Money Management Thread

Discussion in 'Risk Management' started by newbie, Oct 26, 2001.

  1. newbie


    I wanted to start a thread on money management and get others' ideas. This is the article from that I got and thought I should share. I put their name in here so as to not infringe on anything..... hopefully I don't get busted!


    One trader lost ($3000) during the course of a year trading one contract of system A. Another trader makes $25,000 trading the same system that year. One trader makes $24,000 trading system B one year while another makes from that same system $79,000, both with the same starting capital. What is the difference between these traders?



    Money management is what allowed Larry Williams to trade $10,000 into $1.1 million within one year. According to Larry, if he had traded ONE CONTRACT on every single trade, profits that year would have been only around $100,000. There were two aspects to Larry’s record setting trades: 1) The system and strategies he used to determine where to enter and exit trades; and 2) the method he used to increase and decrease the number of contracts to place on any given trade. To put it simply, only 9% of the total profits came from the system and strategies used to determine where to enter and exit trades while 91% of the total profits that year came from the money management strategy he applied. Money management alone increased Williams’ return by 1000%!


    This is a statistic that I have heard for years on many different occasions and from a number of reliable sources. In my own experiences hearing from other traders, I could not offer any data to the contrary. Here is another piece of interesting data I think is correlated to this statistic. 90% - 95% of all traders spend hundreds of hours and thousands of dollars trying to figure out where to enter and exit the market while they barely even put a thought towards how much risk to place on each trade and when to increase or decrease that risk. I seriously doubt that these two statistics are the same by coincidence.

    I opened the article by comparing two traders trading the same system. The first trader lost $3,000 during the year while another trade made $25,000 taking the same exact signals as the first trader. The difference between these two traders is the simple fact that the second one applied proper money management methods to the trades while the first one did not.


    Before we further explore the power of money management, it is important to clarify that not just any money management should be applied to trading, but proper money management.
    To drive the point home, we will use the following illustration:
    Take a coin, toss it in the air 100 times. The ratio of heads to tails landing up should be very close to 50/50. If you were to win $2.00 every time the coin landed heads up and lose $1 every time heads landed face down, you should have won approximately $50 by the end of 100 tosses. This is a positive expectation situation. The odds of you winning are heavily in your favor. We will further say you have $100 to bet with. The question is, what percentage of your money should you risk on each flip of the coin?
    What would you say is the best percentage to reinvest on each flip? 10% 25% 40% of 51%? This means that if you begin with $100 and choose to risk 10% of your capital on each flip, you begin by risking $10 on the first flip. If the coin lands heads up, you win $20. You would then risk $12 of the new $120 total on the next flip of the coin. If you lose, you lose $12 and if you win, you win $24…and so forth the game goes. Would it make a difference which % you used? If so, how much? Remember, you make twice as much when you win than when you lose. The odds of you winning are 50% every time. The answer may surprise you. By risking 10% of your money on each of the 100 flips (a $10 bet on the first flip) you will turn your $100 into $4,700! Money management increases your return from 50% to a 4700% return! Reinvesting 25% of your money would have turned $100 into $36,100! An increase of just 15% per toss increases your total return from 4700% to 36,100%. It looks like it gets better the more you invest. But wait. Increasing your risk another 15% every flip to a total of 40% being risked on each flip would turn your $100 into $4700. This time by increasing your risk, your return dropped drastically. What if 51% of your money is invested? With this scenario, you actually lose money even though the odds are statistically in your favor. Your $100 decreases to $36. A loss of 64%. Our point? USING THE RIGHT OR WRONG MONEYMANAGEMENT CAN MAKE OR BREAK YOU!

    The great thing about money management is the fact that money management is purely a function of math. A hundred years ago, two + two = four. Today, that same equation yields the same answer (unless you were raised in the public school system at which point it would depend on how you feel that day. Therefore, money management IS predictable unlike trading strategies or systems. In the example above, it would not matter in what order heads or tails were achieved. If you flipped 50 tails first and then 50 heads, the outcome would be the same as if you flipped 50 heads first and then suffered the 50 losing tails. You may be skeptical of these numbers at first, but I assure you, the numbers are correct.
  2. newbie



    Before reading further, the previous illustrations should have left one very big impression about how powerful money management can be. Let’s take the time to re-assert a few things before we go on.

    1) Money management is more powerful than any trading system that it can be implemented to.

    2) Money management is more stable than ANY trading system. It is based on math, and math does not change.

    3) It is more logical to implement proper money management to a trading system than to trade that system without it. Money management will take you farther with less.

    4) The wrong money management applied to your trading could actually hurt the end result.

    Finally before proceeding, we want to convey one more thought and leave you a challenge. You may or may not have noticed that the commodity industry is infatuated with trading systems. Have you ever stopped to ask yourself that if money is to be made through trading systems, why do 90% of individual traders end up losing money? Why don’t system vendors know the effect of proper money management? Our challenge is this; Call any system vendor, ANY of them, ask them the following:

    “if I were to purchase your system, at what levels should I increase the number of contracts I am trading?”

    More than likely, you will get one of the following answers:

    1) I don’t know.
    2) It’s really up to you.
    3) Increase one contract for every $10,000 in your account.
    4) X% of your account on each trade. (this will probably range from about 2% to 10%.)
    5) Increase when you double your money.

    After receiving one of these answers, read the following and decide for yourself whether you should take their advice or not.


    The most widely understood technique of money management, especially among professional money managers, is called the fixed fractional method. This method simply risks X% of your money on each and every trade and is the method used in our coin tossing example. If you expect your largest possible loss to be $1,000 in a $20,000 account and you wanted to risk no more than 5% of your account balance on every trade, you would trade one contract for every $20,000 in your account. ($1,000 / .05 = $20,000) When the account is built up to $40,000, you would then be able to increase the number of contracts to two. When you reach $60,000, you will increase to three contracts, etc. You would increase or decrease contracts by one for every $20,000 you have in your account. This is the most commonly used method in the industry today. However, there are some problems with this type of method.


    Fixed fractional trading is an objective process that is fairly simple to implement. But, is it the most practical and logical? The answer is no. Fixed Fractional trading has several drawbacks. For the average trader, a typical account to start trading is about $20,000. Implementing the same scenario of maximum loss per trade of $1,000 and risking no more than 5% on each trade requires you to produce a 100% return before you increase from trading one contract to two contracts. Further, if your largest loss exceeded $1,000 you would be required to break your own rule just to trade one contract. For example, if your largest loss is $1,500 instead of $1,000, you are risking 7.5% of your account balance right off of the bat ($1,500 / $20,000 = 7.5%). You either have to break your own rule or start with $30,000 instead of $20,000 in the account. At this point it would take you $30,000 in profits before you ever increase from one to two contracts.

    On any scenario risking X% on each trade would require a 100% return on your original investment before you increase to two contracts. However, to increase trading two contracts to three requires an additional 50% increase of your account balance. Using the $1,000 largest loss and risking 5% on each trade requires an additional $20,000 in profits but computes to only a 33% increase in the account balance to go from three to four contracts. Keep in mind that you are increasing the ability to achieve the higher goals in a far less amount of time. This is true because you are trading more contracts to reach the same amount of additional money each time. Theoretically, if it took you one year to increase from trading one contract ot trading two contracts, it should take you another six months to increase to three contracts. This scenario continues on until it is absolutely absurd the rate at which you are increasing contracts. For example, to increase from 1 to 4 contracts requires two years provided that you make on average $20,000 per year per contract. However, over the following two years, your increase skyrockets from 4 contracts to 33 contracts. At that rate, the increase is one contract every 11 days instead of the one year it took to go from one to two contracts.

    This also poses a major problem when you try to compensate for the incredible length of time it takes you to increase from one to two contracts. The only possible way to increase that speed on the front end (which is when it is needed most, especially when you are starting with a smaller account) is to increase the percentage of risk. For example, we will raise the percentage of your account to risk on each trade from 5% to 15%. A single contract for every $6,666 in your account ($1,000 / .5 = $6,666). Therefore, according to this scenario, if you start out with a $20,000 account, you begin trading three contracts before the system even started proving itself. The increase from three to four contracts occurs in only forty days. The next increase comes to pass in thirty days and by the rime you go from ten to eleven contracts, a time span of only twelve days has passed! From twenty to twenty-one contracts would take a little more than five days. To look at this same scenario a little differently, instead of using time, we will use dollars required per contract traded. Remember, you only need a total additional $6,666.66 to increase contracts. If you are trading 20 contracts, you divide that required amount by the number of contracts you are trading to come up with how much per contract you need to make ($6,666 / 20 = $333). That’s right, you need a profitable trade of only $333 to increase another contract. But wait…what if your next trade yielded you a $1,300 profit? You actually skip from trading twenty contracts to twenty-four contracts on ONE TRADE! Well, it doesn’t take a rocket scientist to see where we are going with this.

    (*Note – The time examples are illustrative only using averages to make the point. Do not read anything more into it)
  3. newbie


    If the method being used in the above scenario to increase from 20 to 24 contracts has average profitable trades in the range of $1,000 to $2,000, this will cause the money management system to skip contracts at higher levels. If you make it up to twenty contracts (which also means your account balance is at least $130,000 ($6,666 x 20) and you have a profitable trade of $1,300 and jump up to twenty-four contracts on your next trade, what happens if a drawdown occurs? Let’s say your worst drawdown is only $5,000 (which is far better than most realistic drawdowns). If your worst loss is only $1,000, that means your drawdown has to be spread out between at least five trades. To be conservative, we will say that these five trades occurred consecutively rather than simultaneously (five open positions at the same time at twenty-four contracts a piece).

    The first trade occurs and you have twenty-four contracts. Your loss is ($1,000) per contract. Your account goes from at least $160,000 (24 contracts x $6,666) to $136,000 in one trade ($1,000 loss x 24 contracts). As a result, the next trade you only put on twenty contracts $136,000 / $6,666 = 20. The loss of ($1,000) comes and your account goes down to $116,000. The next trade you have seventeen contracts and you move down to $99,000 in account equity. Remember, this is only a $3,000 drawdown per contract so far. Next trade comes, you have fourteen contracts on and your loss takes you down to $85,000. Your final trade you have cut your contracts in half to where you’re now only trading twelve and the loss brings your account balance to $73,000.

    Your small $5,000 drawdown, which was only a 25% drawdown if you were only trading one contract with a $20,000 account, has now turned into an $87,000 drawdown and 54% of your total account balance. Really bad news if your drawdown exceeds $5,000 per contract. Remember, we were also being conservative. If you had put on all five of those losing trades at relatively the same time with the full twenty-four contracts, your account would have gone from $160,000 to only $40,000!!!!! Totally Unacceptable. Further, if the $5,000 drawdown continues, the $73,000 dwindles to only $34,000. A $10,000 drawdown dropped the account by $126,000!


    This is actually just a different way of saying X% risked on every trade. In the previous example using a $1,000 largest loss, one contract for every $10,000 would come out to 10% being risked on each trade ($1,000 / .10 = $10,000). Therefore, the ridiculous discrepancy in time between increasing from one to two contracts and nine to ten contracts is still the same. The drawdown risks are the same with any fixed percentage being risked on each trade…BIG. The only difference is HOW big.

    These are the things most everyone else is telling you to do. As you can see, breaking these methods down strips any logical argument for utilizing them in your own trading.


    It amazes me how many vendors in the industry push this money management method. This may be good for managed funds with millions of dollars, but it is totally impractical for individual traders with average accounts. I need only make one illustration to prove my point. If you have a $20,000 account, you can not trade unless the risk on each trade is at or less than $400. If you have a $50,000 account, you can not take a trade with a risk of more than $1,000. Further, if your maximum risk is only $1,000 with a $50,000 account, you can not increase contracts until the account increases to $100,000! You can not increase to 3 contracts until the account reaches $150,000.

    You might be saying to yourself about now that this is simply a more conservative method of money management and that someone may not want to risk more than this. Don’t entertain that thought because it is totally and completely 100% false. I hear all the time how traders want to say money management is simply a matter of preference and that it is going to be different for every trader. To some degree, this is true. But if you take the same account size with the same risk tolerance and the same profit goals, there is only one "best” money management application for that set of circumstances. In geometry, the definition of a line is the shortest distance between two points. There are other ways to get from point A to point B, but there is only one way that is most efficient to achieve the same results. That is the same way with money management. It is only a matter of preference is one trader doesn’t want to reach point B in the most efficient manner. If that is the case, you should probably hang up your trading shoes. There is a “best” way and it is not a matter of preference. It is a matter of mathematics. Keep that in mind as we continue on.


    Back when I was researching all of the different type of money management and getting frustrated at the various pros and cons, I ended up scrapping everything there was and developing my own. The method I developed is called Fixed Ratio Trading. Before I get into the logic of Fixed Ratio, let me review a few examples of what the Fixed Ratio money management method can do for systems like the ones you trade right now.

    S&P Daytrading System…
    Results trading just one contract were as follows:

    # Trades 123
    #Winners 67
    #Losers 56
    %Profitable 54%
    Total net Profit $25,830
    Avg. Trade $210
    Largest DD 19%

    As you can see, not the Holy Grail. But, apply the Fixed Ratio method to these results and over the same 123 trades, the increase is spectacular:

    #Winners 67
    #Losers 56
    %Profitable 54%
    Total Net Profit $204,000
    Avg. trade $1,658
    Largest DD 22%

    A better than sevenfold increase in profits while only increasing the total drawdown by 3%!

    How about a position trading system in the Bonds?

    #Trades 183
    #Winners 115
    #Losers 68
    %Profitable 63%
    Total net Profit $44,652
    Avg. Trade $244
    Largest DD 14%

    With our fixed Ratio money management applied to the same 183 trades starting with one contract, results were as follows:

    #Trades 183
    #Winners 115
    #Losers 68
    %Profitable 63%
    Total Net Profit $462,787
    Avg. Trade $2,528
    Largest DD 19%

    A better than TEN FOLD increase in profits while only increasing the drawdown by 5%! Is this something you should apply to your trading?
  4. newbie



    I realize some of you may be saying that a fixed fraction and a fixed ratio are the same thing. But, in fact, they are referring to two different subject matters…and that is the difference. The fixed fractional method is referring to what percentage of your capital should you risk on the next trade, and every trade thereafter. The Fixed Ratio method is referring to difference between each increase and decrease. This is the key.

    You will recall earlier in the article that I gave examples using average times to increase as well as average dollars to increase. Using the fixed fractional method, the time needed to increase at the beginning was far slower than the time needed to increase further into trading. The dollars required to increase contracts at the beginning was far more than the dollars require to increase contracts at higher levels. In all of my research, this was the flaw in the method, the fly in the ointment if you will. Fixed ratio corrected this flaw by simply making these differences EQUAL or FIXED.

    For example, if it took an average of 10 trades to increase from one to two contracts, it will take an average of 10 trades to increase from 19 to 20 contracts. If it takes an average of $10,000 WITH THE FIRST CONTRACT to increase from 1 to 2 contracts, then it will take $10,000 PER CONTRACT to increase from 19 to 20 contracts. In other words, there is a Fixed Ratio of contracts traded to dollars required to increase.

    It goes like this. I call the ratio between contracts traded to dollars required the “delta”. This simply means “change”. Depending on how aggressive or conservative you want to be, you simply change the delta in the following formula accordingly. A smaller delta is more aggressive while a larger delta is more conservative.

    Current Balance + (#contracts * Delta) = next increase in contracts.

    A $20,000 starting balance using a $5,000 delta would increase from 1 to 2 contracts once the account reached $25,000. To increase from 2 to 3 contracts, you would apply the same formula:

    Current Balance = $25,000 + (2 contracts * $5,000) = $35,000. You would increase to 3 contracts once the account hit $35,000. This continues throughout your increases.

    This article barely scratches the surface of my research into the powerful topic of money management. For a more thorough and in depth study on everything in this article and so much more, I suggest buying my book “The Trading Game, Playing by the Numbers to Make Millions”. In the meantime, let me make one illustration to prove my next statement. If you believe that money management is a matter of preference, or that it is just my opinion that my Fixed Ratio method is better than any fixed fraction, then I challenge you to prove me wrong. Give me any system, any set of positive results (and in many cases, negative end results) and I guarantee that taking into account both risk levels and profit potential, there is no fixed fractional method out there that will beat the Fixed Ratio method. There are a lot of opinions out there, but I will back mine up. I will do it hypothetically if you wish or real time, real trades and real money. You can choose the method. You use a fixed fraction, any fixed fraction you want, and I’ll use my Fixed Ratio. We will start with 1 contract and the first one to reach a predetermined profit level without violating a certain percentage of the account at any given time will win. Further, both money management plans have to be fully disclosed and stuck with prior to the start of trading. This is a standing offer to anyone at anytime using whatever trading system and/or market they want to use.

    Now for the illustration:

    My PowerTrade S&P XT method made $39,500 based on a single contract from January 1st through the end of April this year. The worst drawdown hit $12,500. Using a delta of $5,000, profits were increased to $104,000 trading 6 contracts. This means that with a $2,000 single contract loss, the drawdown would be $12,000 or 11.5% of the profits. This, by the way, is not “the best” ratio to use in this scenario if you are looking for profitability.

    Using the fixed fractional method, I optimized to find the VERY BEST fixed fraction to trade on this data set. If you will recall in the coin flipping illustration, risking 25% produced more profits than risking 10% or risking 40%. In fact, for that particular situation, risking 25% produced THE MOST profits of any fixed fraction. This is called “Optimal f”. I used Optimal f with this illustration. The VERY BEST fixed fraction could only produce a total of $71,250 and it was trading 9 contracts at the end of that scenario. This means that a $2,000 loss per contract would result in an $18,000 drop, or 25% drawdown.

    This means that the very best fixed fraction produced $32,000 less profits and was risking 13% more of those fewer profits with a single loss of $2,000. By the way, the best was 12% based on a $1,000 possible loss. 12% produced more profits than 11% and more profits than 13%.

    Remember what I said about using a smaller fixed fraction was just being more conservative, and how that thought process was false. Try this on for size…risking 2% based on a $1,000 largest loss would have never increased contracts. This means that after a $10,000 drawdown using the “more conservative” money management, total profits would be at only $29,500 for the year. After the same $10,000 drawdown using a $5,000 delta, the account would still be over $50,000.


    The purpose of this article was not necessarily to promote my Fixed Ratio method above the fixed fractional method. The purpose of this article was more to open your eyes to the power of proper money management and encourage you to look further into the subject. Don’t take my word for it, do your own research and see if the principles outlined in this article are not true. Having not even begun to scratch the surface, money management is the most powerful aspect of trading when it comes to your bottom line. It could mean the difference between your ultimate success or failure in trading.
  5. newbie



    This article should be read only after reading the article "The Power of Proper Money Management". If you have not read that article, then this one might not make as much sense.

    The subject of preserving equity can be divided into two separate categories. The first category is protecting initial capital while the other is protecting profits when and if they accrue, and in that order. If you do not do a good job of protecting the initial capital, you may not stay around long enough to have the opportunity to protect profits. When talking about protecting profits, the first thing that comes into 90% of most traders' heads is protecting profits with a single trade that happens to be profitable. They want to know when to get out of a profitable trade and when to hold onto that profitable trade. While this topic is certainly a worthy topic to discuss and look into, it is not the topic being discussed in this article. When I talk about protecting profits in this article, I am talking about over-all profits. For example, when an account starts at $20,000 and reaches $60,000, how do you take steps to make sure that $60,000 doesn't drop back down to $20,000 if that is your goal? That is what I will discuss in this article.


    This is where you must begin. At the beginning. When you are ready to start trading, you had better have a plan in place to know what you are going to do if profits seem to avoid your account like the plague. Unfortunately, most traders, especially beginners, enter the wonderful world of trading like most newly weds enter into marriage…willfully ignorant. This means "stupid on purpose". Well am I right???? Now come on…when you were first married, did you not think that your spouse could do no wrong? Didn't you think they were the next best thing since sliced bread…yeah, that is until after the honey moon was over and you had peanut butter between two pieces every night for dinner. If you have been married for oh, say longer than one week, reality usually sets in. Lo and behold, your spouse isn't the perfect person you married just one week ago. And, that is usually about how long it takes for reality to set in with new traders. If love is blind, don't love trading.

    Here is the thought process of a beginner. I have done enough research and uncovered one of the most brilliant pieces of trading secrets ever. I don't need to worry about protecting initial capital because I'm going to make a fortune. But what is really sad, is that after the first time they blow out an account in 36 hours flat, they suddenly realized the error of their ways and know what to do differently next time. And, it usually does not include protecting that initial capital. I am embarrassed to say that I think it took me 5 separate occasions to where I totally blew out my account before I finally figured out that I better protect my initial capital just in case my most fabulous trading method ever…has a fllll…has a fllll…might be flll…d…doesn't work.

    I was once asked by a trader who had (and I stress the word "had") $500,000 to begin trading with. He was going to day trade the S&P. He asked me how many contracts he should start with. I asked "have you ever day traded the S&P before?" "no". "Have you done your research on what to expect?" "I think so." My answer was the same as it always has been and always will be, regardless of what the answer to those two questions are; ONE. Start with one contract. The only reason I asked the questions is because I knew the answer and I also knew that he was going to be reluctant to just trade one contract with a $500,000 account. So I tried to let him give me a reason to just trade one. He began trading with eight. One month later, I get a phone call. His $500,000 account slid down to $160,000. He apparently thought that since he started off loosing, things would turn around so he increased contracts after that! That is a topic for a different article. Nonetheless, he called and told me what had happened and proceeded to ask me what he should do now. I said, trade one contract. It was an expensive lesson to learn.

    The first rule of protecting initial capital is to start out trading with ONE contract, a minimal number of shares or one option. I don't care how much capital you have, how much research you have done, what the historical results were, start out with the minimum. You start out with the minimum and make the method prove itself before increasing your risk. (See the article "The Power of (Proper) Money Management").

    The second rule of protecting initial capital is to not over-trade with a single contract with too many markets. If you ever even come close to possibly having a margin call, you are overextending your account. Sometimes this can not be avoided based on the only available capital you have or based on the goals you have. For example, I have some ludicrous goal of beating Larry Williams' trading record. Whether I will ever do it Lord only knows. But as a result, every time I try, I put my entire $15,000 contest account on the line from the start. The reason is due to the magnanimity of the goal. I have to. Others may only have a $5,000 account to work with. It is almost impossible to avoid putting the account under stress while at the same time giving yourself adequate opportunity to build the account. However, if you have the ability to put some space between the account size and the required margin after 3x the largest drawdown incurred in the past, that is a good starting place.

    For other, smaller accounts, there is a fine line between over-trading the account and putting it in a reasonable position to be built up. If in doubt, err to the conservative side. Better cautious than crazy to give yourself a chance to be around next year. In fact, I would suggest keeping considering what I call Smart Trades. Long term investment type trades in the commodities. May be boring, may be slow, but if chosen carefully, the risk/reward ratio can't be beat. Smart Trades are covered in another article.

    Basically, to sum up protecting the initial capital, a little common sense goes a very long way.
  6. newbie



    This is where things begin to not only get interesting, but exciting as well. If you have properly protected the initial capital, you stand a very good chance of staying in the game long enough to finally reap some profits from your trading. Some of the most important trading decisions of your life as far as your ultimate success in trading is concerned will be in the area of what you decide to do with profits if they come. For this section, I am going to assume that you have read and understand how to properly increase your risk as outlined in the article "The Power of (Proper) Money Management". If risk increases were properly applied, there is a chance that the amount of profits that accrue during a positive run may surprise you. Nonetheless, you must address how to protect those profits because there will be a drawdown right around the corner. Most traders do not realize that regardless of what they are trading, all trading methods and/or systems are in drawdowns on average between 65% - 80% of the time. And, if they are not properly planned for after profits accrue, you could easily see those profits grow wings like an eagle and soar away. You won't know what hit you. (See the article entitled "Drawdowns, They Can Always Get Bigger")

    If protecting profits is more important to you than continuing to grow the account at a fast pace, then the most important step you can take to protect profits when the drawdown comes is to decrease your risk per trade faster than the rate at which you increased your risk on the way up. There are two main aspects to money management. When to increase your risk on following trades and when to decrease your risk on following trades. For example, if you used a $5,000 delta with the Fixed Ratio method to increase your risk on trades, to protect profits, you might decrease your risk twice as fast. For example, using a $5,000 delta starting from a $20,000 account, you would be trading 6 contracts if the account increased to $97,000. If a relatively large drawdown of $15,000 per contract were to occur, your account would drop back down to below approximately $34,000 trading 2 contracts which means that you are still pretty exposed should the drawdown continue.

    However, if you were to decrease contracts twice as fast, you would drop to $46,000 but trading only 1 contract. So, even after a relatively large drawdown, you are protecting $12,000 more in profits than had you kept the rate of decrease the same as the rate of increase. Further, the system and/or method you are trading can continue to drawdown another $26,000 before you drop to your original starting capital size of $20,000.

    To put in another way, by decreasing faster than you increase, you can actually turn a loosing scenario into a winning scenario should the profits come first. To increase the account with the Fixed Ratio method from $20,000 to $97,000 as in the example above, the system or method would have had to produce a total single contract profit of $27,000. If the system and/or method then falls completely apart and suffers a $35,000 drawdown, by trading only one contract, the next results would be ($8,000). However, a $35,000 drawdown after applying the Fixed Ratio method coupled with a rate of decrease twice as fast as the increase, the net end results would be positive $6,000! The method made $27,000 and then lost $35,000, but being the well seasoned trader that you are, you still made $6,000 on a losing scenario.

    Obviously this article can not exhaustively cover the myriad of possibilities with using proper money management to protect profits. However, I will cover a few basic things you will run into that should be addressed. First, if you are trading and begin dropping contracts (or options or shares of stock), you will run into the question of where to start re-increasing. The simple answer is to start re-increasing at the same levels at which you decreased. Then once you reach the level at which you started decreasing in the first place, you resume the original rate of increase, in the scenario above, continue using a $5,000 delta.


    Second, nearly every time I begin trading a new method or new account, my first goal is to reach what I call "the point of no return". The point of no return is the most awesome place to be in as a trader and few reach it. If you apply these principles and have the thrill of reaching this point, you will experience a joy and freedom in your trading that is unexplainable. The point of no return is simply the level your account needs to reach to guarantee that no matter what happens after that, due to proper planning and application of money management principles, you will never see that account go negative. It is not as far away as you might think.

    For the example, I will give you my plans for my contest account for this year. I have been day trading the account using my PowerTrade S&P method. My account reached an equity high of $107,000 starting out with only $15,000 at the beginning of the year. I did not use the exact rate of decrease as explained above, but it was close. Nonetheless, my plan was to begin trading a single contract if the account dropped below $50,000. Then, if the drawdown continued, I would drop to trading an e-mini contract in the S&P if the account dropped below $40,000. If that were to occur, the PowerTrade S&P could continue with an additional $125,000 drawdown…that's right, I didn't stutter, an ADDITIONAL $125,000 drawdown based on a single (full) contract before my contest account goes negative. This means that after garnering only $30,000 in profits based on a single contract, the method could go into a total drawdown of $150,000 before I give back that original $30,000 profit!!! Based on a single contract, this scenario would produce a net end result based on trading a single full contract of NEGATIVE $120,000…and I will not have lost a penny trading it the entire time!!!!

    Sit back and ponder the power of the information contained in this article. It should change forever the way you look at and approach trading. And, if you ever have the incredible experience of reaching the point of no return in your own trading, I'd like at least a steak dinner out of it. =0) Enjoy your trading experience!
  7. BKuerbs


    I have read the book of Ryan Jones before and some others about Money Management. There is a lot to be said about Money Management and it is an interesting subject.

    But there are a lot of unrealistic and in some points totally false claims made by Ryan Jones.

    All authors use the example of flipping coins in varying versions to demonstrate their different methods. This example - and some others taken from the arena of Casino Gambling - are totally inappropriate when applied to trading the financial markets. In flipping the coin and in the Casino Games (or betting Horses) you know the probabilities of winning and losing and you know your payout ratio.

    In the financial markets you don't. The very best you have is a system or method backtested on some historical data. We all know - or at least should know - about the dangers of curvefitting. So you have to look very carefully at the process of system development to decide whether this system could hold up in the future. There is no guarantee the probability of winning will hold up nor is there any guarantee that the payout ratio will hold up. To rely upon these numbers to derive a money management method is necessary, but should take into account the possibility of failure, i.e. be conservative.

    No money management of this earth is going to turn a losing system into a winning one.

    Did you notice that all examples given in the articles were based upon a winning system? Even winning systems can have long streaks of losing or just break-even. I have seen equity curves of backtested winning systems traded for real and they made barely to break-even for 18 months. After that they started to make money. Now what if you started aggressively raising your number of contracts after some wins in those first 18 months? You had blown up big. The method of fixed ratio certainly does have its merit, but it is when you made some money, where applying a fixed fractional would be too aggressive, as Ryan Jones very rightly points out. When you start with fixed ratio in your 20000$ account you are risking more than with fixed fractional. Please note that Ryan Jones totally fails to deliver any example in which you lose while starting to trade. There is a reason.

    By the way, anyone claiming that a fair coin thrown 100 times should turn up heads/tails 50/50 does not know much about randomness.

    And claiming that money management is just a matter of math fails to see that the math in this case is like a gigo program: garbage in delivers garbage out (do not get me wrong: I have a diploma in mathematics).

    Have Fun

    Bernd Kuerbs
  8. newbie


    I do agree with what you say. In his book (just bought it) he does make the statement that no money managment plan will turn a losing system into a winning system. The examples in the article are based on the assumption you already trade a system that has a positive mathematical expectation. If you don't-then there's no need to read this article. If you start trading and immediately begin in a drawdown- you will always be stuck trading one contract, until you blow the account up.... in which case-either the method is flawed-or you started with a bad plan and too little capital. Yes-backtested systems don't tell you anything about the future, but it still helps you plan for at least something rather than just guessing. He hits that in this next article to follow.
  9. newbie


    Article from

    May 20, 2001

    I will admit, as long as I have been trading, as many drawdowns as I have gone through, and some totally devastating some of my accounts before the days I focused on money management, they never, ever get any easier. In fact, logically, they get harder to go through. Why, because I have been trading for so long, have done so much research, probably have just as much knowledge on trading as 99% of anyone out there and still go through them. More than 15 years of breathing and living the markets and trading, you would think that someone would have this drawdown thing licked. That logically makes them even more frustrating. Everyone expects a beginner to go through drawdowns, but a World Cup champion trader???? But, here I sit, going through a really hard drawdown again. Fact of life is that for as long as I trade, there will always be drawdowns. So it is a good thing to understand everything you can about them in order to properly deal with them.

    First, it is important to know and understand that historical drawdowns are independent events. One drawdown one year is not linked to another drawdown during a different year. In other words, one drawdown NEVER sets the
    standard for future drawdowns. This is probably one of the biggest mistakes almost all traders make when evaluating drawdowns. "Well, the largest was $10k so if it goes above a $10k, then the system is broke". WRONG! WRONG!
    WRONG! That is like saying that if the historical drawdown was $10k and the system is approaching another $10k drawdown, that the system actually knows that the previous largest drawdown was $10k and therefore better start to
    turn around. Or better yet, some traders actually think that the system KNOWS that it is even in a $10k drawdown. Since each trade is independent from another, there is NO WAY a system can know what size of drawdown it is in and
    therefore begin to turn around. So if all this is true, then my question is WHY DO WE EXPECT SYSTEMS TO ABIDE BY SUCH FOOLISHNESS? Well, the short answer is because many times, we as traders do not want to face reality. We want to think that there is actually a limit to how big a drawdown can get. Reality is that if everything I said about trades and drawdowns is true, there is no limit. If that is the case, the question is how can we use
    historical results regarding drawdowns to help prepare us to properly deal with them?

    Here is how I used the historical drawdown results to help me plan for my World Cup 2001 contest trades. First, I know what the largest drawdown was on a historical basis. $10k. Next, I also know what the average drawdown was each and every month; just over $4,500. In fact, if you look at last years statistics, I think there were only 3 months total that did not have a $4,500 drawdown at some point during the month. So my average was almost $5k and my largest only twice that average. Probably not realistic to plan for. So, I planned for a $15k largest.

    There are four main aspects to planning. The first is how much money and how many contracts am I going to start with. Regardless of how much money, I always say start with one, if not less. Second, I plan for when I will increase contracts. Third, I plan for when I will decrease contracts. Finally, I plan for when I will stop trading the method. All of this is planned before I ever take the first trade. My plan with PowerTrade in my contest was to use a variant of my Fixed Ratio method similar to using a $4,500 delta on the increase. Second, I would not decrease unless the method went into a $10k drawdown. Third, I would drop contracts twice as fast as I increased them once the drawdown increased above $10k. Finally, (and this is the one you need to pay attention to for the purpose of this article) I would quit trading the method if similar market action during good performance periods in the past produced a prolonged and sustained drawdown greater than my max that I was planning for. Right now, I am going through a drawdown of just above that $15k I had planned for. My plan was to look at the market and see if the market action during the drawdown was similar to market action during "good" periods with the system or was market action similar to that during past drawdowns. The answer is the latter, which is why I decided to continue to take the trades. In other words, if a system is properly applied to the market, large drawdowns should occur in similar type cycles of the market. Likewise, the a system is properly applied, high performance periods should happen in similar market conditions. This is what I look for. If my current $15k drawdown was occurring during market conditions that were similar to market conditions in the past that produced profits, then my system is suspect.
  10. newbie


    To give you an example with PowerTrade S&P LT, during average market action, I suffered, on a regular basis, $5,000 drawdowns. During market action where trends prevailed, the average drawdown would be smaller. During market action where sideways movement was dominant, larger drawdowns would ensue. Hence the size of the drawdown is inextricably related to the type of market action going on. In the case of PowerTrade, sideways action equals larger drawdowns. As a result, it is impossible to accurately forecast the maximum size of the drawdown in terms of dollars unless you have a crystal ball to tell you how long a market is going to move in a sideways pattern.

    If the size of a drawdown can not be accurately predicted, how do you prepare for them in trading? By dropping to the absolute minimum risk until the market gets back to normal. If that means trading an emini, so be it. But the wrong thing to do is to stop trading it when you have the ability to continue when you know that sideways market action drawdowns are normal for the method. It is when the market is moving with a discernable trend for a month or two and PowerTrade S&P LT is going into a drawdown that you know the method is probably

    Let me tell you why it is wrong for you to stop trading during these kind of circumstances. Plain and simple, because there is NOT ONE SINGLE METHOD, NOT ONE SINGLE SYSTEM that is not governed by the principles I just
    outlined with regard to drawdowns. So you stop trading this method, where are you going to go to escape these principles regarding drawdowns? NOWHERE! You will run into the same thing, over and over and over and then you die. The only thing you can do is pick out the method you feel gives you the best reward potential over the long haul for the risk, and then make and implement your plan. This is why I chose PowerTrade for my contest, it offers the greatest potential for the risk involved. Still does and until the method shows that it is flawed by not doing well when the market is moving, I will stick with it.

    I will let you in on a couple of other things before I end this article to let you know how I know when a method is not flawed. (when I say flawed I mean probably unexpected to produce a positive expectation over the long run. A method is not flawed simply because it goes through drawdowns, or doesn't catch all the moves or doesn't make money month end without missing, as many traders define “flawed” as). If I am trading daily bars and the daily bars are in a pretty good sideways action and producing a drawdown with PowerTrade, I will look at a shorter time frame in the same market. Normally, there are some trends that occur within the average volatility of a market. If the shorter time frames are showing some intra-day trending movements, PowerTrade should, in theory, be posting some winning trades. With many markets, intra-day trading is not realistic due to slippage, costs and lack of profit potential with the intra-day moves, but you can still look at where the method would have entered and exited and make a determination. With the PowerTrade S&P LT, I began looking at the S&P XT which trades on 5 minute bars, far shorter than the LT. While the LT was in a larger drawdown, the XT was doing quite well. That isn’t always the case as there are times when you have to go to an even shorter time frame to compare or pull some intra-day trends, but you get the point.

    Finally, I want to touch on what I seem to ALWAYS come back to regardless of what subject I am talking about in trading. Money management. You will notice that I listed four main aspects to planning for drawdowns. Three of them had to do with proper money management. There is an entire article dedicated to this one principle to dealing with drawdowns. When a method is producing profits, take advantage of it with proper money management and plan to that point of no return. The point of no return is, in theory, a point that your account reaches that, regardless of what happens from then on, you can not end the account in negative territory. In other words, you apply proper money management so that you can continue trading the method even if it goes through drawdowns unimaginable. For example, I started with $15,000 in the World Cup contest this year. During good performance periods, I took the account up to over $107,000 and reached a point of no return. At that time, I had increased to trading 6 contracts. A drawdown ensued and I began dropping contracts according to my PRE-TRADING plan. Eventually, the drawdown reached a point to where I was once again trading only a single contract at $55,000. This means that I could continue to suffer an additional drawdown of $40,000 and still be making money in this account.

    In conclusion, drawdowns are not as predictable as most traders believe. Further, the mere size of a drawdown does not indicate whether a system is “broke” or not. The next time you plan trading a method, or the next time you begin to suffer a drawdown larger than you expected, make sure your expectations were based on the proper data and plan them out with proper money management.
    #10     Oct 26, 2001