Money_Management_Controlling_Risk_And_Capturing_Profits.pdf

Money Management (Pt. I):Controlling Risk and Capturing

Profits

By Dave Landry

Money management is the process of analyzing trades for risk and potential

profits, determining how much risk, if any, is acceptable and managing a trade

position (if taken) to control risk and maximize profitability.

Many traders pay lip service to money management while spending the bulk of

their time and energy trying to find the perfect (read: imaginary) trading system or

entry method. But traders ignore money management at their own peril.

The story of three not-so-wise men

I know of one gentleman who invested about $5,000 on options on a hot stock.

Each time the stock rose and the options neared expiration, he would pyramid

his position, plowing his profits back into more options. His stake continued to

grow so large that he quit his day job.

As he approached the million-dollar mark, I asked him, "Why don't you diversify

to protect some of that capital?" He answered that he was going to keep

pyramiding his money into the same stock options until he reached three to four

million dollars, at which point he would retire and buy a sailboat.

I recently met a second gentleman at a dinner party. He told me that six months

ago he began day trading hot stocks. It was so profitable, he said, that he quit a

flourishing law practice to trade full time. Amazed at his success, I asked him,

"How much do you risk per trade, a half point, one point?" He replied, "Oh no, I

don't like to take a loss."

A third gentleman was making his fortune buying the hottest stock(s) on the

momentum list(s). He, too, was on the verge of quitting a successful business.

When asked about his exit strategy, he replied "I just wait for them to go up."

When asked, "What if they go down?" his reply was, "Oh, they always come

back."

What ever happened to these "traders?" Gentleman number one is now

homeless, and the other two are about to be. They are on the verge of financial

devastation and the emotional devastation that goes along with it. This is the

cold, hard reality of ignoring risk. How do we avoid following in the footsteps of

these foolhardy traders? Three things will prevent this from happening: 1) money

management, 2) money management, and 3) money management.

The importance of money management can best be shown through drawdown

analysis.

Drawdown

Drawdown is simply the amount of money you lose trading, expressed as a

percentage of your total trading equity. If all your trades were profitable, you

would never experience a drawdown. Drawdown does not measure overall

performance, only the money lost while achieving that performance. Its

calculation begins only with a losing trade and continues as long as the account

hits new equity lows.

Suppose you begin with an account of $10,000 and lose $2,000. Your drawdown

would be 20%. On the $8,000 that remains, if you subsequently make $1,000,

then lose $2,000, you now have a drawdown of 30% ($8,000 + $1,000 - $2,000 =

$7,000, a 30% loss on the original equity stake of $10,000). But, if you made

$4,000 after the initial $2,000 loss (increasing your account equity to $12,000),

then lost another $3,000, your drawdown would be 25% ($12,000 - $3,000 =

$9,000, a 25% drop from the new equity high of $12,000).

Maximum drawdown is the largest percentage drop in your account between

equity peaks. In other words, it's how much money you lose until you get back to

breakeven. If you began with $10,000 and lost $4,000 before getting back to

breakeven, your maximum drawdown would be 40%. Keep in mind that no

matter how much you are up in your account at any given time--100%, 200%,

300%--a 100% drawdown will wipe out your trading account. This leads us to our

next topic: the difficulty of recovering from drawdowns.

Drawdown recovery The best illustration of the importance of money

management is the percent gain necessary to recover from a drawdown. Many

think that if you lose 10% of your money all you have to do is make a 10% gain to

recoup your loss. Unfortunately, this is not true.

Suppose you start with $10,000 and lose 10%

($1,000), which leaves you with $9,000. To get

back to breakeven, you would need to make a

return of 11.11% on this new account balance,

not 10% (10% of $9,000 is only $900--you have

to make 11.11% on the $9,000 to recoup the

$1,000 lost).

% of Gain

Required to

Recoup Loss

10% 11.11%

20% 25.00%

30% 42.85%

40% 66.66%

50% 100%

60% 150%

70% 233%

80% 400%

90% 900%

100% broke

Table 1. Notice that as losses

(drawdown) increase, the

percent gain necessary to

recover to breakeven

increases at a much faster

rate.

Even worse is that as the drawdowns deepen,

the recovery percentage begins to grow

geometrically. For example, a 50% loss

requires a 100% return just to get back to break

even (see Table 1 and Figure 1 for details).

Professional traders and money mangers are

well aware of how difficult it is to recover from

drawdowns. Those who succeed long term

have the utmost respect for risk. They get on

top and stay on top, not by being gunslingers

and taking huge risks, but by controlling risk

through proper money management. Sure, we

all like to read about famous traders who parlay

small sums into fortunes, but what these stories

fail to mention is that many such traders,

through lack of respect for risk, are eventually

wiped out.

% Loss of

Capital

Figure 1. Percent loss (drawdown) vs. percent to recover. Notice that the

percent to recover (top line) grows at a geometric rate as the percent loss

increases. This illustrates the difficulty of recovering from a loss and why money

management is so important.

Summary

Money management involves analyzing the risk/reward of trades on an individual

and portfolio basis. Drawdown refers to how much money you've lost between

hitting new equity peaks in your account. As drawdowns increase in size, it

becomes increasingly difficult, if not impossible, to recover the equity. Traders

may have phenomenal short-term success by taking undue risk, but sooner or

later these risks will catch up with them and destroy their accounts. Professional

traders with long-term track records fully understand this and control risk through

proper money management.

In the next installment: Money management ranges from simple,

commonsense approaches to complex portfolio theory formulas. The good news

is that it does not have to be rocket science. A simple, straightforward approach

should be sufficient for most traders. In the next installment of this series (May

15), we will look at general money management guidelines that should help keep

you out of trouble and help ensure your long-term success.

Money Management (Pt. II): Rules Of The Road

By Dave Landry

In the first installment of this series we stressed the importance of money

management, illustrated through drawdown and percent to recover analysis. We

mentioned that money management ranges from simple, commonsense

approaches to complex portfolio theory.

The good news is that for most traders money management can be a matter of

common sense rather than rocket science. Below are some general guidelines

that should help your long-term trading success.

1. Risk only a small percentage of total equity on each trade, preferably no

more than 2% of your portfolio value. I know of two traders who have been

actively trading for over 15 years, both of whom have amassed small

fortunes during this time. In fact, both have paid for their dream homes with

cash out of their trading accounts. I was amazed to find out that one rarely

trades over 1,000 shares of stock and the other rarely trades more than two

or three futures contracts at a time. Both use extremely tight stops and risk

less than 1% per trade.

Use real stop orders—“mental stop” don’t work

2. Limit your total portfolio risk to 20%. In other words, if you were stopped out on

every open position in your account at the same time, you would still retain 80%

of your original trading capital.

3. Keep your reward-to-risk ratio at a minimum of 2:1, and preferably 3:1 or

higher. In other words, if you are risking 1 point on each trade, you should be

making, on average, at least 2 points. An S&P futures system I recently saw did

just the opposite: It risked 3 points to make only 1. That is, for every losing trade,

it took 3 winners make up for it. The first drawdown (string of losses) would wipe

out all of the trader's money.

4. Be realistic about the amount of risk required to properly trade a given market.

For instance, don't kid yourself by thinking you are only risking a small amount if

you are position trading (holding overnight) in a high-flying technology stock or a

highly leveraged and volatile market like the S&P futures.

5. Understand the volatility of the market you are trading and adjust position size

accordingly. That is, take smaller positions in more volatile stocks and futures.

Also, be aware that volatility is constantly changing as markets heat up and cool

off.

Never add to or “average down” a losing position

6. Understand position correlation. If you are long heating oil, crude oil and

unleaded gas, in reality you do not have three positions. Because these markets

are so highly correlated (meaning their price moves are very similar), you really

have one position in energy with three times the risk of a single position. It would

essentially be the same as trading three crude, three heating oil, or three

unleaded gas contracts.

7. Lock in at least a portion of windfall profits. If you are fortunate enough to

catch a substantial move in a short amount of time, liquidate at least part of your

position. This is especially true for short-term trading, for which large gains are

few and far between.

8. The more active a trader you are, the less you should risk per trade.

Obviously, if you are making dozens of trades a day you can't afford to risk even

2% per trade--one really bad day could virtually wipe you out. Longer-term

traders who may make three to four trades per year could risk more, say 3-5%

per trade. Regardless of how active you are, just limit total portfolio risk to 20%

(rule #2).

9. Make sure you are adequately capitalized. There is no "Holy Grail" in trading.

However, if there was one, I think it would be having enough money to trade and

taking small risks. These principles help you survive long enough to prosper. I

know of many successful traders who wiped out small accounts early in their

careers. It was only until they became adequately capitalized and took

reasonable risks that they survived as long term traders.

This point can best be illustrated by analyzing mechanical systems (computer-

generated signals that are 100% objective). Suppose the system has a historical

drawdown of $10,000. You save up the bare minimum and begin trading the

system. Almost immediately you encounter a string of losses that wipes out your

account. The system then starts working again as you watch in frustration on the

sidelines. You then save up the bare minimum and begin trading the system

again. It then goes through another drawdown and once again wipes out your

account.

Your "failure" had nothing to do with you or your system. It was solely the result

of not being adequately capitalized. In reality, you should prepare for a "real-life"

drawdown at least twice the size indicated in historical testing (and profits to be

about half the amount indicated in testing). In the example above, you would

want to have at least $20,000 in your trading account, and most likely more. If

you would have started with three to five times the historical drawdown, ($30,000

to $50,000) you would have been able to weather the drawdowns and actually

make money.

10. Never add to or "average down" a losing position. If you are wrong, admit it

and get out. Two wrongs do not make a right.

11. Avoid pyramiding altogether or only pyramid properly. By "properly," I mean

only adding to profitable positions and establishing the largest position first. In

other words the position should look like an actual pyramid. For example, if your

typical total position size in a stock is 1000 shares then you might initially buy

600 shares, add 300 (if the initial position is profitable), then 100 more as the

position moves in your direction. In addition, if you do pyramid, make sure the

total position risk is within the guidelines outlined earlier (i.e., 2% on the entire

position, total portfolio risk no more that 20%, etc.).

12. Always have an actual stop in the market. "Mental stops" do not work.

Strive to keep maximum drawdowns between 20-25%

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