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Money Management - What's your system?


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Every successful trader knows that strict money management (MM) is a key component to staying alive in the markets. In trading we are wrong as often as we are right, and it is only strict money management that keeps us in the game.

 

In my own trading I think of MM as one of the three core pillars that you need to get right (the other two being, method/technique, and psychology).

 

So, at the risk of revealing your trading secrets, what are the money management rules that you abide by?

 

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Here's my money management strategy:

 

 

1. Only ever trade with as much as I am willing to lose. For me, that usually means trading with an account size between half to one month's wages. That's an acceptable risk for me - even if I blow up my account, it might leave me hard up for a month or two, but it won't jepodize my financial wellbeing in the long term. It also allows me to sleep at night.

 

2. Risk no more than 5% on any single trade. This may be high, but I'm not a pro, my account size is small and can be reloaded. Losing streaks of 10 or 15 *will happen* when I have been trading long enough... I even expect to see one or two sequence of 20 losses in a row. 20 losses of 5% in a row would mean a 65% drawdown... I have to be prepared that at some point I will experience if I've been trading long enough. That's the ins and outs of trading, pure and simple.

 

3. Never ever add to a losing position, either to an existing trade or opening another trade in a highly correlated market. So if my gold position is under water, I am not allowed to open a new position in silver. Really, this rule is the most important rule in all of trading, and can equally be at home under my other key areas (method, psychology).

 

4. Take money off the table when you have built up some equity. Just my personal philosophy. Some people will try to grow their account as much as they can by keeping all their equity. Me? I believe that it's important to actually be able to get your hands on some of the fruits of your labour. This also keeps my account at the size where I can sleep at night. Loss on new equity is still a loss, after all.

 

5. Position size on all trades is determined by the instruments volatility as defined by the ATR and the 5% rule. So for more volatile the asset, the smaller my overall position must be.

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6. Always set a stop loss when you enter a trade. Know when you are going to get out if you are wrong even before you get in. I use the ATR to set the stop loss level, so my uncle point on is the same, accounting for volatility. This is not negotiable. Without a stop-loss your losses are potentially infinite.

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I would pretty much agree with the above. The trade size, I can put on, and not watch it for a week. That is kind of level I play at. It won't make me a million in 12 months but I am not going to be wiped out by a black swan.

 

Additionally, Never fall in love with a trade, a company, a commodity or any instrument. A trader is like a guy who goes out for one night stands.

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Here's my money management strategy:

 

 

1. Only ever trade with as much as I am willing to lose. For me, that usually means trading with an account size between half to one month's wages. That's an acceptable risk for me - even if I blow up my account, it might leave me hard up for a month or two, but it won't jepodize my financial wellbeing in the long term. It also allows me to sleep at night.

 

2. Risk no more than 5% on any single trade. This may be high, but I'm not a pro, my account size is small and can be reloaded. Losing streaks of 10 or 15 *will happen* when I have been trading long enough... I even expect to see one or two sequence of 20 losses in a row. 20 losses of 5% in a row would mean a 65% drawdown... I have to be prepared that at some point I will experience if I've been trading long enough. That's the ins and outs of trading, pure and simple.

 

3. Never ever add to a losing position, either to an existing trade or opening another trade in a highly correlated market. So if my gold position is under water, I am not allowed to open a new position in silver. Really, this rule is the most important rule in all of trading, and can equally be at home under my other key areas (method, psychology).

 

4. Take money off the table when you have built up some equity. Just my personal philosophy. Some people will try to grow their account as much as they can by keeping all their equity. Me? I believe that it's important to actually be able to get your hands on some of the fruits of your labour. This also keeps my account at the size where I can sleep at night. Loss on new equity is still a loss, after all.

 

5. Position size on all trades is determined by the instruments volatility as defined by the ATR and the 5% rule. So for more volatile the asset, the smaller my overall position must be.

 

 

What's your risk/reward ratio when you enter a trade? What's your edge when you trade? Have you quantified it?

 

There's something wrong with your strategy if you expect to see long chains of losses. Long streaks of 10 to 15 suggests your risk reward ratio is skewed at an unrealistic level where the risk is too small relative to the reward. Based on your strategy would you ever expect to see chains of 10 to 15 winners? If not then why?

 

5% per trade is way too high unless you have a proven track record over perhaps a year and you have high confidence in your strategy.

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What's your risk/reward ratio when you enter a trade? What's your edge when you trade? Have you quantified it?

 

There's something wrong with your strategy if you expect to see long chains of losses. Long streaks of 10 to 15 suggests your risk reward ratio is skewed at an unrealistic level where the risk is too small relative to the reward. Based on your strategy would you ever expect to see chains of 10 to 15 winners? If not then why?

 

5% per trade is way too high unless you have a proven track record over perhaps a year and you have high confidence in your strategy.

 

Trend traders typically run system with less than 50% of trades profitable. 30-40% is not untypical. The unprofitable trades are the result of false signals or whipsaw action.

 

The chances of 10 losing trades in a row with a 40% success on any random trade are 0.6^10, ie 0.6%. In other words, running such a system you will hit a 10 trade losing streak on average ONCE EVERY 165 trades. I intend to be trading more much more than 165 trades; therefore I need stringent money management rules that will allow me to take survive such strings of losses and be able to carry on trading.

 

http://www.youtube.com/watch?v=ew1L6SLpHgM&list=TLOg53LAGwytp7gHHxtblfmv8dEUI-fevK

 

watch from 39m (actually the whole video is excellent) - even the greatest trades have long losing streak.

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I also believe that trying to define your risk:reward is one of the stupidest things a trend follower can do. All you can define is your total risk on any trade. As a trend follower, my target price is always infinity.

If you intend on trading more than 165 trades per year (Is that what you meant?) then that suggests trading over short time frames where market movements (and trends) are limited, what rules do you use to exit a trade?

 

In my experience it's best to define a money management policy after you've defined your expected performance. Start at a conservative level of 1% and increase dependent on performance.

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Trend traders typically run system with less than 50% of trades profitable. 30-40% is not untypical. The unprofitable trades are the result of false signals or whipsaw action.

 

The chances of 10 losing trades in a row with a 40% success on any random trade are 0.6^10, ie 0.6%. In other words, running such a system you will hit a 10 trade losing streak on average ONCE EVERY 165 trades. I intend to be trading more much more than 165 trades; therefore I need stringent money management rules that will allow me to take survive such strings of losses and be able to carry on trading.

 

http://www.youtube.com/watch?v=ew1L6SLpHgM&list=TLOg53LAGwytp7gHHxtblfmv8dEUI-fevK

 

watch from 39m (actually the whole video is excellent) - even the greatest trades have long losing streak.

 

What Nick Radge doesn't point out is that although Bill Eckhart had loss periods of 4 or 5 months he also had runs of positive gains, some of 6, 7 or 8 months. Also before a couple of those loss periods there were exceptional double digit gains, you would expect a drawdown after a period of unusually high gains.

 

 

He talks about expectancy

 

Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss)

 

This is a useful way to test a trading strategy although clearly you need a consistent strategy and many trades for it to be accurate

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165 trades is 165 trades, doesn't matter over what time period. The rules of exiting a trade are when the stop loss price is hit, usually set at 1.5x the ATR20

 

In that presentation by Nick Radge he himself talks about his own longest losing streaks- I think he has had at least x2 17 losing streaks and x1 18 streak. This is over the course of his entire trading history, of thousands of total trades.

 

All systems will have such losing streaks, its the nature of probability. If you want to never see a losing streak greater than 2 or 3 then the only way you're going to get that is by writing deeply out-of-the-money option.. The provervial "picking up a penny in front of a steamroller" strategy, as Jack Schwager eloquently puts it.

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The longest losing streak I've had in 2 and half years is I think 9 or 10 losses, and that was trading a strategy with 30% positive trades that simply didn't work - I came out break even so that shows if you have something that works you can certainly succeed with a low win rate.

Apart from the fact that I was trading with a limited edge my risk reward ratio was 1 : 5.

In my experience that is not a workable risk/reward for short term trading.

It's often interesting to make analogies between trading as a business and trading a more traditional standard business where you might purchase from a wholesaler to sell on the retail market.

So to use the above example I expected to buy stock at x and sell at 5x for a 400% gain on each sale. Is that unrealistic? Is there a business out there right now where you can purchase products and resell them at 5 times the price you bought?

There are probably many opportunities like that out there but since anyone can trade these days finding great opportunities that aren't already being significantly exploited is a difficult task.

In well established highly competitive markets (probably the most competitive markets in the world) is it realistic to enter the market and find a huge edge with no professional experience and expect to succeed?

It's interesting to talk about money management, clearly it's important, the most interesting question for me is what edge has been developed and has it been quantified.

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The longest losing streak I've had in 2 and half years is I think 9 or 10 losses, and that was trading a strategy with 30% positive trades that simply didn't work - I came out break even so that shows if you have something that works you can certainly succeed with a low win rate.

 

Apart front the fact that I was trading with a limited edge my risk reward ratio was 1 : 5.

 

In my experience that is not a workable risk/reward for short term trading.

 

It's often interesting to make analogies between trading as a business and trading a more traditional standard business where you might purchase from a wholesaler to sell on the retail market.

 

So to use the above example I expected to buy stock at x and sell at 5x for a 400% gain on each sale. Is that unrealistic? Is there a business out there right now where you can purchase products and resell them at 5 times the price you bought?

 

There are probably many opportunities like that out there but since anyone can trade these days finding great opportunities that aren't already being significantly exploited is a difficult task.

 

In well established highly competitive markets (probably the most competitive markets in the world) is it realistic to enter the market and find a huge edge with no professional experience and expect to succeed?

 

It's interesting to talk about money management, clearly it's important, the most interesting question for me is what edge has been developed and has it been quantified.

 

Even if you have a defined price target to give you a definite risk/reward, you have no idea about the probability of it reaching that target, it's pie-in-the-sky.

 

This sort of thinking allows you to take poor trade setups just by picking a price target, however improbable, and then justifying it with a random price target.

 

Trend followers generally believe that they cannot predict the future, yet markets are inefficient and they can exploit those inefficiencies through a trend-following strategy. THAT is what gives them the trading edge. We don't know how far the trend will go, we just want to be along for the ride and will look to ride the trend until the trend ends.

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Even if you have a defined price target to give you a definite risk/reward, you have no idea about the probability of it reaching that target, it's pie-in-the-sky.

If you have a defined price target and stop loss for each trade and you have analysed hundreds of trades showing that 48% of the trades you make succeed what is the probability of your next 100 trades succeeding?

 

The answer is somewhere close to 48% provided your edge is quantified and doesn't change in character over the next 100 trades.

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