By James T. Holter
James T. Holter is the editor of Futures.
Money management is mostly about how much to bet. While your trading system or analysis techniques tell you what, when and how to trade, a money management strategy tells you how much to trade.
When asked where money, or risk, management ranks with other aspects of a trading plan, most professional traders respond as trader Fred A. Kingery of the commodity trading advisor (CTA) AM Grace Trading Co. in Volant, Pa.: "It's paramount. It's numero uno."
Still, money management is not something most beginners consider, says trader Michael Dever of the CTA Brandywine Asset Management Inc. in Thorton, Pa. "It's trading strategies that are fun to develop."
But money management strategies make the most difference between success and failure, Dever adds.
George Pruitt, who runs Futures Truth in Hendersonville, N.C., with John Hill, says money management is so important, traders should spend 60% of their time and resources developing money management strategies and the other 40% developing their actual trading strategies and portfolio makeup.
Trader accolades of money management fill books, but the fundamentals will help you the most. (See Jack Schwager's book Market Wizards if you're still not convinced that money management matters.) Here, we look at some of the underlying mathematics and show where these can be applied in your own trading plan. We also look at several distinct approaches and apply two of them to a simple trading system.
The first steps
Before you can decide how to manage your money, you must put your objectives and abilities in perspective. Most experts highlight three areas you must analyze before taking your money management any further: 【交易之路www.irich.info收集整理】
The volatility of the market(s) you trade.
The success you expect from your analysis techniques.
Your trading capital.
Market volatility is an often overlooked part of money management. You will fail if the maximum risk you can endure is $500 and the interday fluctuations of the market you want to trade are $3,000. If you can't afford to trade the S&P 500 or coffee, you must admit it.
You also must have a grasp of the viability of your analysis. Unless you know your average loss should be $1,500, how can you plan for it? With extensive backtesting or paper trading, you can estimate such parameters. Then some simple formulas can help you get an even better picture of your potential success.
Your expected payoff is a function of how often you expect to win or lose and the amount you expect to win or lose. The formula for the expected payoff (often referred to as the mathematical expectation) is:
EP = P1 * W - P2 * L, where
P1 is the probability you will win.
P2 is the probability you will lose.
W is the amount you can win.
L is the amount you can lose.
The expected payoff must be positive if the system is worth trading. 【交易之路www.irich.info收集整理】
While an exact measure can't be known due to fluctuating wins and losses, most experts suggest using the average winner for "W" and the average loser for "L," which your backtesting or paper trading will help you determine. And while it's also not fixed in trading, you can use the percentage of winning trades for "P1" and the percentage of losing trades for "P2." In the book Schwager on Futures: Technical Analysis, these figures are used to compute the expected net profit per trade.
Having enough capital to trade is probably the most important area of money management. If you aren't well-capitalized, an extended drawdown eventually will wipe you out. There is no hard figure needed to start with, such as $15,000, $25,000 or $100,000. Of course, what you need must mesh with what you can afford.
By calculating your risk of ruin, or the chance that you'll lose so much you must stop trading, you can estimate whether you have enough capital. What risk of ruin you settle on is subjective, but experts say anything over 10% is too high. The formula for risk of ruin is:
RoR = ((1 - A) / (1 + A))C, where
A is your trading advantage.
C is the number of units you have.
To figure A, subtract the percent chance you have to lose from the percent chance you have to win. So, if you expect to win 55% of your trades, your advantage would be 10% (0.55 - 0.45 = 0.1). To figure C, divide one by the percent of your capital you'll risk on each trade. So, if that's 4%, you have 25 units (1 / 0.04 = 25).
"Risk of ruin" (below) depicts the chance you'll blow out given certain trading advantages. The number of units you have has a clear impact on the outcome. Overly aggressive trading - betting a high percentage of your stake on each trade - may give you some big winners, but it also will take you down in the end.
An important caveat with this risk of ruin calculation is it assumes your winners and your losers will be equal - an unlikely occurrence. Nevertheless, this still can be a good measure of the viability of your techniques.
The math to calculate your risk of ruin for winners and losers that differ is much more involved.
Mike DeAmicis-Roberts discusses some IBM-compatible software in "Balancing Act," Futures, September 1995, that will calculate this for you. See the download section of Futures' Web site for a free copy of this software. 【交易之路www.irich.info收集整理】
Limiting loss
Stops are orders you give your broker to liquidate a given position if it moves against you a specified amount. While stops can be one way to get a more exact idea of your greatest potential loss, they also can affect the overall profitability of your techniques.
The bane of stops is they can force you out of a position that initially goes against you but ends up moving in your direction. That's why most experts suggest using stops that fluctuate with market volatility.
"I don't believe in fixed money management stops," Pruitt says. Overly constrictive stops, such as those many have employed in the volatile S&P 500 in recent years, will "deteriorate" systems, he says.
A better way is to use wider stops as volatility increases. For example, increase them by some dollar or percentage value as the standard deviation of closes or average true range reaches certain levels.
Other than using stops, you could find a strategy that by its nature seems to avoid large losses based on historical tests. (Of course, the danger is past performance may not match future performance.) This approach appeals to purists who favor sticking to a system and not "polluting" their results with fixed stop loss points, profit objectives, etc. Proponents of stop-and-reverse strategies, which always stay in the market by going directly from long to short positions and vice versa, also lean toward depending on the system to limit risk.
For illustration's sake, we'll look at a simple 20-day, 40-day moving average crossover system that's always in the market. (That is, if we're long and we get a sell signal, we sell to offset our long position, then we sell again to initiate a new short position.) We tested the system on 10 years of daily Treasury bond data, from Jan. 1, 1987, to Jan. 1, 1997. We assumed $100 for slippage and commissions. 【交易之路www.irich.info收集整理】