Money Management Rules and Techniques

agement is to preserve and to protect a trading account against possible excessive losses.

Money management’s purpose is to control the risk and distribution of investment capital so that one loss or even a series of consecutive losses should not result in the inability to continue a trade, and would not destroy a trading account by bringing it to an unmanageable condition. In a more comprehensive sense, money management also means a technique of preserving current profit in an open position and a technique of fixing current profit.

Plenty of literature is devoted to money management, in which authors with a large amount of practical experience in trading mainly share their thoughts and recommendations about the best approach to manage capital.

Their recommendations in general deserve attention but, unfortunately, numerous publications on this subject agree on only one thing: money man- agement is absolutely necessary for a trader, because it is impossible to ex- pect any success without it. However, when it comes to practical advice and recommendation, we see a large variety of opinions sometimes directly contradicting one another. Therefore, it is difficult to understand these con- tradictions when reading the works of different authors.

It is almost impossible to choose only one correct approach to corre- spond to a trader’s individual situation, his trade system, the current market condition, and a concrete currency pair. Most important of all, however, is

the fact that practically all recommendations about money management ba- sically are directed to a long-term positional trade and not much to what would fit an intraday short-term trade. Therefore, my recommendations will now have a common characteristic: practical suggestions on money man- agement in each of the trading templates intended for an intraday trade.

Because all components of a trade strategy and tactics are connected, some repetition of information will occur.

There are five basic principles of my approach to questions of money management and they are outlined in the sections that follow.

This principle directly follows from the first two postulates of my method—that the market has only two possible directions of movement and it moves all the time. In reality, if the market moves against an open position, the immediate compensation of losses is possible most of the time if you liquidate an unprofitable position and open a new one in an op- posite direction. Doing this at the right place at the right time will provide you some additional comfort and should allow you to cover your losses relatively soon. If you place stops, you will be able to get fast compensa- tion of prime loss, assuming that the loss isn’t large enough to keep you from further participation in the market.

This technique works especially well on an intraday trade, according to the third postulate of my method. Because the average daily range on a par- ticular currency pair is usually well-known in advance, it shouldn’t be too difficult to calculate whether the market still has potential to cover the ini- tial loss completely or partially. This approach can easily be used in prac- tice. The details of such a technique will be described in Part V of this book. (During an intermediate or long-term trade, the third postulate plays

only an auxiliary role and the reverse technique is a bit different.)

Only the market itself can offer a trader the time and place at which an un- profitable position should be liquidated. The trader’s only right is to agree

or to deny this market’s offer. Therefore, stops should be tied to the mar- ket’s technical levels instead of to a certain amount that the trader consid- ers safe to lose in one trade. The market level at which the position will be liquidated and loss will be accepted should be planned in advance and be a part of the initial trading plan. A trader always has to have a certain limit of loss affordable in any given situation, and the amount must also be cal- culated in advance. If the nearest technical level suitable for placing stops is outside the limit of acceptable loss, then you should postpone your trade or cancel it altogether. Then, wait until the market comes close enough to such levels or forms a new one, allowing you to place stops on your position within the limits of an acceptable loss.

You should establish your own restrictions on the margin and volume of the contracts you trade, irrelevant to your dealer’s or broker’s policy. These restrictions have a direct relation to an overtrade situation. A trade with the margin of 10 to 20 percent seems optimum to me. For example, on each $10,000 to $20,000 of capital in the trading account, you can have just one open contract at a rate of no more than $100,000. The risk of ex- cessive losses within a short period of time will be considerably limited if trading on such conditions. At the same time, sufficient use of capital will still allow you to make a profit, sufficient compared to the total account size. This is so even for an intraday trade.

Averaging is the most difficult method to control from the money manage- ment point of view, and it can be recommended only in isolated cases. I don’t recommend it for beginners with small trading capital at all. Averag- ing is an enemy of money management and the main reason for complete loss of a trading account for the majority of traders who have already van- ished from this business.

Averaging is the trading technique of adding a new position to already existing ones that have some floating loss on them. All the positions are on the same currency pair and are open in the same direction. Basically, averaging means that all the positions are open against the prevalent mar- ket movement. In many cases, this also means that even having proof of

his own mistake, a trader still continues to insist on his wrong opinion. See Figure 11.1.

The main problem of this method is that, in the overwhelming major- ity of cases, averaging is not part of trader’s consciously chosen initial plan, strategy, or tactics. It is rather compulsive steps taken because events on the market have begun to develop a situation not stipulated by a trader. Things just went wrong.

Speculators who find themselves in such a position against their will usually were led to it by one or more of the following reasons:

• greed

• lack of sufficient trading experience

• unwillingness or inability to recognize their own mistakes

• naive belief that the market always comes back

• reliance on their forecast

• belief in their own infallibility

• hope that a bit later, the market will let them liquidate positions at a break even point; and so on

The largest losses among individual traders-investors and among managers of large investment funds are most often connected with an ap- plication like averaging. Certainly, the institutional investors have other

FIGURE 11.1 This simple illustration is just a reminder of how insisting on a wrong opinion can ruin someone’s account and future trading career.

reasons for having devastating losses different from those common for in- dividual speculators. These are usually mistakes related to the definition of a force of a long-term trend and, as a consequence, an incorrect money management strategy. There are lots of examples of such losses—Barings Bank, Long Term Capital Management, Tiger Fund, and Quantum Fund, just to name a few victims.

As you can see, even very large capital does not guarantee against losses due to mistakes in money management, especially using such tac- tics as averaging.

Later, I shall explain the basic principles of positional trade strategy construction using this technique.

It is widely accepted among traders that the ratio between potential profit and probable loss always should be more than 1. This issue may also be related to money management. If you accept this ratio from a mathemati- cal point of view, it gives you an equal number of profitable and unprof- itable trades (without mentioning possible additional losses from commissions, slippage, and other operational costs). In other words, it means that each position should satisfy the following condition: Risk/Re- ward < 1 or Profit/Loss > 1; they are basically the same.

This type of ratio can be compared to a coin toss in which, each time you win, your opponent pays you more than you pay him when you lose. It is clear that even at the ratio of 50/50 (heads and tail), you guarantee your- self profit on the total of all attempts. Referrals to an RRR in all books, brochures, and training recommendation are always nearly identical, namely, the necessity of a positive ratio for the benefit of reward does not cause doubt for anybody. Moreover, for many traders, the number of un- profitable trades is larger than the number of profitable ones. Success in such cases may be achieved only if the average profit for each profitable transaction exceeds the average loss for each unprofitable trade.

To tell you the truth, such mathematical absolute truths give me strong doubts and suspicions about the excessive simplicity of their con- clusions. It seems these absolutes don’t have any other interpretation, not only because they are based on mathematics, but also because they are easily accepted as true even from the position of common sense. How- ever, the first opinion seems to me to be the wrong one.

When I developed this book, I made a vow to make it as simple and clear as possible to be understood by a person of any level of knowledge

and degree of preparation in an area not connected with trading. There- fore, my basic purpose is to give my students an opportunity to acquire and to develop practical trading skills, being guided by just ordinary com- mon sense, without stuffing their heads with excessive formulas and theo- retical calculations. In this case, I also try to avoid an excessively academic approach and to simplify my point of view.

It seems to me that the supporters of the obligatory condition, Risk/Reward < 1, in real trading make some basic mistakes:

First, they consider each trade as an independent event, assuming that the probability of the profit or loss reception in each concrete case is

50/50. If we agree with this, then the decision to open a position each time really could be based on simply flipping a coin. Moreover, the 3 step ele- mentary mechanical system should work in this case:

1.Flipping a coin at the beginning of a day (or at any other time), you decide to open a position.

2.On a certain fixed distance from the opening price, place a stop that has to limit your possible losses.

3.On the opposite side, on a fixed distance, place profitable liquidation stops on such a condition that this distance is more than the distance from the opening price to a stop loss placement.

A very simple and effective system will guarantee profit if you assume that the probability of the market movement in one direction or the other is identical at any given moment. It is clear that, in reality, nobody trades like this—including the RRR supporters.

Second, you should look at a trade not as a set of unconnected and in- dependent events, but as a process that has its own duration of time and consists of several consecutive steps of the prepared plan of a trade in ac- cordance with the system of probability estimation. It is clear that, in that case, the probability of fulfillment of a profitable transaction is greater each time than the probability of a loss, and constantly changes with the flow of time. If you insert in the trade one more variable component (for example, change contract size in the same series of trades inside a trading plan), the observance of RRR principles becomes senseless.

If we digress from a theoretical discussion and look at real trading, we shall see that in many cases it’s not easy to define the point of liquidation of a profitable position, that is, to have a target on every single trade. The absence of a target makes calculation of RRR impossible.

In conclusion, I need to add that neglecting principles of money man- agement will sooner or later cause a catastrophe for a trader.

CHAPTER 12

Date: 2015-12-17; view: 741