Kelly it can adapt to trading markets and gives you a ﬁxed percentof your account balance to bankroll all your trades.
LOOKING IN NEW DIRECTIONS: DRAWDOWN AS AN ASSET
My trading stumbled along with spectacular up and down swings, while wecontinued looking for an improvement, something, anything that would tamethe beast. From this search came the basic idea that we needed a formula thatwould tell us how many contracts or shares to take on the next trade.
One such thought was to divide our account balance by margin plusthe largest drawdown the system had seen in the past. This sure makes alot of sense. You are certain to get hit by a similar, if not larger, drawdownin the future, so you had better have enough money for that plus margin.As a matter of fact, it struck me that one would need an amount equal tomargin plus drawdown times 1.5 just to be on the safe side.
Thus if margin was $3,000 and the system’s largest drawdown in the pasthad been $5,000, you would need $10,500 to trade one contract [$3,000 +($5,000 × 1.5)]. This is not a bad formula, but it does have some problems.
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I’m not going to be showing a variety of money management schemesapplied to the same system. The system is one of the best I have, so the re-sults  will  look  a  little  too  good.  What  you  should  focus  on  is  the  differ-ences  in  performance  that  are  the  product  of  the  different  approaches  tomanaging  your  money.  The  system  trades  bonds,  which  have  a  $3,000margin. The ﬁrst printout reﬂects the complete results of the system fromJanuary 1990 through mid-July 1998. (See Figure 12.1.)
Now we’ll take this same system and apply a variety of money manage-ment strategies so you can see which one might best work for you. To arriveat  the  various  inputs  I  ran  the  system  for  just  the  ﬁrst  seven  years,  thentraded forward with money management for the remaining time period sothe drawdown, percent accuracy, risk/reward ratios, and the like were de-veloped on sample data and run on out-of-sample data. I allowed the sys-tem to trade up to 5,000 bonds, which is a heck of a lot.
RYAN JONES AND FIXED RATIO TRADING
Another  friend,  Ryan  Jones,  went  at  trying  to  solve  money  managementlike a man possessed. He initially was a student at one of my seminars, andI later went to his on my favorite subject, money management. Ryan hasthought about the problem a great deal and spent thousands of dollars andresearch formulating is solution called Fixed Fractional Trading.
Like Ralph Vince and me, Ryan wanted to avoid the blowup phenomenainherent in the Kelly formula. His solution is to wander away from a ﬁxed ra-tio approach of trading X contracts for every Y dollars in your account.
His reasoning is based largely on his dislike for increasing the number ofcontracts too rapidly. Consider an account with $100,000 that will trade onecontract for every $10,000 in the account, meaning it will start trading 10contracts or units. Let’s assume the average proﬁt per trade is $250, meaningwe will make $2,500 (10 contracts times $250) and need ﬁve trades to in-crease to trading 11 contracts. All goes well and we keep making money un-til we are up $50,000 with a net balance of $150,000, meaning we are nowtrading 15 contracts, which nets us $3,750 per win; thus we increase an ad-ditional  contract  after  only  three  trades.  At  $200,000  of  proﬁts  we  make$5,000 per trade, thus needing only two winners to step up another contract.Ryan’s  approach  is  to  require  a  ﬁxed  ratio  of  money  to  be  made  tobump  up  one  contract.  If  it  takes  $5,000  in  proﬁts  to  jump  from  one  totwo contracts, it will take $50,000 in proﬁts on a $100,000 account to go
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System Report
9/11/98      3:06:15  PM
System Number: 387System Rules:Market:
Description: bonds 7/98 no bail
Test Period:   1/1/90 to 7/16/98
Summary
Trades
PL Ratio
Drawdown TT
Drawdown PV
310
Begin Balance
1.4($3,988)
Ending Balance
Equity Peak
–61.3%
Return
$       30,000
$18,107,546
$18,107,546
    60258.5%
Profitable Trades
Losing Trades
WinsWin Pct
Win Avg
23074.2%
  Losses
Loss Pct
$1,350.68
Loss Avg
   8025.8%
$985.55
Largest Win
$10,137.50
Largest Loss
($1,956.25)
Most Consec Wins
Avg Consec Wins
31
4.11
Most Consec Losses
Avg Consec Losses
Number of trades to reach the maximum units traded
Number of days to reach the maximum units traded
6
1.45
310
0
Base Unit Calculation Rules
BASE Units = account balance/(draw down #2)If Account Balance Increases by: units last tradeINCREASE units on the next trade by: 1If Account Balance Decreases by: units last tradeDECREASE units on the next trade by: 1
Figure 12.1 Varied Results Based on Risk Percent of AccountSource: Genesis Financial Data.
from 10 to 11 units. The ﬁxed ratio is that if it took 15 trades, on average,to go from one to two contracts it will always take 15 trades, on average,to bump up to that next level, unlike Ralph’s ﬁxed ratio that requires fewertrades to go to higher levels.
Ryan accomplishes this by using a variable input (one you can alter tosuit your personality) as a ratio to drawdown. He seems to prefer using the
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largest drawdown divided by 2. We will now look at the same trading sys-tem for the bond market with the Ryan Jones formula (see Figure 12.2).
As  you  can  see,  this  approach  also  creates  wealth  in  that  in  bringsabout  an  exponential  growth  of  your  account.  However,  to  achieve  thesame growth as with the other formulas you need to pony up a larger per-cent of your bankroll on each bet. This can result in a wipeout scenario aswell, as you will see in a minute, unless, you use a very low percent of yourmoney, which in return guarantees a less rapid growth in your account.
System Report
9/11/98      11:54:44  AM
System Number: 387System Rules:Market:
Description: bonds 7/98 no bail
Test Period:   1/1/90 to 7/16/98
Summary
Trades
PL Ratio
Drawdown TT
Drawdown PV
310
Begin Balance
1.4($3,988)
Ending Balance
Equity Peak
–18.3%
Return
$       20,000
     $251,813
     $251,813
      1159.1%
Profitable Trades
Losing Trades
WinsWin Pct
Win Avg
23074.2%
  Losses
Loss Pct
$1,350.68
Loss Avg
   8025.8%
$985.55
Largest Win
$10,137.50
Largest Loss
($1,956.25)
Most Consec Wins
Avg Consec Wins
31
4.11
Most Consec Losses
Avg Consec Losses
Number of trades to reach the maximum units traded
Number of days to reach the maximum units traded
6
1.45
43
370
Base Unit Calculation Rules
Figure 12.2 Bond Trading System without Money ManagementSource: Genesis Financial Data.
ONE CONTRACTONLY
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AND NOW MY SOLUTION TO THE PROBLEM
In talks with Ralph and Ryan I was made aware that what was causing thewild gyrations was not the percent accuracy of the system, nor was it thewin-loss  ratio  or  drawdown.  The  hitch  and  glitch  came  from  the  largestlosing trade. Let me explain—this is a very important concept.
In system development it is easy to fool ourselves by creating a systemthat is 90 percent accurate, making scads of money, but will eventually killus. That doesn’t sound possible, does it? Well it is, and here’s how. Our 90percent system makes $1,000 on each winning trade and has nine winnersin a row, leaving us ahead by a cool 9 G’s. Then comes a losing trade of$2,000, netting us $7,000, not bad. We get nine more winners and are sit-ting pretty with $16,000 of proﬁts when we get another loss, but this oneis a big one, a loss of $10,000, the largest allowed by the system, setting usback on our fannies with only $6,000 in our pockets.
But,  since  we  had  been  playing  the  game  by  increasing  after  makingmoney, we had two contracts on and thus lost $20,000. We were actuallyin the hole $4,000 despite 90 percent accuracy! I told you this money man-agement stuff was important.
What ate us alive was that large losing trade. That’s the devil we need
to protect against, and incorporate into our money management scheme.
The way I do this is ﬁrst determine how much of my money I want to riskon any one trade. I’m a risk seeker so, for sake of argument and illustration,let’s say I’m willing to risk 40 percent of my account balance on one trade.
If  my  balance  is  $100,000,  that  means  I’ve  got  $40,000  and  since  Iknow the most I can lose is, say, $5,000, I divide $5,000 into $40,000 anddiscover I can trade eight contracts. The problem is if I get two large losersin a row I’m down 80 percent, so we know 40 percent is too much risk.Way too much.
Generally  speaking  you  will  want  to  take  6  percent  to  12  percent  ofyour account balance, divide that by the largest dollar loss you will allow,or loss you are willing to take, to arrive at the number of shares you willtrade. A very risk-oriented trader might trade close to 20 percent of his/heraccount on one trade, but keep in mind, three max losers in a row and youhave lost 60 percent of your money.
I’m next showing the same system we’ve been using in this chapter withvarious risk percentages divided by the largest loss in this system, which islocked in by a $1,600 stop loss. As you can see, the more you risk the moreyou make, and the larger your drawdowns will become (see Figure 12.3).
Next, I’ve graphed out the increase in the account equity with the in-
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203
System Report
9/11/98      3:00:45  PM
System Number: 387System Rules:Market:
Description: bonds 7/98 no bail
Test Period:   1/1/90 to 7/16/98
Summary
Trades
PL Ratio
Drawdown TT
Drawdown PV
310
Begin Balance
1.4($3,988)
Ending Balance
Equity Peak
–29.7%
Return
$         30,000
$582,930,624
$582,930,624
  1943002.1%
Profitable Trades
Losing Trades
WinsWin Pct
Win Avg
23074.2%
  Losses
Loss Pct
$1,350.68
Loss Avg
   8025.8%
$985.55
Largest Win
$10,137.50
Largest Loss
($1,956.25)
Most Consec Wins
Avg Consec Wins
31
4.11
Most Consec Losses
Avg Consec Losses
Number of trades to reach the maximum units traded
Number of days to reach the maximum units traded
6
1.45
223
2152
Base Unit Calculation Rules
          BASE UNITS = account balance*.15/largest loss
Figure 12.3 Varied Results Based on Risk Percent of AccountSource: Genesis Financial Data.
crease in drawdown directly below it. As you can see, there is a point wherethe amount you make rises faster than the drawdown, then as the risk per-cent  increases,  drawdown  increases  faster  than  the  increase  in  proﬁts  inyour account. This usually takes place between 14 percent and 21 percent.In most systems, any risk percent value greater than 25 percent will makemore money but at a sharp increase in the drawdown. (See Figure 12.4.)
So  there  it  is,  my  money  management  formula:  (Account  balance  ×
Risk percent)/Largest loss = Contracts or shares to trade.
There are probably better and more sophisticated approaches, but for
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MONEY MANAGEMENT: THE KEYS TO THE KINGDOM
System
Begin Balance    $0.00
EndingBalance
Peak/Valley Risk Max Restart MinProfitPct UnitsDrawdown
Pct
TradingStyle
RecoverLosses
$845,429,594844,881,388842,428,863835,954,544802,829,038759,721,131686,869,688560,344,73118,606
–66.9%–77.1–72.2–61.5–54.4–46.6–38.2–28.4–7.0
40% 5000500050500045500035500030500025500020500015500010
100% $0.00 All trades$0.00 All trades100$0.00 All trades100$0.00 All trades100$0.00 All trades100$0.00 All trades100$0.00 All trades100$0.00 All trades100$0.00 All trades100
NoNoNoNoNoNoNoNoNo
Margin
$3,000.00$3,000.00$3,000.00$3,000.00$3,000.00$3,000.00$3,000.00$3,000.00$3,000.00
Figure 12.4 Top Nine Optimization ResultsSource: Genesis Financial Data.
us  run-of-the  mill  investors,  not  blessed  with  a  deep  understanding  ofmath, this is the best I know of. The beauty of it is that you can tailor it toyour  risk/reward  personality.  If  you  are  Tommy  Timid,  use  5  percent  ofyour bank. Should you think you are Norm Normal, use 10 percent to 12percent.  If  you  are  Leveraged  Larry,  use  from  15  percent  to  18  percent.And if you are Swashbuckling Sam or Dangerous Dan, use in excess of 20percent of your account . . . and go to church regularly.
I have made millions of dollars with this approach. What more can Itell you? You have just been handed the keys to the kingdom of specula-tive wealth.
All  equity  runs  and  money  management  printouts  in  this  chapter  arefrom Ultimanager, a remarkable piece of software that allows you to test awide variety of money management and trade selection techniques for anysystem. The software will teach you about your system or approach. Hereare some examples: It will tell you if you should add more contracts after Xnumber of winning or losing trades, inform you to add or subtract contractsfollowing a big winning or losing trade, tell you what to do if you have a 70percent accurate system that’s running 30 percent on the last X number oftrades, and on and on. If this software can’t improve your system’s perfor-mance,  it  can’t  be  done.  Developed  by  Mark  Thorn,  it  can  be  purchasedfrom Genesis Data at 800-808-3282 and can do full portfolio analysis.
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13
FINAL THOUGHTS:NONRANDOM THOUGHTSON A RANDOM MARKET
You only get out of life what you put into it.—R. S. Williams—my father
The precise up and down moves of the next 2 to 20 years are impossible topredict.  Nonetheless,  I  would  like  to  go  out  on  a  limb  in  this  chapter  tomake overall comments on what I think will be of value to short-term aswell as long-term investors.
The  recorded  history  of  the  past  200  years  of  stock  market  activitymakes one statement: Despite up and down moves in the market, it is on acontinual path upward, ever upward. Never forget that fact of stock mar-ket life. You can count on it having substantial corrections, or dips, alongthe  way.  Those  are  buying  opportunities.  Generally  speaking,  most  bearmarkets  decline  by  about  20  percent.  Sometimes  we  will  be  fortunateenough to step in and buy right at the end of the declines.
At other times, however, there simply is no market decline. The marketmay have gone sideways for a while and then suddenly takes off with furyto the upside. Prices did not decline prior to blastoff. They simply muddledaround. So, in this case our 20 percent decline rule is of no help. Perhapseven an extremely negative reading of investment advisers is not going tobe present. What will most likely tip the prospect of a coming bull marketwill be the cyclical time factors mentioned earlier. I think we need to pay agreat deal of attention to these time zones. I have noticed, concerning the
205
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206 FINAL THOUGHTS: NONRANDOM THOUGHTS ON A RANDOM MARKET
four-year phenomenon, that if the bottom four years ago occurred in Mayit most likely will occur close to May this year. There’s one pointer for you.There is another pattern I have noticed in individual stocks that leadthe way off of major market bottoms. The pattern is simply one of price,one  I  would  like  to  show  you  at  this  time.  As  we  approach  these  majorbuying opportunities you’ll see stocks making step-down moves in the av-erages. By this I mean that each declines to a value, rallies, then declines toa lower value. Ultimately, the low of the bear market is made and pricesrally off this point.
Here’s the secret of selecting which stocks to buy at the start of a buymarket. Stocks that do not go to a new market low while the averages go alow are most likely the ones to be the leaders on the upside. There’s goodlogic to this idea. After all, the stock is in real strong hands. It resisted amajor decline in the overall market, which took prices to the lows. Its re-luctance to decline tells us that people who own the stock are unwilling todump it even during the heat of the passion of negative inﬂuences that haveimpacted the rest of the stock market.
Figure 13.1 shows what this pattern looks like. If the same time mar-
Market  Average
Stock  NoDivergence
Stock  withDivergence
Buy  this one
Figure 13.1 Stair Step Pattern
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207
ket averages have gone to a new low our stock has had a rally but on thenext leg down is able to hold above the prior low, we can say the stock iscomparatively  stronger  than  the  Dow  Jones  or  other  market  averages.Hence the stock, on a comparative basis (perhaps not relative basis), hasbeen outperforming the majority of other stocks. This is the one we wantto buy, not one that is now making the lows with the averages. This diver-gence tells us the stock is in good hands. Accordingly, I would expect it torally more on the upside than other stocks.
The  only  caveat  here  is  that  you  don’t  want  to  buy  stocks  that  are
countercyclical to the market averages.
INITIAL PUBLIC OFFERINGS
Many  investors  have  seen  the  tremendous  price  increases  of  stocks from  an  initial  public  offering  (IPO).  There  are  many  instances  where the stocks doubled or tripled in a very short time. However, it really allgets  down  to  what  the  market  itself  has  been  doing.  Sometimes  IPOsperform  well,  but  when  times  are  not  good  IPOs  don’t  do  so  well.  In2000 and 2001 they underperformed the entire stock market by a dra-matic amount.
While the S&P 500 was down 14 percent, the new issue index wasdown  a  staggering  79  percent.  That’s  even  worse  than  the  Nasdaq,which was off 60 percent. There are no free lunches on Wall Street! IPOinvesting can be positive and negative. Why? First of all, these are rela-tively new companies that have just entered the big boys’ arena. Some ofthe stocks and companies will perform well in the future, but others arebased  on  hype  and  dreams.  There  are  more  dreams  and  hype  late  in  abull market than in the beginning of a bull market. If we think we’re atthe beginning of a bull market, we might want to take some select posi-tions in IPOs, but late in the game there’s no way I want to touch thesetypes of stocks.
There is very little history on these IPOs. Some of them have been inexistence for only three years, and had a blockbuster three-year report. Butthey may also have maximized their market position, or are “hip stocks,” atrend that will soon quickly fade, leaving investors holding the bag. Thesestocks are “concept stocks,” and concepts being ﬁgments of people’s imag-inations, can change quickly.
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LOOKING INTO MY CRYSTAL BALL
Nobody on Wall Street has a very clear crystal ball. It’s hazy for all of us. Ifwe stop and think we can come up with some pretty good ideas of whatmost likely will happen in the economy over the next few years. Here aresome thoughts I’d like to share with you about what I think is going on inthe American economic system. First of all, the most underlying thing I seein economy is we continue to be a consumer-driven economy. We have somany people, and they have so much money, that there is simply nothingthat  can  permanently  stop  the  overall  progress  of  mankind  and  our  eco-nomic system. The business of business is now people—serving them, tak-ing  care  of  them,  entertaining  them.  At  all  levels  there  are  hugeopportunities. These people companies will be as successful and as spectac-ular as any high-tech company.
While there will continue to be a great deal of focus on high-tech, sci-entiﬁc dream teams, who possess the answer to all medical woes and crea-ture comforts, I don’t think these are nearly as safe bets as companies thatare selling things used virtually every single day.
One area that I ﬁnd of particular interest is that of energy.I’ve watched over the years and heard the cry of “energy crisis.” Go-ing back in history I see this ﬁrst occurred around 1920, then again inthe  1940s,  in  the  1950s,  and  during  Jimmy  Carter’s  presidential  time,when we reached perhaps the peak of the energy crisis. The Cassandras,at that time were telling us we did not have enough energy to last untilthe end of the century. Well, here we are in 2001 and we still a plenty ofenergy. Yes, it does cost more now than it did, but what doesn’t? On arelative basis gasoline is still extremely cheap. The cost of one gallon ofNyquill  sells  for  about  $98.  Compare  that  to  the  cost  of  one  gallon  ofgasoline.
Or, go by a gallon of Evian water, when I last checked that was sellingfor about six dollars a gallon. To produce that Evian water one didn’t haveto  drill  down  6,000  to  10,000  feet  below  the  crust  of  the  surface  of  theearth, suck it back up, then transport it to a reﬁnery where the process ofincredible  pressures  and  heats  begins.  The  folks  at  Evian  didn’t  have  tohave  a  special  trucking  and  piping  system  to  get  the  ﬁnished  product  tospeciﬁc stores where their product could be purchased.
All they had to do was get water out of a spring, put it in bottles, andship to the stores all over the world . . . for six dollars a gallon. Now, I do
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not  like  high  gasoline  prices  better  than  the  next,  but  gasoline  is  cheapcompared to most commodities.
I  suspect,  however,  we’re  going  to  see  continuing  increases  in  energyprices, because there are fewer places open for exploration. Unless there issome new wisdom that suddenly prevails or wakes up the American publicto  the  trade-offs  between  the  importance  of  mankind  versus  natural  re-sources (animals and tundra), we’re going to be gridlocked in a battle ofpeople wanting to explore for more energy and those not wanting the en-ergy to be explored for. Hydrogen fuel cells are the answer and certainlythe wave—and save—of our future. The strongest companies in this newtechnology are great growth stocks.
This is obviously a perfect investment scenario. It doesn’t take a crystalball to predict energy prices are going to go up. Trade accordingly. I sus-pect  that  energy  companies  will  be  doing  better  in  the  future,  and  theyhaven’t done so poorly in the past.
The  big  focus,  at  this  time,  is  on  medical  costs,  HMOs  and  the  like.One thing we can say for sure about the cost of health is that it has notgone down; it has only gone up. This will continue to happen. As an in-vestor I think one of the poorest investments most people make is that ofbuying insurance, whether life insurance or health insurance. Here’s a com-ment certain to strike people as being unsound.
Let me tell you why I think it is a bad investment; if you’re responsi-ble for your health, as opposed to simply handing that problem, and thebills, over to an insurance company, you take much better care of your-self. Insurance companies are not in business to be good guys, they arein business to make money. If you have health insurance you pay some-thing called a premium. If your health claims paid by the insurance com-pany exceed your premiums, the insurance company loses money. Sinceit  is  not  in  business  to  lose  money,  that  means,  on  average,  if  you  canself-insure yourself you’ll be better off than paying a premium to an in-surance company.
I realized there are extenuating circumstances to this. Some of us arebasically healthier than others. Some are more health challenged than oth-ers. Some of us take better care of ourselves than others. You have to makethat  decision  on  your  own.  But  whenever  it  comes  to  insurance  I  wouldrather take that