person had an 85% accuracy rate, that would guarantee him to be profitable when trading and investing.

Nothing could be further from the truth.

It's an idea which is wrong. False. Untrue. And downright dangerous to believe. The reason people focus on accuracy, is because they get everything in reverse, when it comes to their trading and investing. It comes about, is because people look to the system that sells signal first, and money management principles second. If they look to money management at all. Want proof? Do a Google Search for "Market Picks" or "Winning Signals". Then try to find one, just ONE of them that teaches about money management.

The system for giving you signals comes second to your money management strategy, not the other way around!

In fact, an investor and/or trader can be right only 50% of the time, and still be profitable if his money management strategy is set correctly. An investor? Can generally stand an even lower accuracy rate, and still be highly profitable. This is because it generally takes less capital, less leverage to invest in the stock market, than it does to trade stocks, or trade futures and commodities.

Regardless, want proof? Simple test.

You have a trader who is right 50% of the time. Let's say every trade he engages in, he risks 1 dollar, to try to make 4. He actually averages a ratio, in practice of 1 risk to 3.5 dollars. What does the math tell us? That he is a profitable trader.

SYSTEM A:
TRADE 1: Loss - $1
TRADE 2: Profit - $3.2
TRADE 3: Loss - $1
TRADE 4: Profit - $3.2
TRADE 5: Loss - $1
TRADE 6: Loss - $1
TRADE 7: Profit - $3.2
TRADE 8: Loss - $1
TRADE 9: Profit - $3.2
TRADE 10: Profit - $3.2

5 Losses. 5 Wins. Total Lost: $5.00. Total Wins: $16.00.

Now lets take the 80% accurate trader, who doesn't pay attention to money management principles or have a money management strategy.

SYSTEM B:
TRADE 1: Profit - $1
TRADE 2: Profit - $3.2
TRADE 3: Profit - $1
TRADE 4: Profit - $3.2
TRADE 5: Loss - $10
TRADE 6: Profit- $1
TRADE 7: Profit - $3.2
TRADE 8: Loss - $7
TRADE 9: Profit - $1
TRADE 10: Profit - $1

2 Losses. 8 Wins. Total Lost: $17.00. Total Wins: $14.60

System A was 50% accurate. System B was 80% accurate. But which system made money?

Now do we see why risk / reward ratios, both projected and actual are so important? Why accuracy isn't as important as money management? Why it's important to have an adequately funded trading account, and only risk 3%?

Now that I'm done debunking the "Accuracy" overhype? Let me stress how important Accuracy is to your money management strategy overall.

It's important to view your Money management strategy as a math equation. You need all of the variables to work together, in order for you to be a success, right? Accuracy is one of those equations, and it is important to know both what your accuracy rate is, and how it fits in with the rest of your money management strategy. Let's face it, an 80% signal system would be good, as long as it doesn't call for large losses. Unfortunately, by the very nature of some systems and how they work? That's exactly what happens. When they lose, they lose big. Regardless, I won't digress into that speech again.

One must keep track, and know ones accuracy rate, in order to know how to work the rest of your money management strategy. It's one of the variables. Mind you, it's only ONE of the variables, but a variable nonetheless.