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Thank you to all who responded to the Rethinking the 2% MM thread. Your
input was greatly appreciated. I've drawn some conclusions from the
responses.
Some advocated risking even less than 2% on each trade and a maximum of 4%.
The rational was that if you have a string of consecutive looses, you
won't get hurt badly. Support for this approach was usu. couched in terms
of system trading where a string of 5 consecutive losers is, IMO, more
possible than in discretionary trading. Thus systems traders didn't mind
sitting on the majority of their cash to buffer unexpected drawdowns in
system performance.
If you don't mind sitting on the majority (apprx. > 50%) of your capital
and/or you want to trade many markets then this approach works. Some
traders felt that it was realistic to trade 20-30 markets at one time ("a
large portfolio"). As a private trader, I think trading more than 5
markets can be considered a form of overtrading. It causes you to take
marginal trades and increases your chance of error. Thus, because my
evolved approach is to take only the choicest trades each week while still
utilizing as much available capital as I can, I am forced to risk
considerably more than 2%. In futures, more than 2% is realistically
required. One person pointed that references in the literature to the 2%
were stated in the context of large money managers with relatively huge
capitalization. If this true, then I understand why most money managers
are content 10%-20% a year on total capital -- they only use around 20% of
available capital.
Still others had very precise means of calculating leverage and risk using
equations. Honestly, I have yet to fully digest the implications of their
equations in backtesting. It used an approach based on the Sharpe Ratio to
calculate risk and pos. size. It plotted the annualized SD against
Average annualized return to produce a graph region that showed where
return variability as minimized while return size was maximized. While it
worked well in stocks, it didn't work well in the futures markets due to
the extreme leverage. The 2% rule was an attempt to better fit the model
to the inherent risk of futures markets. While I agree that being
conservative is better, I don't like it because of the fact that it seems
to have taken us full circle right back to where we started. It calculates
a percentage that doesn't allow us utilize all (even a majority) of
available capital and/or forces us to trade too many markets to efficiently
utilize all capital. Arbitrarily, based on my experience, I would say
that utilizing >60-70% of capital for margin in no more than 5 markets
would be considered efficient for me. If, as suggested, the equation
approximates the 2% rule to "keep us towards the left of the graph" then
it's utility, for the average futures trader, appears low. A closer look,
however, is warranted. For me, the complexity of the approach is also a
negative factor.
Another person used historical drawdown (Maximum Adverse Excursion) to
calculate risk and position size. They set their stop at the point where
historically, trades would turn around and still be profitable in a single
commodity. For me this approach works better because it takes into account
typical entry point and the historical drawdown relative to the probability
of success. This person found that the probability of profit became too
low to withstand further drawdown than 9 points (in the S+P). The curve
started to drop off around 6 points. Thus his MM stop is 9 points. It can
force you to focus on your entry point relative to your stop which I think
is absolutely essential. It's also seems relatively simple to implement.
This thread has been good for me because it has confirmed my belief, that
FOR ME the 2% is not valid. It's too constrictive and too limiting to
trade futures markets with. Futures markets involve huge amounts of
leverage which by definition involve more risk. I do not trade a system
though I have an approach that is consistent. My entries are determined by
how much risk I think there is (support/resistance). Position size is
based on how likely I think success is or what the probability failure is.
If it's low, I go in bigger, if it's high, I trade small looking to
pyramid if I'm right. I like to pyramid because I already have the markets
money in hand. While I haven't done the math, I find that I don't like to
risk more than 200-500/contract. This figure has evolved because I know it
is relatively easy to quickly get it back. I would rather take several
small losses than one large one because psychologically it's easier to
continue trading and I know my history of, at worst, 33% (1 in 3) trades
working out. I am looking to quantify my approach a little more thus the
thread.
I hope that this has given new traders food for thought. I wish I had had
this when I started.
DISCALIMER: If I've misunderstood or misrepresented anything here I
apologize.
Good Trading,
Brian.
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