Items Tagged With money management

I just finished this flowchart that summarizes the flow of a trade using money management techniques.  Of course, this is totally discretionary from the amount of lots traded, stop loss placement and target profit placement.   If it's useful to me or you, maybe I'll add hyperlinks to pictures of chart examples. 

Since I have deemed this week, "Money Management Week", I felt like I should mention a new Investopedia article titled, "A Logical Method of Stop Placement." I'm not overly impressed by the article but you might find it more useful than I did.   The author gives a brief overview of 5 different types of stop methods:

1. Hard stop - placing a stop a predefined number of pips away from the entry price
2. ATR % stop - stop calculated by taking a percentage of the current ATR
3. Multiple day high/low - placing stops at predetermined day's low or high
4. Closes above/below price levels - placing stops above or below specific price levels (ie: double zeros)
5. Indicator stop - stopping out a position based on the value of a certain indicator (RSI, ROC, CCI, etc)

OK, so I'll admit that I'm using a catchy headline to force people to enhance their knowledge on the all important subject of Money Management. 

I went to Borders yesterday to search for some literature on money management and found a majority of trading books having only one or two pages on the subject.  I couldn't find a book dedicated to the subject, though I know there are several out there.  One book I spent some time reading had a pretty large money management section.  It was called "High Probability Trading" by Marcel Link.  I didn't take notes though so I already forgot a lot of what I read.  One thing I was able to take away from the book was the comparison between you as a trader and a casino.  As a trader, you would benefit most by acting like a casino.  The casino has established rules for their games that provide them with an edge.  For example, with most bets in the game of roulette, the house has an edge of 5.26%.  They are not concerned with any one person winning unless this person compromises this edge like counting cards.  They are more concerned about all gamblers as a whole.  The casino expects that in the long run, of all the money bet on the roulette wheel, they will come out on top 5.26%.  I'm sure in most cases, it's a lot more.  As a trader, money management isn't quite good enough if you don't have a system with some sort of edge.  The bigger the edge, the better.

There is an excellent website on money management that I had talked about in a previous post months ago.  The content isn't presented all that great though.  Information is scattered and there are sections where the presenter just copies and pastes certain content relevant to the subject.   Nevertheless, it is the best site I've seen out there that's dedicated to money management and I'll attempt to summarize the important points starting from the first section.

Source: http://members.aon.at/tips/moneyMan1.htm  

"We cannot influence how the markets will behave, (therefore) we should at least exercise control over those variables that we have actual control of."  This is where money management comes into the picture.

Q & A 

Q. What is the difference between risk management and money management?

A.  Risk management deals mainly with maximizing profits using contract sizes.  Money management deals mainly with minimizing losses using stops as well as showing you when to take profits.  You must have both.

Q. What is the Percent Risk Model?

A.  Simply, it is using a certain percentage of your capital for position sizing.

Q. What is constant risk?

A.  Adjusting your stops according to your system and peel off (reduce) contracts when the risk got above the level you wanted to maintain.  

Q. What is Market Wizard "money management" rule?

A.  Always risk exactly 2.6% of total (closed + open) account equity on every trade 

TIPS FOR FAILURE

1. Trading 1 contract at a time will cause you to fail. 

TIPS FOR SUCCESS 

1. The key is to have more positions when you are right and less positions when you are wrong.
2. Stagger out of your trades when wrong or put another way, stagger your stop losses
   
3. Hold on to all positions when right
4. Never let a winner become a loser by adjusting your stops as the market moves with you
5. Know the Pareto Principle, also known as the 80-20 rule which when applied to trading states that 80% of your profits comes from 20% of your trades
6. Stay with all of your positions until they meet the minimum profit objective
7. Exit a portion of your trade at the minimum profit objective.  Hold the rest using a trailing stop to take advantage of huge trenders
8. Remain unbiased or without opinion as to the market direction.  Realize there is no such thing as overbought/oversold and no price is too high or too low. 
   
9. Like your losses because losing is a big part of trading and it also puts you one step closer to a winning trade
10. Visualize what you want to accomplish before getting there

Do you have a problem with exiting your positions too early? I always have.  It's one aspect of my trading that concerns me because I'm never sure if closing it early was the smart thing to do.  Let me give you an example which just happened to occur today.  I went long on the EUR/CAD before the European session open.  I went to bed and woke up to see the position up 80 pips.  I had a 100 pip stop loss and a 200 pip target.  I was a bit surprised to see it up this much so quickly.  I thought about it for a minute and decided to close the position and take the profit.  Why violate my pip target? Based on my experience with the ebb and flow of the currency market, I figured there was a good chance that the price will not continue in my direction and retrace, wiping out any profit I had. I've seen this happen so many times.   Today, this didn't happen.  The EUR/CAD continued going up and would have easily hit my 200 pip profit target.  This frustrates me more than losing.  Here are a couple of ways I've handled a position that goes in my favor by a substantial amount:

1. Close it out based on feel or maybe fear.  I'll do this even if I have a target set on the position.  My rationale for closing it is that either I'm satisfied with the amount of profit or I'm fearful that if I don't, the pair will turn against me and wipe out my profit.  
2. Close a portion of my position based on feel or fear and leave the other portion open to run if the pair continues in my favor. From my experience, when I do this, more times than not, the remaining portion gets stopped out and I lose the profit.  Almost always, when I close a portion of my position for profit, I'll set the stop to breakeven on the remaining portion so I won't lose any money.
3. It runs to completion and my target price is hit.  This almost always occurs when I don't have time to monitor the position.   The target price usually gets hit very quickly.  I typically obtain my highest reward to risk in this scenario. 

In scenario #1, I feel good about the trade if I close it out and then it does exactly what I thought it would, turn against me.  I don't feel so good if the pair continues in my favor after I've closed it and would have hit my target.

My feelings in scenario #2 and very similar to those in scenario #1.

In scenario #3, I feel great about the results of the trade.

So which is better, any of the three scenarios or flat out losing money on a trade? I think not losing money is best but the first two scenarios can sometimes lead to losing money.  If I'm not getting a decent reward/risk because I'm exiting a position too early, when I do hit that losing streak (trust me, it will happen), my losses could be much greater than my gains.  How many times have you closed a position early when it at a negative and not going in your favor? I can count the times on one hand. 

I'd love some feedback on what your experiences are and if you can relate to my possible problem.  It hasn't affected my profit the last month and a half though.  I'm up over 13% this month alone but like I said, this could be short-lived if I don't address this now.    

I have definitely been sidetracked for some time now, preoccupied with only particular GBP/USD forex trading systems.  Due to this fact, I feel like I've disregarded other aspects of technical analysis that may one day turn out to be useful.  This started about 6 months ago after my first full year of trading, where I found myself sitting in front of my computer staring at charts for what felt like forever.  I don't know if it was burn-out or if I just felt like these other forms of technical analysis required discretion, something that I wasn't successful at.  it could also have been that I was looking for instant gratification after months of hard-core learning. 

I'm not sure where my trading will be next year or this year for that matter but I feel the need to start concentrating on some of these neglected areas.  It's strange that I spend so much time optimizing and organizing this website but I don't translate this over to my forex trading and studies.  I feel very disorganized and sometimes behind in what others have learned in an equal or shorter period of time.  I've said this before but I'm going to try to put together a list of things that I want to study and learn more about.  I want to continue with my GBP/USD trading systems but I also want supplement other things into the fray.  Just off the top of my head are:

1. Ichimoku specifically on the USD/JPY.  I'm still reading the new ichimoku book that was sent to me but I've always been interested in this indicator and I want to explore it further
2. Chart patterns
3. Money Management
4. Carry Trades
5. Divergence
6. Fibonacci
   

These are only a few but I think the key as I said previously is to get organized and try to create a learning schedule so that I can become more adept at forex technical analysis.

I took my first trade in months this past Thursday.  I have been slowly trying to get back into the forex market by cautiously watching the GBP/USD.  It's been a while since I followed any currency pair so I wanted to be sure that I watched the GBP/USD for a couple of days before taking any trade.  I've decided to start referring to my profits/losses in terms of expectancy.  Expectancy is "simply the mean or average R-multiple generated."  (Source:http://www.iitm.com/sm-Expectancy.htm)

The "R" in R-multiple is short for risk.  The best way to understand it is to either read the source above or continue reading.  Let's take my first trade as an example.  I knew my total dollar risk before entering the trade, that amount being $650.94.  (yes, that exact)  I exited half of my position when I had profited $329.  I moved my stop to breakeven on the remaining position.  Unfortunately I was stopped out on the rest giving me a total profit of $329.  To figure out the R-multiple, you would take (profit / amount risked) which in this case was $329/$650.94 = .5R.  Ideally, the higher the R in a profit situation, the better.  For instance, a 2R multiple would be obtained in a 2:1 reward/risk trade and a 3R multiple in a 3:1 reward/risk trade.   In a loss situation, a higher R is actually worse.  Ideally, if you lose on a trade, the R-multiple should be 1R or less.  If it's 1R, it simply means that you lost the amount you were expecting to risk.  So in my above example, if I lost $650.94 on the entire trade, my R-multiple would have been 1R.  Let's just say that I got stupid and decided to stay in the position and not honor my stop loss setting.  Because of this stupidity, let's also say that I wound up losing $1301.88, twice as much as my initial risk.  Calculating using (loss / amount risked) I would have an R-multiple of $1301.88/$650.94 = 2R.  

So what does all of this mean? Well, I only have 1 trade to calculate my expectancy which would currently be .5R.  I'll get more into calculating mean expectancy once I've compiled more trades.  But having .5R isn't desirable because it basically means that I risked twice as much as the reward I obtained.  This is exactly why I want to try to use R-multiple when I talk about my trades because even though I had a $329 profit on my first trade, it isn't as rosy as it may seem.  The R-multiple was only a .5R and although it was profitable, if I trade this way in the long haul, I'll surely lose.  

Another good source that also mentions the critics of R-multiple can be found at http://tradermike.net/2006/09/r_r-multiples_defined/

I've been emulating my real account trades with my demo account for the January forex trading contest.  I'm currently in first place with a return of 11.16%.  After today though, my return will drop 2 percentage points to about 9% since I lost 2% on a trade.  I don't know if this will be enough to hold on to the lead.  

This is an overview of how I've been trading so far in January 2008: 

1. I have been risking exactly 2% on every trade.  No more, no less.  
2. I've been using my forex position size calculator everyday when figuring out my trade size and find it very handy.  Some of you have commented the same.  
3. My R-multiple on every trade has been 2R.  For those of you that haven't heard of R-multiple, it's really just an abbreviation for reward-to-risk.  2R means my reward-to-risk is 2:1.  
4. I'm not watching my positions so there isn't any fancy money management going on.  I haven't once set my stops to breakeven. I'm just letting them ride.  If they hit my target, they hit it.  If they don't and stop out, so be it.  This is quite different from what I've done in the past.  In the past, I've been quick to set my stops to breakeven when they move a little in my favor.  The consequence of doing this was typically a gain/loss of zero.  I can't tell you how many times I've moved my stop to breakeven only to see it get stopped out.  Then I have to watch as the price goes back in the direction I was trading where it hits my initial target price.  This to me was more frustrating than losing.  I'd rather stick to my guns on a trade instead of playing it scared. 

I'm going to take the opportunity to call this week, Money Management Week.  A lot of what I'll be posting will hopefully be related to this topic which probably means that website traffic will decrease.  This would not be unusual considering that "on average, traders spend at least 10 times more time and effort on seeking the magic formula for trading than on learning to manage the trade." (Source: Matt Blackman, "Losing to Win")  

I've been very aware of the fact that money management is the most important aspect of trading but hopefully by bringing this subject into the forefront this week will make you and I even more aware.

From a lot of the backtesting and forward testing I've done over the last year, it's become quite evident that winning percentage for most systems are below 40%.  Some hover around the 40% level and others are even lower, reaching the 20%-30% level and below.  According to Perry Kaufman, author of "A Short Course in Technical Trading" and a veteran trader, trend-following systems are the best trading systems around.  But he also states that you can expect 6 or 7 out of every 10 trend trades to be losses, some small losses and some a little larger.  For this reason, a lot of beginner and novice traders wonder how it's possible to ever be profitable trading.  

The point is that the focus shouldn't be placed on how to achieve an unrealistic expectation for your win to loss ratio but to concentrate on money management.  I'll admit that money management hasn't been my prime focus and it's reflected in the subject of my posts over the last year.  In fact, I've only tagged 1 post with the subject money management attached to it.   

This week I'll be gathering together some useful links to money management articles and I'll also be talking more about money management as it pertains to my trading.  Larry Williams, a veteran trader said, "Since losses are an integral part of this game, a strategy is as essential as the proper attitude.  All jobs have good days and bad days so deal with it..."

Losing to Win

The blog's been silent since Sunday which usually means I'm busy doing other things or concentrating on trading.  That has definitely been the case this week.  I've been participating in the forex trading contest, getting Metatrader primed and ready for backtesting expert advisors again, finishing the development of a new AJAX forex position size calculator, trading for real, and working my real job.  Being busy is probably common for a lot of you out there too who are trading forex but have real jobs and responsibilities.  

I've searched around for a forex position size calculator but what I mostly found were pip value calculators, excel calculators, or calculators that were part of some proprietary trading platform (like Oanda's.)  I didn't find what I was really looking for which was a simple calculator that gave me a recommended position size in units and where I just had to enter my account balance, the percentage I want to risk on a trade and my stop loss.  So this is exactly what I developed.  It's completed and in beta at http://www.forexcalc.com.  It currently only works with accounts in USD but I'll expand on that later.  You have a choice of determining the position size for 110 currency pairs, way more than you'll ever need.  It also works no matter what your account size is.  It can be $1 or $10,000,000 though I doubt anyone with an account this big would utilize it.