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I believe that every successful trader uses a system similar to this.
The following is one of the best presentations I have seen on this
subject. Hope that this will help some of you. good trading. Ira
Title: Risk Management
Author: John Moore
Successful traders develop an objective trading plan and discipline
themselves to
let their plan govern their trading decisions. When developing a plan,
try to KEEP
IT SIMPLE!! Whether employing the use of fundamental, technical, or
statistical
research; or a combination of all three, one must be cognizant of it's
limitations.
There is no such thing as a "system" or "methodology" that is accurate
100% of
the time.
There is much hype in academia, and also recently in the industry,
which involves
the use of statistics in calculating "probabilities of profit." One
must recognize,
however, that statistics are merely one of many tools that a trader can
use when
determining whether or not to take a position. Be very cautious in
relying totally
on these complex mathmatical models. Betas, gammas, thetas, vegas, and
deltas
are excellent buzz words and do "assist" in the decision-making
process, but
successful traders whether cognizant or not, understand that these
econometric
models do, indeed, have their own limitations. For example, how can
variables
such as GREED, HOPE, and FEAR be quantified? Everyone knows that these
emotions are prevalent to varying degrees in the day to day
determination of
prices, yet econometric models group them all in to one variable and
call it the
"unexplained." This is because they are impossible to quantify. Thus,
when
considered in the context of being one, and only one, of many different
analytical
techniques, statistics can be a useful tool. Outside of this context,
one must be
aware of the inherent risks which exist when attempting to analyze a
"three-dimensional" problem in only two dimensions!
No matter how a trading plan is constructed, all plans should include
the following:
1.Determine a price objective
2.Determine a time horizon
3.Predict the PATH of the future price move
4.Determine the maximum $ risk exposure
5.Make sure the $risk falls within the scope of the plan
6.MANAGE THE TRADE
Clearly, 1, 2, 4, and 5 are fairly simple and straightforward
processes. The most
difficult part of trading is TRADE MANAGEMENT. Trades are very easy to
initiate, very difficult to manage. A trading plan should always
govern the
decisions a trader needs to make WHEN the market does NOT perform
exactly
as the trader anticipated. There are many who can forecast future
prices with a
fairly high degree of accuracy. There are few, if any, who can
accurately predict
the exact PATH the market will travel in reaching a target price
objective. This is
why a plan must be flexible and include objective decision-making
criteria which
allow the trader execution ability WHEN the market does NOT perform as
anticipated! This is the essence of risk/money management which is
characteristic
of all successful traders, yet absent in most.
The methodology I will present is comprised of the following four
functions:
1.Establish Profit Centers to organize trading results along business
lines
2.Allocate Initial Trading capital to each Profit Center to cover
margin and trading losses
3.Enter actual trading results into the Profit Centers as trades are
closed out
4.Calculate key money management statistics after approximately 25
trades are accumulated in a Profit
Center
The key money management statistics in step four are then used to:
1.Identify trading strengths and weaknesses
2.Capitalize on trading strengths and minimize or eliminate trading
weaknesses
3.Provide early warning signs of deteriorating trading performance
4.Analyze risk management
5.Provide "management reports" on trading performance enabling the
trader to manage his trading businesses.
6.Create a professional, disciplined and confident trading
environment designed to overcome the psychological problems of fear,
greed and uncertainty which plague every trader.
The key statistics are segregated into four general categories:
1.Operating statistics ( % Profitable trades, % Unprofitable trades,
consecutive profitable trades, consecutive unprofitable trades etc )
2.Profitability ( % return in Initial Capital , Net Income etc )
3.Risk management ( % capital lost on unprofitable trades, % of
profits lost on unprofitable trades, etc )
4.Drawdown ( There are at least 10 drawdown statistics which you must
know on a trade by trade basis. )
Ideally, before you make your first trade, you should establish your
business organization. This
business organization will reflect your approach towards speculation
and how you plan to organize and manage your trading business.
What type of trader do you plan to be.......long or short
term?.......What is your risk profile?.......How much do you plan to
lose as a % of capital on unprofitable trades? What are you profit
targets on each trade?.......in other words, what is the business plan
you will use to compete in the business of trading and more
importantly, what is the business organization you will use to monitor
your trading performance to ensure that you are adhering to your plan?
Needless to say, very few, if any, traders perform this exercise, and
this factor probably accounts for the 95 % failure rate of futures
traders. They throw themselves into the business of trading without a
business plan or business organization and eventually fall victim to the
psychological boogey men of uncertainty, fear and greed and are
eventually forced to leave the marketplace. How can you succeed in
business without a business plan or business organization?
The methodology I will present is comprised of the following four
functions:
1.Establish Profit Centers to organize trading results along business
lines
2.Allocate Initial Trading capital to each Profit Center to cover
margin and trading losses
3.Enter actual trading results into the Profit Centers as trades are
closed out
4.Calculate key money management statistics after approximately 25
trades are accumulated in a Profit Center
The key money management statistics in step four are then used to:
1.Identify trading strengths and weaknesses
2.Capitalize on trading strengths and minimize or eliminate trading
weaknesses
3.Provide early warning signs of deteriorating trading performance
4.Analyze risk management
5.Provide "management reports" on trading performance enabling the
trader to manage his trading businesses.
6.Create a professional, disciplined and confident trading
environment designed to overcome the psychological problems of fear,
greed and uncertainty which plague every trader.
The key statistics are segregated into four general categories:
1.Operating statistics ( % Profitable trades, % Unprofitable trades,
consecutive profitable trades,
consecutive unprofitable trades etc )
2.Profitability ( % return in Initial Capital , Net Income etc )
3.Risk management ( % capital lost on unprofitable trades, % of
profits lost on unprofitable trades,
etc )
4.Drawdown ( There are at least 10 drawdown statistics which you must
know on a trade by trade
basis. )
Ideally, before you make your first trade, you should establish your
business organization. This
business organization will reflect your approach towards speculation
and how you plan to organize
and manage your trading business.
What type of trader do you plan to be.......long or short
term?.......What is your risk profile?.......How
much do you plan to lose as a % of capital on unprofitable trades?
What are you profit targets on each
trade?.......in other words, what is the business plan you will use to
compete in the business of trading
and more importantly, what is the business organization you will use
to monitor your trading
performance to ensure that you are adhering to your plan?
Needless to say, very few, if any, traders perform this exercise, and
this factor probably accounts for
the 95 % failure rate of futures traders. They throw themselves into
the business of trading without a
business plan or business organization and eventually fall victim to
the psychological boogey men of
uncertainty, fear and greed and are eventually forced to leave the
marketplace. How can you succeed
in business without a business plan or business organization?
The advantages of adopting a business type organization towards trading
are:
1.Creates a disciplined and professional trading environment.
2.Provides the framework required to identify and capitalize on
trading strengths and minimize or
eliminate trading weaknesses.
3.Significantly reduces the psychological problems of fear, greed and
uncertainty by providing the most
valuable commodity any trader or business manager can
possess.........information. Without access to
properly structured information, it is impossible to intelligently
manage any type of business activity.
If you agree that trading is a business, then you must organize your
trading activities similar to the way
all successful businesses are structured........which is the Profit
Center type structure of business
organization. Profit Centers segregate revenues and expenses by
product line. For example, a grocery
store may maintain separate Profit Centers for Frozen Foods, Dairy
Products, Canned Goods, etc.
As another example, a shoe store may create Profit Centers for Men's
Shoes, Women's Shoes, Formal
Shoes, Sneakers etc. For instance, the store owner purchases 50 pair
of men's shoes for $20 a pair and
sells all 50 pair for $50 a pair, he will enter the $1000 purchase
cost, $2500 revenue and resulting $1500
Net Income into the Men's Shoes Profit Center. He also purchases 50
pair of women's shoes for $30 a
pair but can only sell 5 pair for $50 a pair. He enters the $1500
purchase cost, $250 revenue and $1250
Net Loss into the Women's Shoes Profit Center.
In this manner, the store owner knows which type of shoes are producing
a profit, which shoes are
generating losses, which shoes to buy more of, which shoes to
discontinue selling etc. Without
properly organized information which reflects the business activity
of his store, the owner is managing
his business activities in the dark......... and it is easy to see how
the psychological problems of
uncertainty, fear and greed quickly enter into the picture. Which shoes
are selling well, which shoes are
not? Should I raise or lower the sales price? Am I paying too much for
the shoes? Why are some shoes
selling well and others are not? The owner is unsure as to what do,
when to do it and why he his doing
what he does.
The above examples are simplistic but the same basic idea is utilized
by every business, especially
industries with very distinct product lines such as the automobile and
steel industries.
The same concepts applies to the trading arena. Every trader, wether he
likes it or not, will be involved
in activities which can be segregated along Profit Centers.
Before the first trade is taken, the trader should spend much time in
reflection as to how he will organize
his trading operations. How will you manage your trading business? How
will you monitor your trading
performance? How will you identify and capitalize on trading strengths
and eliminate trading
weaknesses? Will you be operating in the dark or will your trading
decisions be educated, informed,
disciplined and confident? What type of statistics are required to
properly manage your business?
Have you asked yourself those questions?
If trading is a business, how can you hope to succeed if you do not
have a business plan or business type
organization? If you are not organized, then you will be
.....disorganized. To remedy this situation, here are
some ideas as to how to structure a trading business organization.
The trading business organization consists of a Profit Center type
structure arranged in a heirarchy. I will
give a few examples to illustrate the concept. Our first hypothetical
trader is long term ( 2 weeks or
longer in a trade ) and trades futures only. He uses two trading
methods, a breakout system and a moving
average system. He only trades Beans and the Swiss Franc. After much
thought, he creates the following
business organization. At the top of the heirarchy is a Profit Center
named GLOBAL in which he enters
every trade he makes regardless of trading system or future traded.
Then he creates a Profit Center for
BEANS and another for SWISS to segregate his Soybean and Swiss Franc
trades. He also creates a Profit
Center named BOTSY for all his breakout trading system trades ( Beans
and Swiss trades ) and another
Profit Center named MATSY for all his moving average trading system
trades ( Beans and Swiss
trades ).
Finally, he creates Profit Centers named BOTSYBEANS, BOTSYSWISS,
MATSYBEANS and
MATSYSWISS. These Centers segregate trades by the trading system used
and the future traded. For
instance, the MATSYBEANS Center contains all trades for Beans taken
from the moving average
trading system.
His trading business organization looks like this:
GLOBAL
BEANS
SWISS
BOTSY
MATSY
BOTSYBEANS
BOTSYSWISS
MATSYBEANS
MATSYSWISS
Notice that the trader is able to monitor his trading performance on a
macro (GLOBAL) level as well as
an individual future level, individual trading system level and a
trading system/future level. Just by taking
the time to develop this simple organizational structure, the trader
has "forced" himself to conceptualize
how he plans to organize, evaluate and manage his trading business. He
has decided to become involved
in the business of trading so he first has developed his business plan
and business organization before he
makes his first trade.
When a trade is closed out, the trade information is entered into the
appropriate Profit Centers. For
example, on 7/10/98, a Bean trade is closed out from a signal
generated by the break out trading system.
Two contracts are traded at a commission of $50 and the trade shows a
$1,000 profit when closed out.
The following trade information is entered:
Date trade closed out: 7/10/98
Name of trade: Beans
$profit or loss: + 1,000
Number traded: 2
Commission: 50
This trade information is entered into the following Profit Centers:
GLOBAL
BEANS
BOTSY
BOTSYBEANS
The GLOBAL Center contains all his trades, regardless of future or
trading system. The BEANS Center
contains all his Beans trades regardless of trading system. The BOTSY
Center contains all his breakout
trades, both Beans and Swiss. Lastly, the BOTSYBEANS Center contains
all his breakout trades for
Beans only.
Since each Profit Center is a separate business, each Center requires
an Initial Capital to accommodate
margin requirements and trading losses. I will describe how to allocate
Initial Capital to Profit Centers in
my next article. In this example, let's assume that the trader
capitalizes each Profit Center with $50,000.
Therefore, in the four Profit Centers where the trader entered the
$1,000 profitable Bean trade and $50
commissions, Trading Capital will now equal $50,950. Trading Capital
increases after profitable trades
and decreases after unprofitable trades.
When a Profit Center contains 25 or more trades, the trader has access
to extremely important statistical
information which allows him to intelligently manage his trading
activity and slowly, but surely, evolve
into a more confident, disciplined and profitable
trader.......increasing his skill levels not only in the
money management discipline but also the psychological and trading
methodology disciplines as well.
Our second hypothetical trader is a short term SP500 and Bond day
trader. He uses one trading system on
30 minute bars and another trading system on 10 minute bars. In
addition, he makes trades based on
recommendations taken from a daily fax service named John Doe's SP500
DayTrader. He also has
noticed that the SP500 market tends to go sideways and become very
choppy during the 1130 AM to
130PM New York lunch break. He would like to know his trading
performance during this time period to
see if he is getting stopped out too often during the market's lunch
hour sideways price movements.
He decides to create the following trading business organization:
GLOBAL
SP500
BONDS
SP50030
SP50010
BONDS30
BONDS10
SP1130130
JOHNDOEFAX
The Global Center monitors all his trades. The SP500 and BONDS Centers
monitor trades segregated by
future. The SP50030 and SP50010 monitor trades based on the 30 minute
and 10 minute bar trades for
the SP500. The BONDS30 and BONDS10 Centers monitor trades based on the
30 minute and 10 minute
bar trades for Bonds. The SP1130130 Centers monitors all SP500 day
trades taken in the 1130AM to 130
PM New York lunch break time period. Finally, the JOHNDOEFAX Center
monitors trades taken from the
John Doe fax service.
On 7/11/98, the trader makes a $500 losing SP500 trade based on the 10
minute bar trading system at
1230 PM New York time, trading one contract and paying $25 commission.
The following trade
information will be entered into the appropriate Profit Centers:
Date trade closed out: 7/11/98
Name: SP500
$ profit or loss: ( 500 ) Loss
# traded: 1
Commissions: 25
The trade will be entered into the GLOBAL, SP500, SP50010 and
SP1130130 Profit Centers. The
GLOBAL Center monitors all his trades. The SP500 Center segregates his
SP500 trades from his Bond
trades. The SP50010 monitors his SP500 trades based on his 10 minute
bar trading system and finally,
the SP1130130 monitors SP500 trades taken during the 1130 AM to 130 PM
New
York lunch break.
If he capitalizes each Profit Center with $20,000 Initial Capital,
after the $500 losing trade and $25
commissions, he will then have $19475 in Trading Capital in each
Center. After 25 trades are entered
into a Profit Center, there is sufficient information for the trader to
begin analyzing and managing his
trading business. How to do this will be discussed in future articles.
Notice that there is no right or wrong way when developing a trading
business organization. The
organization you create will reflect your own personalized trading
style and overall approach towards the
marketplace. Creating your own personal trading business organization
is the first step in becoming a
professional and disciplined trader.
Some other types of Profit Centers for futures traders are:
CBOT
Trades segregated by exchange to monitor slippage
PORT1
Trades segregated by portfolio ( portfolios can be
different types of futures, trading systems
etc )
GRAINS
Trades segregated by complex ( Grains, Currencies,
Indexes etc )
AUG1998
Trades segregated by time period
SEASONAL
Seasonal trades
SPREAD
Spread trades
LONG
Long trades
SHORT
Short trades
PATTERN1
Trades segregated by price pattern if price patterns
are used to initiate a trade
A similar approach can be used for stock, options and fund traders.
Have you entered the highly competitive trading arena without a
business plan or business type
organization? Do you think you can succeed in the long run without such
a plan or organization? Do you
think a division manager at General Motors, U.S. Steel or Xerox can
manage his division without a
formal business plan, business organization and monthly statistics
which reflect the operating results of the
division under his supervision? I will let the reader of this article
answer those questions for himself.
Once the trader has settled on his business plan and organization, he
is then ready
to trade.
These statistics will reveal the trader's 1) trading performance, 2)
risk management, 3) profitability and
4) drawdown situation for each Profit Center.
The trader will now be able to manage his trading operations on a
professional level and make informed,
educated and confident trading decisions.
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