|
PureBytes Links
Trading Reference Links
|
At 1:00 AM -0400 7/31/98, Brian Massey wrote:
>Many textbooks advocate never risking more than around 2% of your equity
>on any one trade. This means that with, say a $20K account in the futures
>markets, you can only risk $400-$600 on one trade.
At 2:24 AM -0400 7/31/98, A.J. Carisse wrote:
>Although futures allow more leverage, and one may be under the illusion
>that one is far better off than, say, with the smaller leverage of equity
>trading, one must consider the impact that this has on MM - especially
>considering that one is stuck trading relatively dead instruments
>percentage wise. Since the goal is to maximize return in the context of
>minimizing drawdown, it may not be such a good idea to advantage oneself
>of high margin ratios. 4:1 might be as high as I would want to go - and
>even then, by ensuring that the loss per trade isn't any higher than it
>would be at 1:1 - instead using it to be able to trade higher priced
>issues while using the same $loss level, and/or spreading it around with
>more trades than one would do without leverage.
You can test your trading system to see what level of leverage is appropriate.
If you define leverage as:
Leverage = <Value of contract> / <Starting account size> - 1
where <Value of contract> is the total value of equity the contract controls
(currently 1140 * 250 = $285,000 for the big S&P contract)
Then, backtest the system and calculate the periodic (eg: monthly) returns
(Return = <Account value end of month> / <Account value start of month> - 1
Calculate the average monthly return and multiply by 12 to annualize.
Calculate the standard deviation of monthly returns and multiply by the
square root of 12 to annualize.
Obviously, if the equity curve of your system increases smoothly with time,
the monthly returns will be fairly consistent and the standard deviation of
returns will be small.
Repeat this over and over for several values of leverage ranging from 0 to
about 10. Each run will result in two values, the <average annualized
return> and the <annualized standard deviation>. As leverage is increased
both will increase for a while.
Now plot the <average annualized return> on the vertical axis of a graph
and the <annualized standard deviation> on the horizontal axis. It should
look something like the following:
|
|
|
Annual |
Return | * *
| * *
| *
| * *
| *
|
|
|
|_______________________________________________________
Annualized Standard Deviation
(The slope of the left part of the curve is the Sharpe Ratio of the system.)
You should be operating on the left portion of the curve, to the left of
the peak. If you operate further to the right (eg: higher leverage), you
are creating a bigger variability of returns with no increase or even a
decrease in returns over time.
With stocks, the regulations only allow a leverage of 1.0 (maximum margin
balance = account equity) which keeps investors operating on the left
portion of the curve for most trading systems. But with futures, the
regulations allow people to operate with a leverage as high as 10 or more.
With most trading systems, this is well to the right of the peak and very
risky. Rules of thumb such as the 2% MM rule are attempts to force you to
operate on the left side of the curve.
This analysis is derived assuming that you scale the number of contracts
traded with account size but even if you only trade one contract, it will
give you a reasonable idea of what leverage and thus account size you
should have to trade a system optimally.
It follows that a system with a high Sharpe Ratio (maybe > 2), means a
steeper initial portion of the curve and moves the peak of the curve
farther to the right, allowing you to use higher leverage with less risk.
All of this assumes that past performance in backtesting the system will be
indicative of future performance, etc., etc., with all the implied
assumptions in this.
Bob Fulks
|