Topics covered in this chapter:
- How to control losses, protect profits and maximize gains with more than ten formulas and techniques that everyone can follow and understand.
- How to protect your profits and make your account grow beyond ‘The Safe Point.’ Imagine never having to worry about "busting" again.
- How a consistent building of small accounts can become reality and what techniques can exponentially improve smaller accounts.
- How to exploit the strengths and to correct the weaknesses of many money management methods by creatively optimizing them.
- How to detect the “gambler's fallacy” and face bad luck with proven maths.
One of the requirements when developing a trading method is that traders have to fully describe the methods they use to initiate and liquidate trades. However, when forced to describe how they size and manage their positions, few traders have a concrete answer. Without a proper position sizing any trading methodology is incomplete.
Many people avoid the topics of risk and money management because they realize that by controlling risk they will not become rich overnight. But the fact is that they will not become rich at all if they don't learn how to manage money.
One of the pillars of the industry is the search for the holy grail and indeed the industry is infatuated with trading systems. Many traders, specially those who go through that initial phase of frustrating losses, look for mechanized methods of trading that just generate entry and exit signals to follow, no questions asked. However, they rarely search for a a system of money management able to generate "signals" that dictate how to size and manage positions. But the reality is that these techniques exist and, although being mechanical, they are much more effective than mechanical buy and sell signal generators.
Have you ever stopped to ask yourself that question: if money is to be made through trading systems, why the big majority of individual traders end up break-even or losing money? This is because money management is barely an afterthought for so many traders.
While most novice traders think there is some kind of order to the market that only few people know, and tend to focus on finding an inefficiency or an edge in the markets, the greatest opportunity for profit is often found in a money management method. The key to wealth accumulation in the markets does not come from knowing where you get in and out. Neither it comes from being able to accurately forecast market direction.
Successful traders are those who realize that money management has to be part of the trading plan. Sadly, many people never even come to this realization.
The aim of this chapter is to make you realize that money management has to be part of your trading life. And if you welcome the knowledge, we are sure that you will find among the next pages something that will stick out in your mind and make you understand its importance and the potential for your trading career.
In this chapter we will keep making use of formulas, numbers and tables to illustrate the contents. It would surely be much more attractive to show colored charts with a system ripping a lot of pips, but that does not correspond to the nature of this subject area.
We will start by differentiating risk control from money management through fundamental considerations on risk. Then we will move to risk control measures: most novice traders make vague references to experts that recommended risking one or two percent of the equity on any trade; others rely on intuition to determine when to increase position size. But as we shall see, there is much more into it.
Finally, we are going to lay out the most famous and tested money management models and by breaking these methods down you will find logical arguments for utilizing them in your own trading.
1. Considerations On Risk
Trading the Forex market can be a very profitable business. Based on this fact some traders are convinced they will make huge amounts of money in a very short time – usually by risking too much. They primarily focus on making money and not on preserving their capital. Doing so invariably results in severe Drawdowns or complete wipe-outs of their trading accounts.
The following considerations help to reveal the origin of some of the common failures when starting a trading career.
Just Bad Luck Or An Immutable Mathematical Law?
Let's jump now into the trading arena: here, the Win Rate and the Payoff may vary with changing market conditions. The only parameter the trader may effectively change is the risk.
One of the greatest things about money management is that it is purely a function of math. In this sense, unlike trading systems, the outcome of a money management system is predictable.
We will use the illustration of a coin toss to present some fundamental concepts of risk management. In a coin toss game, our luck equals a Win Rate of 50%. The risk is the amount of money we wage, and therefore place at risk, on the next toss depending on the Payoff Ratio. In our coin toss example, our “luck” and our Payoff stay constant (if you have any doubts concerning statistical figures, please refer to the previous Chapter C02.
Keeping with the coin toss example: it would not matter in what order heads or tails appear. If you flip 50 tails first and then 50 heads, the outcome would be the same as if you flip 50 heads first and then the 50 losing tails.
In trading, the order of the occurring trades, as well as the outcome of any single trade are almost always random. Therefore, from a risk control perspective, it is not advisable to attach yourself neither emotionally to the result of any single trade or a series of trades, nor financially by risking too much.
To understand that what appears to be improbable outcomes are in fact to be expected we need the help of the Law Of The Large Numbers.
For example, we should not be too surprised if after 100 tosses there were 60% heads. But if after a million tosses there were still 60% of heads, we would certainly be astonished. Why is this so? It is basically a common belief that the more often the coin is tossed the closer we expect its deviation to be from 50%.
The Law Of Large Numbers says that a chance event is uninfluenced by the events which have gone before. This explains why the Win Rate of a system does not increase even if the system has just registered 20 losses in a row. While it's true that recent trades affect the overall Win Rate, many traders step in the market thinking a corrective move is due, just because they had several consecutive winning or losing trades. By doing so, they are expressing a belief in the so called “gambler's fallacy”.
This brings us to the next point: imagine you feel just unlucky after a really bad losing run when it seemed before that you found a winning system. If only there was a way to know how long a losing streak will last...
Well, if you know the probability of an event (Win Rate) and how many times you will perform the event, there is a mathematical formula that will work out the maximum winning and losing streaks. But in trading the number of times the event will perform is not known, since it may comprise your entire trading life.
If you knew the number of trades you are going to perform in your life, you could work out the maximum number of consecutive losses, provided that the Win Rate remains exactly the same. By varying the Win Rate, the number of consecutive losses gets better or worse. But both numbers are impossible to know in foresight.
Since that is out of the realm of the possible, what lesson can we extract from this? Let's look again at the Law Of Large Numbers and understand why there will always be the possibility of long winning and losing streaks, and why a losing streak does not change the probability of the next trade. Indeed, the law, as explained in “The Law Of Large Numbers / The Law Of Averages” by Peter Webb, states that:
“If the probability of a given outcome to an event is P and the event is repeated N times, then the larger N becomes, so the likelihood increases that the closer, in proportion, will be the occurrence of the given outcome to N*P.”
As Peter Webb explains in his website, it is the overlooking of the vital words “in proportion” in the above definition that leads to much misunderstanding among gamblers (we should read: traders). As the number of coin tosses gets larger (we should read: the number of executed trades), the probability is that the percentage of heads or tails thrown (we should read: Win Rate) gets nearer to 50%, but the difference between the actual number of heads or tails thrown and the number representing 50% gets larger. In other words, in the long run individual trade results will NOT even out, that is, the difference in the number of winning and losing trades can vary a lot even if the Win Rate is the same. For example, in 100 trades with a Win Rate of 60%, the difference is 20 trades, but if the next 100 trades show a Win Rate reduced to 55% the difference has increased to 35 trades even if the overall Win Rate is now closer to 50% at 57,5%.
Capitalization Is A Requirement
Accordingly to the above reasoning, if the number of profit and loss trades becomes larger when more trades are executed, it means that a trader would deplete a trading account with a probability that approaches certainty (100%) as the total number of trades increases- both winning and losing trades. Theoretically speaking, it is merely a matter of time to blow a trading account if there is no risk control.
The risked amount is thus mathematically decisive for the longevity of any trading endeavor. Reducing the risk amount from, for example, 10% to 5% might assure the survival of a trading system during losing streaks. The trader may try to increase the Win Rate by acquiring more technical skills, but this still doesn't assure any outcome. In turn, if the trader chooses to change the risked amount the next expected maximum consecutive number of losing trades will not ruin the account.
Following this logic there is one more parameter which can be determinant: the amount of capital to start with. If you risk the same amount but the account size changes, so will the outcome - the probability of ruin becomes smaller. The so-called “richer man's advantage” can also be calculated. This is what casinos do: even with a small house edge, the probability of a player ruining the casino is reduced to such an extent that the chance of profiting becomes infinitesimal.
The prospect of ruin exists because of the Law Of Large Numbers. In real trading though, the above mathematical calculations are of no service since the parameters of Win Rate and total number of trades are unknown in hindsight. The only two parameters the trader can set is the start capital and the amount of risk. What we are going to see is how to work effectively with these two.
Why capitalization is so important can be seen in this webinar held by Sunil Mangwani: Understanding the simple rules of Money Management – Part II: Position sizing.
Ralph Vince's Experiment
Ralph Vince did an experiment with forty doctorates with no background in statistics or trading, in which they were given a computer simulated trading environment. Each of them started with 1,000 US Dollars, a Win Rate of 60% and were given 100 trades with a Payoff of 1:1. The experiment was published in 1992 in the Technical Traders Bulletin (Lucas & Lebeau, pages 1-2).
At the end of 100 trials, results were tabulated and only two of them made money. 95% of them lost money playing a game in which the odds of winning were in their favor. Why? The reason they lost was their adoption of the gambler's fallacy and the resulting poor money management. Greed and fear were instead used to calibrate the trades.
The purpose of the study was to demonstrate how our psychological limitations and our beliefs about random phenomena are the cause why at least 90% of people who are new to the market lose their accounts. After a string of losses, the impulse is to increase the bet size believing that a winner is now more probable - that's the gambler's fallacy because your chances of winning are still just 60%.
Together with the level of capitalization, the psychological preferences of the trader - the trader’s ability to tolerate risk - is an important aspect that must be taken into account when applying money management techniques.