In the first installment of this series we stressed the importance of money management, illustrated through drawdown and percent to recover analysis. We mentioned that money management ranges from simple, commonsense approaches to complex portfolio theory.
The good news is that for most traders money management can be a matter of common sense rather than rocket science. Below are some general guidelines that should help your long-term trading success.
1. Risk only a small percentage of total equity on each trade, preferably no more than 2% of your portfolio value. I know of two traders who have been actively trading for over 15 years, both of whom have amassed small fortunes during this time. In fact, both have paid for their dream homes with cash out of their trading accounts. I was amazed to find out that one rarely trades over 1,000 shares of stock and the other rarely trades more than two or three futures contracts at a time. Both use extremely tight stops and risk less than 1% per trade.
Use real stop orders—“mental stop” don’t work
2. Limit your total portfolio risk to 20%. In other words, if you were stopped out on every open position in your account at the same time, you would still retain 80% of your original trading capital.
3. Keep your reward-to-risk ratio at a minimum of 2:1, and preferably 3:1 or higher. In other words, if you are risking 1 point on each trade, you should be making, on average, at least 2 points. An S&P futures system I recently saw did just the opposite: It risked 3 points to make only 1. That is, for every losing trade, it took 3 winners make up for it. The first drawdown (string of losses) would wipe out all of the trader's money.
4. Be realistic about the amount of risk required to properly trade a given market. For instance, don't kid yourself by thinking you are only risking a small amount if you are position trading (holding overnight) in a high-flying technology stock or a highly leveraged and volatile market like the S&P futures.
5. Understand the volatility of the market you are trading and adjust position size accordingly. That is, take smaller positions in more volatile stocks and futures. Also, be aware that volatility is constantly changing as markets heat up and cool off.
Never add to or “average down” a losing position
6. Understand position correlation. If you are long heating oil, crude oil and unleaded gas, in reality you do not have three positions. Because these markets are so highly correlated (meaning their price moves are very similar), you really have one position in energy with three times the risk of a single position. It would essentially be the same as trading three crude, three heating oil, or three unleaded gas contracts.
7. Lock in at least a portion of windfall profits. If you are fortunate enough to catch a substantial move in a short amount of time, liquidate at least part of your position. This is especially true for short-term trading, for which large gains are few and far between.
8. The more active a trader you are, the less you should risk per trade. Obviously, if you are making dozens of trades a day you can't afford to risk even 2% per trade--one really bad day could virtually wipe you out. Longer-term traders who may make three to four trades per year could risk more, say 3-5% per trade. Regardless of how active you are, just limit total portfolio risk to 20% (rule #2).
9. Make sure you are adequately capitalized. There is no "Holy Grail" in trading. However, if there was one, I think it would be having enough money to trade and taking small risks. These principles help you survive long enough to prosper. I know of many successful traders who wiped out small accounts early in their careers. It was only until they became adequately capitalized and took reasonable risks that they survived as long term traders.
This point can best be illustrated by analyzing mechanical systems (computer-generated signals that are 100% objective). Suppose the system has a historical drawdown of $10,000. You save up the bare minimum and begin trading the system. Almost immediately you encounter a string of losses that wipes out your account. The system then starts working again as you watch in frustration on the sidelines. You then save up the bare minimum and begin trading the system again. It then goes through another drawdown and once again wipes out your account.
Your "failure" had nothing to do with you or your system. It was solely the result of not being adequately capitalized. In reality, you should prepare for a "real-life" drawdown at least twice the size indicated in historical testing (and profits to be about half the amount indicated in testing). In the example above, you would want to have at least $20,000 in your trading account, and most likely more. If you would have started with three to five times the historical drawdown, ($30,000 to $50,000) you would have been able to weather the drawdowns and actually make money.
10. Never add to or "average down" a losing position. If you are wrong, admit it and get out. Two wrongs do not make a right.
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Monday, July 14, 2008
Money Management :Controlling Risk and Capturing Profits
Money management is the process of analyzing trades for risk and potential profits, determining how much risk, if any, is acceptable and managing a trade position (if taken) to control risk and maximize profitability.
Many traders pay lip service to money management while spending the bulk of their time and energy trying to find the perfect (read: imaginary) trading system or entry method. But traders ignore money management at their own peril.
The story of three not-so-wise men
I know of one gentleman who invested about $5,000 on options on a hot stock. Each time the stock rose and the options neared expiration, he would pyramid his position, plowing his profits back into more options. His stake continued to grow so large that he quit his day job.
As he approached the million-dollar mark, I asked him, "Why don't you diversify to protect some of that capital?" He answered that he was going to keep pyramiding his money into the same stock options until he reached three to four million dollars, at which point he would retire and buy a sailboat.
I recently met a second gentleman at a dinner party. He told me that six months ago he began day trading hot stocks. It was so profitable, he said, that he quit a flourishing law practice to trade full time. Amazed at his success, I asked him, "How much do you risk per trade, a half point, one point?" He replied, "Oh no, I don't like to take a loss."
A third gentleman was making his fortune buying the hottest stock(s) on the momentum list(s). He, too, was on the verge of quitting a successful business. When asked about his exit strategy, he replied "I just wait for them to go up." When asked, "What if they go down?" his reply was, "Oh, they always come back."
What ever happened to these "traders?" Gentleman number one is now homeless, and the other two are about to be. They are on the verge of financial devastation and the emotional devastation that goes along with it. This is the cold, hard reality of ignoring risk. How do we avoid following in the footsteps of these foolhardy traders? Three things will prevent this from happening: 1) money management, 2) money management, and 3) money management.
The importance of money management can best be shown through drawdown analysis.
Drawdown
Drawdown is simply the amount of money you lose trading, expressed as a percentage of your total trading equity. If all your trades were profitable, you would never experience a drawdown. Drawdown does not measure overall performance, only the money lost while achieving that performance. Its
calculation begins only with a losing trade and continues as long as the account hits new equity lows.
Suppose you begin with an account of $10,000 and lose $2,000. Your drawdown would be 20%. On the $8,000 that remains, if you subsequently make $1,000, then lose $2,000, you now have a drawdown of 30% ($8,000 + $1,000 - $2,000 = $7,000, a 30% loss on the original equity stake of $10,000). But, if you made $4,000 after the initial $2,000 loss (increasing your account equity to $12,000), then lost another $3,000, your drawdown would be 25% ($12,000 - $3,000 = $9,000, a 25% drop from the new equity high of $12,000).
Maximum drawdown is the largest percentage drop in your account between equity peaks. In other words, it's how much money you lose until you get back to breakeven. If you began with $10,000 and lost $4,000 before getting back to breakeven, your maximum drawdown would be 40%. Keep in mind that no matter how much you are up in your account at any given time--100%, 200%, 300%--a 100% drawdown will wipe out your trading account. This leads us to our next topic: the difficulty of recovering from drawdowns.
Drawdown recovery The best illustration of the importance of money management is the percent gain necessary to recover from a drawdown. Many think that if you lose 10% of your money all you have to do is make a 10% gain to recoup your loss. Unfortunately, this is not true.
Many traders pay lip service to money management while spending the bulk of their time and energy trying to find the perfect (read: imaginary) trading system or entry method. But traders ignore money management at their own peril.
The story of three not-so-wise men
I know of one gentleman who invested about $5,000 on options on a hot stock. Each time the stock rose and the options neared expiration, he would pyramid his position, plowing his profits back into more options. His stake continued to grow so large that he quit his day job.
As he approached the million-dollar mark, I asked him, "Why don't you diversify to protect some of that capital?" He answered that he was going to keep pyramiding his money into the same stock options until he reached three to four million dollars, at which point he would retire and buy a sailboat.
I recently met a second gentleman at a dinner party. He told me that six months ago he began day trading hot stocks. It was so profitable, he said, that he quit a flourishing law practice to trade full time. Amazed at his success, I asked him, "How much do you risk per trade, a half point, one point?" He replied, "Oh no, I don't like to take a loss."
A third gentleman was making his fortune buying the hottest stock(s) on the momentum list(s). He, too, was on the verge of quitting a successful business. When asked about his exit strategy, he replied "I just wait for them to go up." When asked, "What if they go down?" his reply was, "Oh, they always come back."
What ever happened to these "traders?" Gentleman number one is now homeless, and the other two are about to be. They are on the verge of financial devastation and the emotional devastation that goes along with it. This is the cold, hard reality of ignoring risk. How do we avoid following in the footsteps of these foolhardy traders? Three things will prevent this from happening: 1) money management, 2) money management, and 3) money management.
The importance of money management can best be shown through drawdown analysis.
Drawdown
Drawdown is simply the amount of money you lose trading, expressed as a percentage of your total trading equity. If all your trades were profitable, you would never experience a drawdown. Drawdown does not measure overall performance, only the money lost while achieving that performance. Its
calculation begins only with a losing trade and continues as long as the account hits new equity lows.
Suppose you begin with an account of $10,000 and lose $2,000. Your drawdown would be 20%. On the $8,000 that remains, if you subsequently make $1,000, then lose $2,000, you now have a drawdown of 30% ($8,000 + $1,000 - $2,000 = $7,000, a 30% loss on the original equity stake of $10,000). But, if you made $4,000 after the initial $2,000 loss (increasing your account equity to $12,000), then lost another $3,000, your drawdown would be 25% ($12,000 - $3,000 = $9,000, a 25% drop from the new equity high of $12,000).
Maximum drawdown is the largest percentage drop in your account between equity peaks. In other words, it's how much money you lose until you get back to breakeven. If you began with $10,000 and lost $4,000 before getting back to breakeven, your maximum drawdown would be 40%. Keep in mind that no matter how much you are up in your account at any given time--100%, 200%, 300%--a 100% drawdown will wipe out your trading account. This leads us to our next topic: the difficulty of recovering from drawdowns.
Drawdown recovery The best illustration of the importance of money management is the percent gain necessary to recover from a drawdown. Many think that if you lose 10% of your money all you have to do is make a 10% gain to recoup your loss. Unfortunately, this is not true.
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