Traders Use a Hit-and-Miss ApproachMost traders who are confident enough to risk large sums of money, are also confident enough tothink they can figure out the future. That translates into two problem areas.First, we think we can select the winning trades from the losers in our system or approach. Worst,though, is knowing we are smart enough to do that we than trade an unequal number of contracts or shareson our various trades.just as we must consistently follow our battle plan to succeed, we must also be consistent in the amountof money we marshal behind each trade. The instant you get the notion you can "for sure" spot the bigwinners and back those trades with more contracts than you have been trading, trouble will find you.Every now and then, you will hit it right and score big, but eventually, you will have a loss on that largeposition. The loss is bad enough, but since you have overstepped good money management, you will thenbecome emotional and probably hold onto the trade too long in hopes of recouping the big hit. Thus thingsdon't get better, they get worse'Let me turn to our well-worn LasVegas casino analogy one more time. Casinos all over the world limittheir losses by having a maximum amount the player can bet on any one decision in every game. A goodcommodity trader should limit losses in the same way. Can you imagine a pit boss suddenly allowing a highroller to bet more than the house limit because the boss "feels" the customer is going to lose on the next roll'Of course not; the pit boss would be fired on the spot for breaking a cardinal rule of money management,risking too much.Trading too much, betting too much will cost you far more than bad market calls.
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Approaches to Money Management One Is Right for YouThere are many ways to go about this problem, many formulas to follow. But all the superiorsystems to manage your investment dollars have a common tenet; you will increase the number of units,contracts, or shares as you make money and decrease as you lose money. That is the essence of the sweetscience of the correct marshaling of your funds. This basic truth can be worked several ways.I am going to show you the major ones in hopes you find the shoe that fits you. No discussion on thesubject could be complete without bringing up the name Ralph Vince. In 1986, I ran across a moneymanagement formula for playing blackjack originally developed in a 1956 paper, "A New Interpretation ofInformation Rate," regarding flow of information and now called the Kelly formula by commodity traders.System ReportSystem Number: 387System Rules:Market:
9/11/98 3:06:15 PMDescription: bonds 7198 no bailTest Period: 1/1/90 to 7/16/98
Base Unit Calculation RulesONE CONTRACT ONLY
Figure 13.1 Bond trading system without money management.
174What I know about math, you could add up on your thumb and first finger, but I know "math works"so I began trading commodities using the Kelly formula (see Figure 13. 1). Here it is with F representingthe amount of your account you will back every trade with:F ((R + l)*P - I)/ R
P Percentage Accuracy of the System WinningR Ratio of Winning Trade to Losing Trade
System ReportSystem Number: 387System Rules:Market:
9/11/98 3:06:15 PMDescription: bonds 7198 no bailTest Period: 1/1/90 to 7/16/98
Base Unit Calculation RulesBASE 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 13.2 Varied results based on risk % ofaccount.
175Let's look at an example using a system that is 65 percent accurate with wins 1.3 times the size oflosses. The math is done as follows using P as .65 and R and 1.3:1.3 + 1*.65 - 1/1.32.3* .65 = 1.495 - 1 = 0.495/1.3 = 38% of account used to trade.In this example, you would use 38 percent of your money behind every trade; if you had a $100,000account you would use $38,000 and divide that by margin to arrive at the number of contracts (see Figure13.2). If margin was $2,000, you would be trading 19 contracts.
The Good, the Bad, and the Ugly of Money ManagementWhat this formula did for my trading results was phenomenal. In a very short time, I became a real-lifelegend, as very small amounts of money skyrocketed. Using a percentage of the money in the account, basedon Kelly divided by margin, was my approach. It was so good that I was kicked out of one trading contestbecause the promoter could not believe the results were accomplished without cheating. To this day, peopleon the Internet claim I used two accounts, one for winning trades and one for losers! They seem to forget, ornot know, that in addition to being highly illegal, all trades must have an account number on them before thetrade is entered, so how could the broker, or myself, know which trade should have the winning accountnumber on it?But, what would you expect, when no one to my knowledge, had turned in that type of performanceever before in the history of trading. To make matters "worse," I did it more than once. If it wasn't a flukeor luck, the losers lament is that it must have been done by pinching some numbers or trades along the way!What I was doing was revolutionary. And, as with any good revolution, some blood flowed in thestreets. The blood of disbelief was that first the National Futures Association and then the CommodityFutures Trading Commission commandeered all my account records, looking for fraud!The CFTC went through the brokerage firm's records with a finetooth comb, then took all my recordsand kept them for over a year before giving them back. About a year after getting them back, guess what,they wanted them back again! Success kills.All this was due to market performance that was unheard of. One of the accounts I managed went from$60,000 to close to $500,000 in about 18 months using this new form of money management. Then theclient sued me, her lawyer saying she should have made $54,000,000 instead of half a million.
176Now my believers were willing to put me on a pedestal, if they could collect some money. Therevolution was more than anyone could handle.What a story, huh?But there are two sides to the edge of this money management sword.My extraordinary performance attracted lots of money for me to manage. Lots of money, and then itbegan to happen: the other side of the sword flashed in the sun. Amidst trying now to be a business manager(i.e., running a money management firm) with precious few skills at doing something I am no good atanyway, my market system or approach hit the skids, with a cold streak that saw equally spectacularerosions of equity. Whereas I had been making money hand over fist, I was now losing money, hand overfist!Brokers and clients screamed, and most took the off-ramps, they simply could not handle this type ofvolatility in their account balances. My own account, which had started the first of the year at $10,000 (yes,that is $10,000.00) and reached $2,100,000 ... got hit along with everyone else's ... it too was caught in thewhirlpool, spiraling down to $700,000.About then, everyone jumped ship but me. Hey, I am a commodity trader, I like roller coasters, is thereanother form of life? Not that I knew, so I stayed on, trading the account back to $ 1, 100,000 by the end of1987. What a year!Watching all this over my shoulder every day was Ralph Vince, when we were working together onsystems and money management. Long before I could see it, he saw it, saw there was a fatal flaw in theKelly formula. I was too blind; I kept trading it, while Ralph, math genius that he is, began intense researchinto money management, the culmination of which are three great books. His first was The Mathematics ofMoney Management, followed by Portfolio Management Formulas, and my favorite, The New MoneyManagement. These are all published by John Wiley and Sons, New York, and are mustreads for any serioustrader or money manager.Ralph noticed the error of Kelly, which is that it was originally formulated to assist in implementing theflow of electronic bits, then used for blackjack. The rub comes from the simple fact that blackjack is notcommodity or stock trading. In blackjack, your potential loss on each wager is limited to the chips you putup, whereas your potential gain will always be the same in relationship to the chips bet.We speculators don't have such an easy life. The size of our wins and losses bounces all over the place.Sometimes we get big winners, sometimes miniscule ones. Our losses reflect the same pattern: they arerandom in size. Figure 13.3 shows a trade-by-trade recap on a system I use so you can see the irregularity ofwins and losses.
177As soon as Ralph realized this, he could explain the wild gyrations in my equity swings; they cameabout because we were using the wrong formula! This may seem pretty basic as we are about to enter a newcentury, but back then we were in the midst of a revolution in money management and this stuff was noteasy to see. We were tracking and trading where, to the best of my knowledge no one had gone before. Whatwe saw were some phenomenal trading results, so we did not want to wander too far from whatever it waswe were doing.Ralph came up with an idea he calls Optimal F; it is similar to Kelly, but unlike Kelly can adapt totrading markets and gives you a fixed percentage of your account balance to bankroll all your trades. Let'slook at what can happen with this general approach.
On the End of a Limb and Sawing It OffThe problem with an optimal F approach or fixed fraction of your account is 'that, once you get on aroll, you roll too fast. Let me prove my point; if your average win/loss trade is $200 and you have 10 tradesper month and you will increase on contract at every $10,000 of profits, it will take you 50 trades or 5months to add that first additional contract. Then it will take only 2.5 months to go from 2 to 3; about 7weeks to boost it up to 4 contracts; 5 weeks to jump to 5; one month to reach 6; 25 days, to 7; 21 days, to 8contracts. Eighteen days later, you are at 9, and at 16.5 days, you trade a 10 lot.Then disaster strikes, as it surely must. You have now scooted out on the end of a limb and are sittingthere with lots of contracts on. Although the limb snaps when you have a large losing trade (3 times theaverage of $200 or $600 per contract times the 10 lot so you just dropped $6,000), you have not given back$10,000 yet. So you trade a 10 lot on the next trade and lose another $6,000. Now in two trades, you aredown $12,000 from your equity high at $100,000.The next trade is also a loser, three in a row, for the average of $200 times the 9 lot you are nowtrading and you get tagged for another $1,800 (let's call it $2,000). You are now down $14,000.Meanwhile, a "smarter" trader decreases faster than you, cutting back two contracts for every $5,000lost, so on the first hit he or she is back to 8 contracts, losing only $2,400, sidestepping another $6,000 hit,and on it goes.And It Can Get Worse by Far...
178Let's take a winning system. It wins 55 percent of the time, and you decide to trade 25 percent of yourbank roll, starting at $25,000 on each trade. Wins are equal to losses at $1,000 each. Table 13.1 shows theway the trades played out.You made $1,000 yet had a 65 percent drawdown while a single contract trader would have dipped$16,000 with a 20 percent drawdown!Let's look at another scenario where we hit it right from the get-go winning 5 of 8 trades (Table 13.2),a great deal, right?Table 13.1Winning 55 Percent of the Time
Table 13.2A Winning Combination
Look at this ... 5 winners, 3 losers, and you are down. How can this be? Well, it is a combination of twothings, one the money management that got you to the
$58,000 also brought you down. Plus, I threw in a
kicker, the last trade was just like trades the market gives us all the time, a loss 2 times greater than theaverage loss. Had it been the traditional loss, your account would be at $26,000. The smart trader who cutback twice the amount after the first loss would have lost $5,000 on trade 7, taking him to $29,000 and-$8,000 on the double hit on trade 8 to show a net of $31,000!
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Looking In New Directions, Drawdown as an AssetMy trading stumbled along with spectacular up-and-down swing, while we continued looking for animprovement, something, anything that would tame the beast. From this search came the basic idea that weneeded a formula that would tell us how many contracts to take on the next trade.One such thought was to divide our account balance by margin+ the largest drawdown the system hadseen in the past. This sure makes a lot of sense. You are sure to get hit by a similar, if not larger, drawdownin the future, so you had better have enough money for that plus margin. Matter of fact it struck me that onewould need an amount equal to margin + drawdown *1.5 just to be on the safe side.Thus, if margin was $3,000 and the system's largest drawdown in the past had been $5,000, you wouldneed $10,500 to trade one contract ($3,000 + $5,000*1.5). This is not a bad formula, but it does have someproblems.I am now going to show several money management schemes applied to the same system. The systemis one of the best I have, so the results will look a little too good. You should also notice the almostunbelievable gains the system produces, millions of dollars of profits. Now the reality is this system maynot hold up in the future exactly like this. Most of you will not want to trade up to 5,000 bonds, as this testallowed, which means one tick, the smallest price change bonds can have, will cost you $162,500 if thatone tick is against you. Let me add, it is not unusual for bonds to open 10 ticks against you, on any givenmorning, that is $1,625,000! So, don't get carried away with the profits, focus on the impact moneymanagement can have on the results.What you should focus on is the differences in performance produced by different approaches tomanaging your money. The system trades bonds, which have a $3,000 margin. Figure 13.1 shows nomoney management; it simply reflects the complete results of the system from January 1990 through July1998, starting with a $20,000 account balance.Now we will take this same system and apply a variety of money management strategies so you cansee which one might best work for you. To arrive at the inputs, I ran the system for just the first 7 years,then traded forward with money management for the remaining time period so the drawdown, percentaccuracy, risk/reward ratios, and the like were developed on sample data and run on out-of-sample data. Iallowed the system to trade up to 5,000 bonds, which is a heck of a lot.
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Ryan Jones and Fixed Ratio TradingAnother friend, Ryan Jones, went at trying to solve money management like a man possessed. I methim when he was a student at one of my seminars; I later went to his seminar on my favorite subject,money management. Ryan has thought about the problem a great deal and spent thousands of dollars andresearch formulating his solution called Fixed Fractional Trading.Like Ralph and me, Ryan wanted to avoid the blowup phenomenon inherent in the Kelly formula. Hissolution is to wander away from a fixed ratio approach of trading X contracts for every Y dollars in youraccount.His reasoning is based largely on his dislike of increasing the number of contracts too rapidly. Consideran account with $100,000 that will trade one contract for every $10,000 in the account, meaning it will starttrading 10 contracts or units. Let's assume the average profit per trade is $250, meaning we will make $2,500(10 contracts times $2 50) and need 5 trades to increase to trading 11 contracts. All goes well, and we keepmaking money until we are up $50,000 with a net balance of $150,000 meaning we are now trading 15contracts, which times $250 nets us $3,750 per win. Thus we increase an additional contract after only threetrades. At $200,000 of profits, we make $5,000 per trade, thus needing only two winners to step up anothercontract.Ryan's approach is to require a fixed ratio of money to be made to bump up one contract. If it takes$5,000 in profits to jump from one to two contracts, it will take $50,000 in profits on a $100,000 account togo from 10 to 11 units. The fixed ratio is that if it took 15 trades, on average, to go from one to two contractsit will always take 15 trades, on average, to bump on to that next level, unlike Ralph's fixed ratio thatrequires fewer trades to go to higher levels.Ryan accomplishes this by using a variable input (one you can alter to suit your personality) as a ratioto drawdown. He seems to prefer using the largest drawdown times 2. We will now look at the same tradingsystem for the bond market with the Ryan Jones formula.As you can see, this approach also "creates wealth" in that it brings about an exponential growth ofyour account, in this case $18,107,546! However to achieve the same growth as with the other formulas youneed to pony up a larger percent of your bankroll on each bet. This can result in a wipeout scenario as well,unless you use a very low percentage of your money, which in return guarantees a less rapid growth in youraccount.
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And Now My Solution to the ProblemIn talks with Ralph and Ryan, I became aware that what was causing the wild gyrations was not thepercent accuracy of the system, nor was it the win/loss ratio or drawdown. The hitch and glitch came fromthe largest losing trade and represents a critical concept.In system development, it is easy to fool ourselves by creating a system that is 90 percent accurate,making scads of money, but will eventually kill us. Doesn't sound possible does it? Well it is, and here'show. Our 90 percent system makes $1,000 on each winning trade and has 9 winners in a row leaving usahead by a cool 9 G's. Then comes a losing trade of $2,000, netting us $7,000, not bad. We get nine morewinners and are sitting pretty with $16,000 of profits when we get another loss, but this one is a big one, aloss of $10,000, the largest allowed by the system, setting us back on our fannies with only $6,000 in ourpocket.But, since we had been playing the game by increasing contracts after making money, we had twocontracts on and thus lost $20,000! We were actually in the hole $4,000 despite 90 percent accuracy! I toldyou this money management stuff was important.What ate us alive was that large losing trade. That is the demon we need to protect against andincorporate into our money management scheme.The way I do this is to first determine how much of my money I want to risk on any one trade. I am arisk seeker so, for sake of argument and illustration, let's say I am willing to risk 40 percent of my accountbalance on one trade.If my balance is $100,000 that means I have got $40,000 to risk and since I know the most I can loseis, say, $5,000 per contract, I divide $5,000 into $40,000 and discover I can trade 8 contracts. The problemis if I get two large losers in a row I am down 80 percent, so we know 40 percent is too much risk. Way toomuch.Generally speaking, you will want to take 10 percent to 15 percent of your account balance, dividethat by the largest loss in the system, or loss you are willing to take, to arrive at the number of contractsyou will trade. A very risk-oriented trader might trade close to 20 percent of his or her account on onetrade, but keep in mind, three max losers in a row and you have lost 60 percent of your money!The final product of such a money management approach is shown in Figure 13.3. The $582,930,624of "profits" came from determining a risk factor of 15 percent, taking that percentage of the account toarrive at a dollar amount which was then divided by the largest loss in the system.
182As your account increases in value, you trade more contracts; as it declines, you trade fewer. This iswhat I do and this is the general area of risk I am willing to assume. It does not matter too much; a lower,and thus safer risk of 10 percent still makes millions of dollars.What I find fascinating is that the Ryan Jones approach, which did very well, "made" only$18,107,546 while a one-contract trader would have made a mere $251,813, and my approach, at least onpaper, makes a staggering $582,930,624. clearly, how you play the game does matter, it mattersimmensely.Figure 13.4 shows the system with various risk percentages being used. The graph in Figure 13.5 depictsthe increase in the account equity with the increase in percent risk drawdown directly next to it. As you cansee, there is a point where the amount you make rises faster than the drawdown, then as the risk percentincreases, drawdown increases faster than the increase on profits in your account. This usually takes placebetween 14 percent and 21 percent; in most systems, any risk percent value greater than 25 percent willmake more money but at a sharp increase in the drawdown.System ReportSystem Number: 387System Rules:Market:
9/11/98 3:00:45 PMDescription: bonds 7/98 no bailTest Period: 1/1/90 to 7/16/98
Base Unit Calculation RulesBASE UNITS = account balance*. 1 5/largest loss
Figure 13.3 Varied results based on risk % of account.
183System Begin Balance $0.00
Figure 13.4 Top 10 optimization results.
So there it is, my money management formula: (account balance *risk percent) /largest loss = contracts orshares to trade.There are probably better and more sophisticated approaches, but for run-of-the-mill traders like us, notblessed with a deep understanding of math, this is the best I know of. The beauty of it is that you can tailor itto your risk/reward personality. If you are Tommy Timid, use 5 percent of your bank; should you think youare Normal Norma, use 10 percent to 12 percent; if you are Leveraged Larry, use from 15 percent to 18percent; and if you are Swashbuckling Sam or Dangerous Danielle, use in excess of 20 per cent of youraccount ... and go to church regularly.I have made millions of dollars with this approach. What more can I tell you-you have just been handedthe keys to the kingdom of speculative wealth.
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Back to Ryan and RalphAll equity runs and money management printouts in this chapter are from ULTIMANAGER aremarkable piece of software that allows you to test money management and trade selection techniques forany system. The software will teach you about your system or approach. For examples, it will tell you if youshould add more contracts after "X" number of winning or losing trades, inform you to add or subtractcontracts following a big winning or losing trade, tell you what to do if you have a 70 percent accuratesystem that is running 30 percent on the last "X" number of trades, and on and on. If this software doesn'timprove your systems' performance, it can't be done. Developed by Mark Thorn, it can be purchased fromGenesis Data at 800-808-3282 or by writing them at 425 East Woodmen Road, Colorado Springs, CO80919.In any formula, even the fixed fractional approach, it is the largest loss that can kill you. Consider theresults from my system with Ryan's money management shown earlier. To achieve a return even close to myformula, you would have to use a percentage of your account so high that when the large losing tradecomes-and it will-you may be done in. What we need is a balance of risking but not so much that one or twovery predictable events will cause too much damage. Longest losses are predictable.
Chapter 14
Thoughts from the Past
Success in trading comes from knowIng the markets well and knowing yourself better.
Successful trading is based on a combination of using systems and the like tempered by thinking andcontrolling our emotions. To be successful. you need to know as much about yourself and marketpsychology as you do the markets. Until you get a handle on both these elements, Your trading will not beat its best.For that reason, I have selected what I think are some of my most useful writings from back issues ofmy newsletter, Commodity Timing I hope they can help you, as they have helped me, become morebalanced and controlled in trading.
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October 1995
Volume 32, Issue 10Lock-Up Time
More comments on why traders "choke," freeze, or lock up, thus not trading, or worse yet,bypassing winning trades in favor of taking guaranteed losers.At least once a week someone calls, telling me they know what to do in the markets but just can'tpull the trigger. They are afraid to do anything. Strangely, this is truer for traders with less to lose. The$10,000-and-under traders have more of this fear than the heavy capitalized traders.Let's Take a Good Look at Fear ItselfWe fear only two things. They are things we don't understand, hence there is no way to rationallydeal with the situation, or similar things that have hurt us in the past.It's no wonder then the markets stir up so much fear. No one really fully understands the markets ...and are continually bitten by market alligators. So what's one to do for this self-inflicted catatonia?Since fear is largely emotional, you need to reframe yourself with valid data to offset the fear. Here issome of that data.First, if you use stops, you really can't get clobbered too badly. Ever. Sure, you will have losing trades.But wiped out, killed? That's not going to happen.. Next, if you only trade with 30 percent of your bankrollat any one time, you can never get blown out. Again, never. Ever. The quickest way to bring sanity totrading is to use stops and only a fixed fraction of your bankroll.By so doing, you have full understanding that you are trading with a huge safety net. You will survive,because you have controlled the seemingly uncontrollable game.At a more cosmic level, you need to check out if your deck of cards in life is one of blowouts, crashes,cycles of major success leading only to cycles of failure. For most, it isn't. You can trade (with stops andpercentage of bankroll) knowing blowouts are just not your thing, not your spiritual calling. Speaking ofspirituality, I'm a firm believer that God will not let us down. Knowing that gives me ample courage ...sometimes too much, in fact ... to trade, to pull the trigger.
187June 7995
Volume 32, Issue 6Enough on Greed ... Now Let's Deal with Fear
I've written at length about Greed being the dominant and most difficult emotion to deal with. Nowit's time to walk through Fear.There are several things that distinguish winning traders from losers. Perhaps the least discussed is what Irefer to as “locking up." I've seen it in countless traders, and experienced it myself many a time.The repercussions of locking up are numerous, and all bad. A locked up trader doesn't get out ofwinners or losers ... he/she is too frozen to act. Or, the lock up prevents you from pulling the trigger ongetting into positions. This is the worst of all problems ... a trader who can't trade! When this happens,know that fear is motivating you. The good news is that there are several things you can do to release thegrasp old man fear has on your mind.There Is a lot More to Fear Than Fear ItselfRoosevelt was as poor at understanding emotions as he was at being a President. Have you evernoticed that sometimes it seems impossible to do something, maybe even something physical, like takeaction, step on the brakes, get out of harm's way, etc? You can be so locked up with fear that your attentionis on the fear, not on taking the correct action. Yes, fear is the great immobilizer.Proof? Okay, remember the last time you looked at a truly frightening person, some one either sougly, so big, so dangerous, or of a different race that you "just knew" the guy was a killer? Okay, good,recall that. Then recall what you did ... you turned away. You would not look into the object of fear. Youfroze, and not because you were hurt or because you were about to be harmed!When you see fear, you MUST look directly into its ugly face before your fear will diminish. The vilevillain we traders look at (the market), is that of being hurt. Hurt in our case means losing money and ego.There is no other harm that can become you in this business, ego and money, that's all there is to lose. Sowhich is it for you?The more you focus on losing, the better off you will be. Winners plan what to do if their trades don'twork out. Losers have no plan for disaster; when it occurs, they don't know what to do ... and are stuck infear's grip.
188Think about it. You, and you alone, have absolute and total control over what and how much you willlose. You control the number of contracts you trade, you control the stop or dollar risk (you set your fearlevel). Knowing that, what's there to be afraid of? That you might have another losing trade?Let me tell you, 0 loyal follower, I have losing trades all the time. I had about 20 in a row a few yearsago ... losing trades are as much a part and parcel to this business as breathing is to living. It happens,always has, always will. Once you fully acknowledge that at a deep inner level (looking it in the face), andlearn to only commit $$ up to your "Fear Level," fear will no longer have you in its ugly grasp.
June 1996
Volume 33, Issue 6
In an Information Age ... Information Is Not EnoughIt takes more than data to be a winning trader ... it also takes ability, attitude, and mostimportantly focus ...What Dennis Rodman and You Should Have in CommonIt's become increasingly clear