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Hi Ed,
Betting the farm. Let's be realistic. Not every trade is going to be
a winner. Here is a simple rule for you to remember. Never risk more
than 50% of your account equity for your total active portfolio
positions including new positions assuming that your Portfolio
Reward Risk Ratio (PRRR) is greater than 10.0 and the %wins of your
system is atleast 50%. When I was trading in Chicago I heard for the
first time about the "RIO TRADE". Simply put, you take a huge
position in the market. If it works out, you are a hero and rich. If
you lose, you leave home and head for Brazil never to be heard from
again. Remember, NEVER BET THE FARM ON ANY ONE POSITION.
When you hear of someone making a huge killing in the market on a
relatively small trading account, more likely than not it was a
fluke: The trader was not using sound money management techniques.
The trader probably exposed his trading account to obscene risk due
to an abnormally large trade size. The trader may have just gotten
lucky and experienced a profit windfall. Trading like this means
it's just a matter of time before huge losses dwarf the wins, and
the trader is devastated emotionally and financially.
Money management in trading involves specialized techniques combined
with your own judgment. Not adhering to a sound money management
program can find you exposed to a deadly risk of ruin, and, worst of
all, most probable equity bust. Keeping this in mind, you may find a
few essential money management techniques can make a big difference
to your bottom line. Here are some things to remember when it comes
to money management.
CALCULATING PROPER TRADE SIZE
If you are trading the exact same number of shares or contracts on
every trade, you may not be calculating the proper trade size for
your own risk tolerance. Trade size can vary from trade to trade
because your entries, stops, and account size are constantly
changing variables.
To help reduce your risk exposure, the first step is for you to
believe you need this sort of program. Usually, this belief comes
from suffering a few large losses that make you want to change. This
kind of experience can enable you to see how the wrong trade size
and lack of discipline can sabotage your trading results.
Calculating proper trade size is a relatively simple process and can
ultimately reward you with greater profits and more efficient risk
control. I calculate the maximum trade size using a proprietary
algorithm.
Sorting out the criteria for a coherent money management plan is a
complex, detailed job. Using a spreadsheet to keep track of the
logic helps ensure nothing has been omitted.
With a little planning, you can develop a logically sound money
management system. Historically, too much emphasis has been placed
on the development of profitable entry and exit rules, whereas the
determination of the proper number of contracts or shares to trade
has been treated as a distant afterthought.
An individualized money management algorithm (using a spreadsheet
program such as Microsoft Excel) will control the equity growth of
any positive-expectancy system as a direct function of using correct
position sizing. Risking too large a portion of trading capital per
position will eventually cause even the most profitable trading
system to fail.
The second advantage to developing your own position-sizing strategy
is to preserve trading capital during periods of extended drawdown
or losing trades. This saves you the money to trade when things
finally turn around. Unfortunately, many traders inadvertently lose
their hard-earned trading capital as a result of improper position
sizing. This becomes painfully obvious when they have risked too
much capital over an extended series of losing trades.
I developed an effective money management algorithm using Excel 5.0.
It is based on the theory of using volatility-derived stop-losses as
a logical method to allocate capital. The logic behind using a
volatility-based stop compared with a fixed-dollar stop is that the
volatility-based stop can dynamically adjust to changes in a stock's
recent price noise. This contrasts to trading with a fixed-dollar
stop, which ignores volatility by forcing the placement of an
externally derived, subjective stop without considering the
underlying trade's true character.
As an example, assume stock XYZ has traded within a range of $10 to
$12 per share over the last 14 days, with an average price during
that time of $11 per share and a standard deviation of $2. A stop-
loss could be placed at the time of entry such that it is so far
away that it will never be touched except during rare events which
cannot be predicted in advance. A stop loss is the core of any
system. If the stop is vulnerable, so is the entire system. The
stop loss could be moved when making profits, representing twice the
standard deviation of $2 per share if it has been determined that
the trend has caught up or if it has been determined that the trend
has not been caught up, then move the stop loss to entry point.
Setting the stop at this $4 per share risk acts as a useful proxy of
the stock's recent two-week normal price fluctuations. A stop-loss
placed at this level is now less likely to suffer whipsaw losses
solely because of a stock's normal price volatility.
My algorithm allows a portfolio to grow at an above-average rate of
return while consistently controlling risk. You should examine the
assumptions inherent in my model and make changes in the values to
reflect your own overall risk tolerance and trading philosophy
My algorithm is based on the following personal assumptions:
1 The maximum number of open positions is limited to 15/per major
sector (Equity instruments, Interest Rate Sensitive instruments, FX
and Commodity futures).
2. Assuming that your PRRR > 10.0 and %wins of your system is
atleast 50%, the absolute maximum % of closed equity to risk per
trade/major sector is 50% for 1 position, 25% for 2 positions,
16.67% for 3 positions etc.,.. all the way to 3.34% for 15
positions/major sector.
By the way the optimal trade-size should be 50% (not 25%) of the
capital risked for 1 position in the portfolio which is what the
optimum kelly criterion approaches for systems which have a
Portfolio Risk Reward Ratio (PRRR) > 10 and %wins > 50. The maximum
% for the portfolio decreases to 25% for 2 positions, 16.67% for 3
positions, and all the way to 3.34% for 15 positions. Again, the
exact percentage depends on the PRRR and the %wins (Expectancy) of
your system.
rgds, Pal
--- In amibroker@xxxxxxxxxxxxxxx, "ed nl" <ed2000nl@xxxx> wrote:
> hi,
>
> you are obviously very knowledgeable but the problem I have with
your posts is that it feels like I am reading out of one of these
trading books where they claim to exactly know how to make good
profits and explain it in a very lengthy way and in the end when I
ploughed all through it I ask myself ..... what have I been reading
and haven't I been reading this before in some other book and what
did I learn? Can I use what he is saying? No actually not.
>
> All over the place you can read about the fact that money
management is the trick to increase your profits substantially. In
Ralph Vince his book I liked the example of the coin and what amount
(25%) of your capital you have to risk each time you place a bet
(the Kelly principle). All this leading to Optimal f but for
trading with stocks I haven't found a use for it. In my simple mind
I believe one simply has to have good timing skills but I would be
very happy to be convinced otherwise.
>
> Since you understand money management maybe you can explain what
you mean by it (optimal f or do you just mean that you don't put all
your money in 1 bet :) ). Maybe you could give a simple example why
for instance Optimal f would transform a marginally winning stock
trading system into a supersystem. I just don't see it. If you come
with concrete examples that make sense (I don't mind if you just
copied them from one of your books) I will be very happy to read it.
>
> Maybe you can help me with this simple example: I trade Nasdaq 100
stocks. My capital I divide in portions of 5% per trade. It is a
swing system of which 60% of the time I win. On average the winners
are the same as the losers in percent. What money management should
I now use to make this sytem increase it's profits more rapidly.
>
> thanks, Ed
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