|
PureBytes Links
Trading Reference Links
|
Gary Fritz posts, Bob replies, Gary replies, now is Bob replying again:
> > >if you need $10k profit to move from 1 to 2 contracts, you should
> > >need $10k profit **per contract** to move from 100 to 101. You'd
> > >need $1M total profit to increase by 1 contract.
> >
> > Yes, but you are talking about position sizing changing from 1
> > contract to 100 contracts. That is a huge increase.
>
>The size isn't the issue; it was reductio ad absurdum. Jones says
>you should always require the same gain *per contract* when going
>from X to X+1 contracts, whether X is 1, 2, 5, 10, or 100. That
>means you require increasingly large profits per contract to increase
>your position size by 1.
This doesn't sound right. In fact, it is exactly the opposite. The whole
basis of Fixed Ratio is that the per contract profit necessary to add
another contract is always the same no matter how many contracts you are
trading.
I think this might help. Let's go back to your original statement, still
quoted above. You said that with Fixed Ratio if you need $10K to move from
1 to 2 contracts, then you need $1 million profit to increase from 100 to
101 contracts. I agree with this. However, the thing I think you are
missing is that the $1 million profit you need to increase from 100 to 101
contracts is based upon the trading of 100 contracts, not the trading of 1
contract. So, the profit needed per contract is $1M / 100 which is still
$10K. That $10K always remains the same. This is the core of Fixed Ratio.
The profit per contact needed to increase position size is a constant.
Yes, you do need increasing larger profits to increase position size by 1,
but that is based upon trading more and more contracts. The terminology I
like to use is that it is that it is the money management influenced
combined portfolio equity Jones is talking about. Not the single contract
combined portfolio equity.
> > I think it needs to be clear that it is the trader who makes this
> > initial decision, not the Fixed Ratio strategy.
>
>If I remember correctly, Jones' book has a formula for determining
>it, and I disagreed with the logic of that too, but I don't remember
>the details.
I think what you say above is the cause of a lot of our difference in
perception. This is a quote from the Jones book: "The word delta stands for
change. It is the only variable in the equation that the user freely
changes to fit a particular method and/or trading style."
Clearly he is saying that the user can "freely change" the delta parameter.
Fixed Ratio does not specify what the delta should be. Rather, delta is a
user decided aggressiveness parameter, similar to how in fixed fractional
the user must make the decision whether to risk 2%, 4%, or 5%.
> > So, the trader decides that given the risk dynamics of his
> > portfolio, he chooses $10K profit as the amount for when he wants
> > to add a second contract. In other words to add a single
> > additional contract. This is an initial decision the trader makes
> > based upon the size of his portfolio, how aggressive he wants to
> > be, etc..
> >
> > If $10K is the tolerable risk for 1 contract, then for 100
> > contracts the tolerable risk is $10K * 100 = $1 million.
>
>Hold on, you went from "profit to increase size" to "tolerable risk."
> Was that a typo or did I misunderstand something?
No, it was not a typo. The hypothetical trader has decided to use a delta
of $10K. He made that decision based upon expected performance of his
portfolio and his risk tolerance.
An easy way to view the delta is that it is the amount of profit the user
of the strategy decides is needed to move from trading 1 contract to
trading 2 contracts. This is a user input parameter.
Then at 2 contracts, 2 * delta = $20K additional profit is needed to add
the third contract. However, that is $20K profit for the trading of 2
contracts, which is $10K profit per contract. Exactly the same profit per
contact as moving from 1 to 2 contract. And, this continues on. To move
from 3 contracts to 4 contracts requires 3 * delta which is $30K, but that
is for the trading of 3 contracts, which is still the same $10K profit per
contract.
The general formula is that it requires N * delta additional profit to
increase from trading N contract to N+1 contracts. Since this can be
confusing, let me explicitly highlight two points:
1) The additional profit required is position sized influenced profit based
upon the trading of N contracts. Therefore, the required additional profit
PER CONTRACT is profit / N, which is ALWAYS delta. I think this is what you
were confused about in your original post.
2) Note that I am saying "additional profit". This is additional profit on
top of the profit the account had in building up to the trading of N contracts.
So, yes, I think it is proper to view the delta as "tolerable risk" per
contract. It is a subjective user input parameter which is the amount of
profit needed to make the move from 1 contract to 2 contracts. The trader
must make a judgement about what to use as the delta parameter. That
judgement will likely be based upon expected combined portfolio drawdown
and risk tolerance.
> > Is the glass half full or half empty? If you want to be less
> > aggressive in the early stages, adjust your delta parameter to be
> > less aggressive. However, that will lead to also being less
> > aggressive as equity increases. So, the criticism of being too
> > aggressive in the early stages will change to a criticism of not
> > being aggressive enough in the later stages.
> > Jones does discuss this problem of Fixed Ratio not being
> > aggressive enough as equity increases in Chapter 16 "Money
> > Management Marriage". He proposes that in the later stages to
> > consider switching from Fixed Ratio to Fixed Fractional.
>
>Or you could just avoid the complexity and (in my opinion) excessive
>risk of Jones' Fixed Ratio, and use a simple Fixed Fractional
>throughout. Start with a higher fraction early on, when you're
>willing to accept more risk, and back it off as you get more
>conservative.
There is nothing wrong with this an alternative approach to consider. In
fact, this is exactly what Mark Johnson was saying in the Club 300 article
I referred to in my last post.
However, you keep talking about Fixed Ratio as having excessive risk. I
want to clearly point out that the risk of Fixed Ratio is in direct
proportion to the delta value. You can trade Fixed Ratio with less risk by
increasing the delta value.
I think Fixed Ratio is also an approach to consider. I think that your
extreme criticism of Fixed Ratio is based upon some misunderstanding, which
I hope I have explained above.
> > Now, take the example of a money manager starting out with $1
> > million to trade. It is a completely different situation. There is
> > no way this money manager would decide he is willing to tolerate
> > 100% drawdown from his initial $1 million account equity.
>
>Very true. Jones' strategy is clearly aimed at the small trader who
>is trying to go from 1 contract (or other small position size) to 2.
>He ratchets the leverage up very high in the early growth stages in
>order to do that.
Yes it is true that risk is higher in the early growth stages. Jones would
call that a feature of the strategy. I will repeat what I said in my last
post. For example, for a trader starting with a $30K account willing to go
through a 100% drawdown, this might be exactly what they want. Fixed
fractional might be too slow in the early stages for this $30K trader.
As to whether Jones shows risk that is excessively high, that is only
talking about the examples in the book. The Fixed Ratio strategy does not
necessarily imply excessive risk. It is the user who decides what to use
for the delta value. But yes, Fixed Ratio does take more risk in the early
growth stages. Jones presents this as a positive. Is it the right or wrong
thing to do? There is no right or wrong answer. It depends on the traders
goals.
In summary, I am not proposing that everyone on this list should
immediately start trading Fixed Ratio money management. However, I am
willing to say that I think the Fixed Ratio strategy is worthy of
consideration, and might be appropriate for some traders.
Lets review your original arguments:
1) Fixed Ratio requires increasing large profit per contract to increase
position size.
This was stated at the top of your original post and repeated at the top of
this post. It seems to be the basis of much of your arguments. What you
were saying didn't sound right to me, which is why I originally replied,
but then I wasn't sure what you were trying to say. Now it turns out it
seems there was a misunderstanding on your part, which I explain above. It
is actually the opposite that required profit per contract remains the same
through the life of the account.
2) Fixed Ratio forces extreme aggression in the early stages.
This is incorrect. Aggression in the beginning is decided upon by the user
of the strategy. It is an input parameter, the delta parameter.
3) Fixed Ratio starts off taking higher risks, then progressively reduces risk.
Or your exact words were:
<<<<
Fundamentally what he's doing is using
very high leverage when the account is small, and backing off as the
account gets big. This has the advantage that it gets the small
account off the ground & running quickly. But it also exposes you to
a lot more risk early on.
>>>>
That Fixed Ratio starts off taking higher risks then reduces is correct. It
is something Jones talks about in detail in the book. Whether this is a
good thing or a bad thing depends upon a traders goals.
However, you feel that the strategy exposes you to *too much* risk when the
account is small. That may be true of the examples in book, but this can be
adjusted via the delta. Then, certainly if you adjust the delta to be less
aggressive that will also yield less aggression in the later stages.
Possibly the backing off of risk as the account grows would be too extreme.
Jones discusses this subject in the book in the chapter "Money Management
Marriage", and proposes switching to fixed fractional as account size grows.
I have not myself run enough historical simulations to form an opinion
about whether the backing off of risk is too extreme. Of course, this is
highly subjective. First it is subjective what risk to expose the account
to in the early stages, then you need to see how that selected delta value
plays out over time. Also, I would expect the trading characteristics of a
specific trading strategy to have an effect on the simulation. Also, to do
it properly requires also simulating handling of drawdown, which is a
complex topic where Jones suggests a variety of approaches. In other words,
it isn't as if a single historical test would prove or disprove anything.
However, testing would lend some insight beyond our speculations here.
Maybe I will run some tests someday and present the results to the list,
but that is more than I want to get into right at this moment.
4) The explanations in the book could be better, there are "a host of
logical and math errors" (your words), the examples are cooked.
I am not disagreeing on these points. However, I also think that the book
has a wealth of interesting discussion that anyone with an interest in
money management could benefit from. Even if you don't agree with his
conclusions (and obviously his conclusions are to use the strategy he
invented, which is Fixed Ratio), there is a lot of good discussion. In my
opinion, this Jones book and the Tharp "Trade Your Way To Financial
Freedom" book are currently the two must read books on the subject of money
management. You don't have to agree, but that is my opinion. Maybe someone
will write a better book someday, with more balanced discussion, better
explanation, better proofreading, and uncooked examples. But until then, I
think the Jones book is worth reading despite the flaws you point out.
Bob Bolotin
|