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Wednesday, July 17, 2013
solid strategies for investing money
Investing has been a massive exercise in frustration for millions of Americans over the last decade or so.
Two market crashes in 12 years drove many people away from equities. Now key U.S. stock market indexes are at or near record highs again, after a strong 2012 rally that has spilled into 2013.
Two market crashes in 12 years drove many people away from equities. Now key U.S. stock market indexes are at or near record highs again, after a strong 2012 rally that has spilled into 2013.
The
average domestic stock mutual fund rose 15% last year, the third annual
gain in four years. Meanwhile, the hunger for perceived safety has
driven interest rates on bonds and other fixed-income securities to
record lows. It's a backdrop that seems to cry out for a complex,
headache-inducing game plan.
But in fact, the best strategy for many people may be just the opposite: Focus on the basics. Mainly, keep sight of the things you can control to reduce your mental stress and improve your odds of long-term success.
Here are four strategies for keeping it simple:
Keep it balanced. You say you can't decide how to build and maintain a diversified portfolio? Then don't bother. Let someone else do it for you. That's the beauty of "balanced" mutual funds — portfolios that always own a mix of stocks and bonds.
A balanced or "allocation" fund is the simple, elegant solution for people who know they want to be in financial markets for the long haul but don't have the time or interest to devote to closely managing their nest eggs.
The basic idea is that the stock portion of a balanced fund provides long-term growth while the less-volatile bond portion provides regular interest income and a buffer against any plunge in stock prices. A typical mix is 60% big-name stocks, 40% bonds, but the mix varies depending on whether a fund follows a conservative, moderate or aggressive strategy.
Here's how it works in practice: In the 10 years ended Dec. 31, the average moderate-mix balanced fund gained 6.4% a year, according to investment research firm Morningstar Inc. That was only modestly less than the 7.1% average annual gain in the Standard & Poor's 500 stock index in that period.
But the balanced fund's return came with a lot less volatility, including much smaller losses than in the overall stock market in down years.
You could create a balanced portfolio of individual stock funds and bond funds on your own. But if your goal is to maintain a specific percentage of your portfolio in each type of asset, you'd need the discipline to "rebalance" each year by selling some portion of the funds that have done best and channeling that money into the funds that have performed worst.
"Buy low, sell high" always sounds easy, but psychologically it's very difficult. "What you're asking investors to do is really against their human intuition," said Fran Kinniry, a principal at Vanguard Group's investment strategy unit in Valley Forge, Pa.
A balanced fund makes that decision for you. And it keeps you in the stock market in periods when your instinct might be to flee — such as after the 2008 crash.
But in fact, the best strategy for many people may be just the opposite: Focus on the basics. Mainly, keep sight of the things you can control to reduce your mental stress and improve your odds of long-term success.
Here are four strategies for keeping it simple:
Keep it balanced. You say you can't decide how to build and maintain a diversified portfolio? Then don't bother. Let someone else do it for you. That's the beauty of "balanced" mutual funds — portfolios that always own a mix of stocks and bonds.
A balanced or "allocation" fund is the simple, elegant solution for people who know they want to be in financial markets for the long haul but don't have the time or interest to devote to closely managing their nest eggs.
The basic idea is that the stock portion of a balanced fund provides long-term growth while the less-volatile bond portion provides regular interest income and a buffer against any plunge in stock prices. A typical mix is 60% big-name stocks, 40% bonds, but the mix varies depending on whether a fund follows a conservative, moderate or aggressive strategy.
Here's how it works in practice: In the 10 years ended Dec. 31, the average moderate-mix balanced fund gained 6.4% a year, according to investment research firm Morningstar Inc. That was only modestly less than the 7.1% average annual gain in the Standard & Poor's 500 stock index in that period.
But the balanced fund's return came with a lot less volatility, including much smaller losses than in the overall stock market in down years.
You could create a balanced portfolio of individual stock funds and bond funds on your own. But if your goal is to maintain a specific percentage of your portfolio in each type of asset, you'd need the discipline to "rebalance" each year by selling some portion of the funds that have done best and channeling that money into the funds that have performed worst.
"Buy low, sell high" always sounds easy, but psychologically it's very difficult. "What you're asking investors to do is really against their human intuition," said Fran Kinniry, a principal at Vanguard Group's investment strategy unit in Valley Forge, Pa.
A balanced fund makes that decision for you. And it keeps you in the stock market in periods when your instinct might be to flee — such as after the 2008 crash.
There
are two types of balanced funds in most 401(k) retirement savings
programs. One is the conventional balanced fund, including such hugely
popular offerings as the Vanguard Wellington fund and American Balanced
fund. These funds generally keep the stock-versus-bond ratios in a
specific range, depending on where the manager believes there is better
value.
The other type is the target-date retirement fund. You pick a target-date fund based on your expected retirement year, and the portfolio is automatically adjusted over time to gradually lower its stock assets and raise its bond assets. The goal is to lower the portfolio's risk and volatility as you age.
Lately, some investors may be worried less about the stock portion of their balanced fund than the bond portion. With bond yields at or near historic lows, a jump in market interest rates could devalue bonds.
That may happen eventually. But calling the turn is no easy feat.
"Just because the level of interest rates is low doesn't tell you about the direction of rates," Kinniry said. "Japan has had low rates for 25 years."
And if stocks pull back soon, high-quality bonds would be a logical refuge.
Get on the right side of the tax man, and stay there. This is the true no-brainer. Shelter as much wealth as you can from current taxes, allowing your nest egg to compound over time.
If you have access to a 401(k) or similar retirement savings plan, contribute as much as possible. If you don't at least max out any match from your company, you're leaving free money on the table.
If you're eligible and able to contribute to traditional individual retirement accounts and Roth IRAS, those too can be no-brainers.
Realistically, many people are limited in how much they can save. But the start of every year is the logical time to rethink your spending versus saving goals.
For investors, 2013 kicked off with good news from Washington: Congress kept the top tax rate on long-term capital gains and on dividends at 15% for most people.
The other type is the target-date retirement fund. You pick a target-date fund based on your expected retirement year, and the portfolio is automatically adjusted over time to gradually lower its stock assets and raise its bond assets. The goal is to lower the portfolio's risk and volatility as you age.
Lately, some investors may be worried less about the stock portion of their balanced fund than the bond portion. With bond yields at or near historic lows, a jump in market interest rates could devalue bonds.
That may happen eventually. But calling the turn is no easy feat.
"Just because the level of interest rates is low doesn't tell you about the direction of rates," Kinniry said. "Japan has had low rates for 25 years."
And if stocks pull back soon, high-quality bonds would be a logical refuge.
Get on the right side of the tax man, and stay there. This is the true no-brainer. Shelter as much wealth as you can from current taxes, allowing your nest egg to compound over time.
If you have access to a 401(k) or similar retirement savings plan, contribute as much as possible. If you don't at least max out any match from your company, you're leaving free money on the table.
If you're eligible and able to contribute to traditional individual retirement accounts and Roth IRAS, those too can be no-brainers.
Realistically, many people are limited in how much they can save. But the start of every year is the logical time to rethink your spending versus saving goals.
For investors, 2013 kicked off with good news from Washington: Congress kept the top tax rate on long-term capital gains and on dividends at 15% for most people.
Monday, July 15, 2013
Money Management
Money Management Myths:
Myth 1: Traders should focus on pips.
You may have heard that you should concentrate on pips gained or lost instead of dollars gained or lost. The rationale behind this money management myth is that if you concentrate on pips instead of dollar you will somehow not become emotional about your trading because you will not be thinking about your trading account in monetary terms but rather as game of points. If this doesn’t sound ridiculous to you, it should. The whole point of trading and investing is to make money and you need to be consciously aware of how much money you have at risk on each and every trade so that the reality of the situation is effectively conveyed. Do you think business owners treat their quarterly profit and loss statements as a game of points that is somehow detached from the reality of making or losing real money? Of course not, when you think about it these terms it seems silly to treat your trading activities like a game. Trading should be treated as a business, because that’s what it is, if you want to be consistently profitable you need to treat each trade as a business transaction. Just as any business transaction has the possibility of risk and of reward, so does every trade you execute. The bottom line is that thinking about your trades in terms of pips and not dollars will effectively make trading seem less real and thus open the door for you treat it less seriously than you otherwise would.
From a Mathematical standpoint, thinking of trading in terms of “how many pips you lose or gain” is completely irrelevant. The problem is that each trader will trade a different position size, thus, we must define risk in terms of “Ddollars at risk or dollars gained”. Just because you risk a large amount of pips, does not mean you are risking a large amount of your capital, such is the case that if you have a tight stop this does not mean your risking a small amount of capital.
Myth 2: Risking 1% or 2% on every trade is a good way to grow your account
This is one of the more common money management myths that you are likely to have heard. While it sounds good in theory, the reality is that the majority if retail forex traders are starting with a trading account that has $5,000 in it or less. So to believe that you will grow your account effectively and relatively quickly by risking 1% or 2% per trade is just silly. Say you lose 5 trades in a row, if you were risking 2% your account is now down to $4,519.60, now you are still risking 2% per trade, but that same 2% is now a smaller position size than it was when your account was at $5,000.
Thus, in the % risk model, as you lose trades you automatically reduce your position size. Which is not always the best course of action. There’s psychological evidence that suggests it’s human nature to become more risk averse after a series of losing trades and less risk averse after a series of winning trades, but that doesn’t mean the risk of any one trade becomes more or less simply because you lost or won on your previous trade. As we can see in my article on randomly distributed trading results, your previous trade’s results don’t mean anything for the outcome of your next trade.
What ends up happening when traders use the % risk model is that they start off good, they risk 1 or 2% on their first few trades, and maybe they even win them all. But once they begin to hit a string of losers, they realize that all of their gains have been wiped out and it is going to take them quite a long time just to make back the money they have lost. They then proceed to OVER-TRADE and take less than quality setups because they now realize how long it will take them just to get back to break even if they only risk 1% to 2% per trade.
So, while this method of money management will allow you to risk small amounts on each trade, and therefore theoretically limit your emotional trading mistakes, most people simply do not have the patience to risk 1 or 2% per trade on their relatively small trading accounts, it will eventually lead to over-trading which is about the worst thing you can do for your bottom line. It is also a difficult task to recover from a drawn down period. Remember, once you drawn down, using a 2 % per trade method, your risk each trade will be smaller, there fore, your rate of recovery on profits is slower and hinders the traders effort.
The Most important fact is this.. if you start with $10,000 , and drawn down to $5,000, using a fixed % method, it will take you “much longer” to recover because you started out risking 2% per trade which was $200, but at the $5,000 draw-down level, your only risking $100 per trade, so even if you have a good winning streak, your capital is recovering at “half the rate” it would using “fixed $ per trade risk.
Myth 3: Wider stops risk more money than smaller stops
Many traders erroneously believe that if they put a wider stop loss on their trade they will necessarily increase their risk. Similarly, many traders believe that by using a smaller stop loss they will necessarily decrease the risk on the trade. Traders that are holding these false beliefs are doing so because they do not understand the concept of Forex position sizing.
Position sizing is the concept of adjusting your position size or the number of lots you are trading, to meet your desired stop loss placement and risk size. For example, say you risk $200 per trade, with a 100 pip stop loss you would trade 2 mini-lots: $2 per pip x 100 pips = $200.
Now let’s you want to trade a pin bar forex strategy but the tail is exceptionally long but you would still like to place your stop above the high of the tail even though it will mean you have a 200 pip stop loss. You can still risk the same $200 on this trade, you just need to adjust your position size down to meet this wider stop loss, and you would adjust the position down to 1 mini-lot rather than 2. This means you can risk the same amount on every trade simply by adjusting your position size up or down to meet your desired stop loss width.
Let’s now look at an example of what can happen if you don’t practice position sizing effectively by failing to decrease the number of lots you are trading while increasing stop loss distance.
Example: Two traders risk the same amount of lots on the same trade setup. Forex Trader A risks 5 lots and has a stop loss of 50 pips, Trader B also risks 5 lots but has a stop loss of 200 pips because he or she believes there is an almost 100% chance that the trade will not go against him or her by 200 pips. The fault with this logic is that typically if a trade begins to go against you with increasing momentum, there theoretically is no limit to when it may stop. And we all know how strong the trends can be in the forex market. Trader A has gotten stopped out with his or her pre-determined risk amount of 5 lots x 50 pips which is a loss of $250. Trader B also got stopped out but his or her loss was much larger because they erroneously hoped that the trade would turn around before moving 200 pips against them. Trader B thus losses 5 lots x 200 pips, but their loss is now a whopping $1,000 instead of the $250 it could have been.
We can see from this example why the belief that just widening your stop loss on a trade is not an effective way to increase your trading account value, in fact it is just the opposite; a good way to quickly decrease your trading account value. The fundamental problem that afflicts traders who harbor this believe is a lack of understanding of the power of risk to reward and position sizing.
The Power of Risk to Reward
Professional traders like me and many others concentrate on risk to reward ratios, and not so much on over analyzing the markets or having unrealistically wide profit targets. This is because professional traders understand that trading is a game of probabilities and capital management. It begins with having a definable market edge, or a trading method that is proven to be at least slightly better than random at determining market direction. This edge for me has been price action analysis. The price action trading strategies that I teach and use can have an accuracy rate of upwards of 70-80% if they are used wisely and at the appropriate times.
The power of risk to reward comes in with its ability to effectively and consistently build trading accounts. We all hear the old axioms like “let your profits run” and “cut your losses early”, while these are well and fine, they don’t really provide any useful information for new traders to implement. The bottom line is that if you are trading with anything less than about $25,000, you are going to have to take profits at pre-determined intervals if you want to keep your sanity and your trading account growing. Entering trades with open profit targets typically doesn’t work for smaller traders because they end up never taking the profits until the market comes swinging back against them dramatically. (I think this is very important, go back an re read that last sentence)
If you know your strike rate is between 40-50% than you can consistently make money in the market by implementing simple risk to reward ratios. By learning to use well-defined price action setups to enter your trades you should able to win a higher percentage of your trades, assuming you TAKE profits.
Myth 1: Traders should focus on pips.
You may have heard that you should concentrate on pips gained or lost instead of dollars gained or lost. The rationale behind this money management myth is that if you concentrate on pips instead of dollar you will somehow not become emotional about your trading because you will not be thinking about your trading account in monetary terms but rather as game of points. If this doesn’t sound ridiculous to you, it should. The whole point of trading and investing is to make money and you need to be consciously aware of how much money you have at risk on each and every trade so that the reality of the situation is effectively conveyed. Do you think business owners treat their quarterly profit and loss statements as a game of points that is somehow detached from the reality of making or losing real money? Of course not, when you think about it these terms it seems silly to treat your trading activities like a game. Trading should be treated as a business, because that’s what it is, if you want to be consistently profitable you need to treat each trade as a business transaction. Just as any business transaction has the possibility of risk and of reward, so does every trade you execute. The bottom line is that thinking about your trades in terms of pips and not dollars will effectively make trading seem less real and thus open the door for you treat it less seriously than you otherwise would.
From a Mathematical standpoint, thinking of trading in terms of “how many pips you lose or gain” is completely irrelevant. The problem is that each trader will trade a different position size, thus, we must define risk in terms of “Ddollars at risk or dollars gained”. Just because you risk a large amount of pips, does not mean you are risking a large amount of your capital, such is the case that if you have a tight stop this does not mean your risking a small amount of capital.
Myth 2: Risking 1% or 2% on every trade is a good way to grow your account
This is one of the more common money management myths that you are likely to have heard. While it sounds good in theory, the reality is that the majority if retail forex traders are starting with a trading account that has $5,000 in it or less. So to believe that you will grow your account effectively and relatively quickly by risking 1% or 2% per trade is just silly. Say you lose 5 trades in a row, if you were risking 2% your account is now down to $4,519.60, now you are still risking 2% per trade, but that same 2% is now a smaller position size than it was when your account was at $5,000.
Thus, in the % risk model, as you lose trades you automatically reduce your position size. Which is not always the best course of action. There’s psychological evidence that suggests it’s human nature to become more risk averse after a series of losing trades and less risk averse after a series of winning trades, but that doesn’t mean the risk of any one trade becomes more or less simply because you lost or won on your previous trade. As we can see in my article on randomly distributed trading results, your previous trade’s results don’t mean anything for the outcome of your next trade.
What ends up happening when traders use the % risk model is that they start off good, they risk 1 or 2% on their first few trades, and maybe they even win them all. But once they begin to hit a string of losers, they realize that all of their gains have been wiped out and it is going to take them quite a long time just to make back the money they have lost. They then proceed to OVER-TRADE and take less than quality setups because they now realize how long it will take them just to get back to break even if they only risk 1% to 2% per trade.
So, while this method of money management will allow you to risk small amounts on each trade, and therefore theoretically limit your emotional trading mistakes, most people simply do not have the patience to risk 1 or 2% per trade on their relatively small trading accounts, it will eventually lead to over-trading which is about the worst thing you can do for your bottom line. It is also a difficult task to recover from a drawn down period. Remember, once you drawn down, using a 2 % per trade method, your risk each trade will be smaller, there fore, your rate of recovery on profits is slower and hinders the traders effort.
The Most important fact is this.. if you start with $10,000 , and drawn down to $5,000, using a fixed % method, it will take you “much longer” to recover because you started out risking 2% per trade which was $200, but at the $5,000 draw-down level, your only risking $100 per trade, so even if you have a good winning streak, your capital is recovering at “half the rate” it would using “fixed $ per trade risk.
Myth 3: Wider stops risk more money than smaller stops
Many traders erroneously believe that if they put a wider stop loss on their trade they will necessarily increase their risk. Similarly, many traders believe that by using a smaller stop loss they will necessarily decrease the risk on the trade. Traders that are holding these false beliefs are doing so because they do not understand the concept of Forex position sizing.
Position sizing is the concept of adjusting your position size or the number of lots you are trading, to meet your desired stop loss placement and risk size. For example, say you risk $200 per trade, with a 100 pip stop loss you would trade 2 mini-lots: $2 per pip x 100 pips = $200.
Now let’s you want to trade a pin bar forex strategy but the tail is exceptionally long but you would still like to place your stop above the high of the tail even though it will mean you have a 200 pip stop loss. You can still risk the same $200 on this trade, you just need to adjust your position size down to meet this wider stop loss, and you would adjust the position down to 1 mini-lot rather than 2. This means you can risk the same amount on every trade simply by adjusting your position size up or down to meet your desired stop loss width.
Let’s now look at an example of what can happen if you don’t practice position sizing effectively by failing to decrease the number of lots you are trading while increasing stop loss distance.
Example: Two traders risk the same amount of lots on the same trade setup. Forex Trader A risks 5 lots and has a stop loss of 50 pips, Trader B also risks 5 lots but has a stop loss of 200 pips because he or she believes there is an almost 100% chance that the trade will not go against him or her by 200 pips. The fault with this logic is that typically if a trade begins to go against you with increasing momentum, there theoretically is no limit to when it may stop. And we all know how strong the trends can be in the forex market. Trader A has gotten stopped out with his or her pre-determined risk amount of 5 lots x 50 pips which is a loss of $250. Trader B also got stopped out but his or her loss was much larger because they erroneously hoped that the trade would turn around before moving 200 pips against them. Trader B thus losses 5 lots x 200 pips, but their loss is now a whopping $1,000 instead of the $250 it could have been.
We can see from this example why the belief that just widening your stop loss on a trade is not an effective way to increase your trading account value, in fact it is just the opposite; a good way to quickly decrease your trading account value. The fundamental problem that afflicts traders who harbor this believe is a lack of understanding of the power of risk to reward and position sizing.
The Power of Risk to Reward
Professional traders like me and many others concentrate on risk to reward ratios, and not so much on over analyzing the markets or having unrealistically wide profit targets. This is because professional traders understand that trading is a game of probabilities and capital management. It begins with having a definable market edge, or a trading method that is proven to be at least slightly better than random at determining market direction. This edge for me has been price action analysis. The price action trading strategies that I teach and use can have an accuracy rate of upwards of 70-80% if they are used wisely and at the appropriate times.
The power of risk to reward comes in with its ability to effectively and consistently build trading accounts. We all hear the old axioms like “let your profits run” and “cut your losses early”, while these are well and fine, they don’t really provide any useful information for new traders to implement. The bottom line is that if you are trading with anything less than about $25,000, you are going to have to take profits at pre-determined intervals if you want to keep your sanity and your trading account growing. Entering trades with open profit targets typically doesn’t work for smaller traders because they end up never taking the profits until the market comes swinging back against them dramatically. (I think this is very important, go back an re read that last sentence)
If you know your strike rate is between 40-50% than you can consistently make money in the market by implementing simple risk to reward ratios. By learning to use well-defined price action setups to enter your trades you should able to win a higher percentage of your trades, assuming you TAKE profits.
Money Management
Money Management
Smart money management doesn't just involve risking an appropriate amount on every trade (covered in the risk management section), it also involves managing a winning trade from start to finish. This is an important part of any good trading methodology that is often overlooked by beginning and expert traders alike.
"What do I do after I enter a trade and it begins to make money?", is a question that is frequently asked by my traders
You hear so-called experts often making general comments such as "Don't let a winning trade turn into a loss," or "You'll never go broke taking a profit." These tidbits belong in the same trash can as "The trend is your friend" and other similar remarks. This general pieces of advice can do more harm than good because of their nature - THEY ARE TOO GENERAL!!!
A beginning trader cannot be left filling in the blanks. Everything must be defined. That is why a complete trading strategy must include specifically how winning trades will be managed until the position is closed.
The basic diagram below was provided to illustrate, in a funny way, what typically happens to traders that don't have a smart trade management plan in place. I have included the trader's thoughts (in blue) on the diagram as the trade progresses (in this example, I assumed that the trader is not completely clueless and at least has a stop loss in place. In reality, if the trader did not use a stop loss, it could have gotten a lot nastier and funnier).
Click image to enlarge
Even though the example about is very basic, it does illustrate the importance of protecting existing profits by raising your stops. When the trade became profitable, instead of having left the stop at 1% below the initial entry point, the trader should have raised the stop.
The stops on different portions of the entire position could have been set at different logical points; for example, a certain amount above the initial entry point, below the point corresponding to thought number 4, below the point corresponding to thought number 5, and so on and so forth. Even though I am oversimplifying the management of these stop losses, this example demonstrates the importance of using a logical money management technique to handle winning trades.
Since one of the goals of every day trader should be to protect his trading capital, protecting profits becomes just as important as limiting losses. If you think about it, protecting profits is a way to limit losses as well. When a trader is in a winning trade, the amount of unrealized profit becomes part of the total equity of his account. Consequently, protecting profits through smart money management is equivalent to conserving the value of the trading account.
Smart money management should be a part of every trading strategy and it is something that I really stress all the time to my traders.
Smart money management doesn't just involve risking an appropriate amount on every trade (covered in the risk management section), it also involves managing a winning trade from start to finish. This is an important part of any good trading methodology that is often overlooked by beginning and expert traders alike.
"What do I do after I enter a trade and it begins to make money?", is a question that is frequently asked by my traders
You hear so-called experts often making general comments such as "Don't let a winning trade turn into a loss," or "You'll never go broke taking a profit." These tidbits belong in the same trash can as "The trend is your friend" and other similar remarks. This general pieces of advice can do more harm than good because of their nature - THEY ARE TOO GENERAL!!!
A beginning trader cannot be left filling in the blanks. Everything must be defined. That is why a complete trading strategy must include specifically how winning trades will be managed until the position is closed.
The basic diagram below was provided to illustrate, in a funny way, what typically happens to traders that don't have a smart trade management plan in place. I have included the trader's thoughts (in blue) on the diagram as the trade progresses (in this example, I assumed that the trader is not completely clueless and at least has a stop loss in place. In reality, if the trader did not use a stop loss, it could have gotten a lot nastier and funnier).
Click image to enlarge
Even though the example about is very basic, it does illustrate the importance of protecting existing profits by raising your stops. When the trade became profitable, instead of having left the stop at 1% below the initial entry point, the trader should have raised the stop.
The stops on different portions of the entire position could have been set at different logical points; for example, a certain amount above the initial entry point, below the point corresponding to thought number 4, below the point corresponding to thought number 5, and so on and so forth. Even though I am oversimplifying the management of these stop losses, this example demonstrates the importance of using a logical money management technique to handle winning trades.
Since one of the goals of every day trader should be to protect his trading capital, protecting profits becomes just as important as limiting losses. If you think about it, protecting profits is a way to limit losses as well. When a trader is in a winning trade, the amount of unrealized profit becomes part of the total equity of his account. Consequently, protecting profits through smart money management is equivalent to conserving the value of the trading account.
Smart money management should be a part of every trading strategy and it is something that I really stress all the time to my traders.
Trading and Money Management
Trading and Money Management
Money management is the key to successful commodities trading. Trading requires discipline. In trading, we need to let the amount of money in our account dictate to us how we are going to trade. This is called trading within our means or… money and risk management.
Money management is one of the most crucial and yet one of the most overlooked aspects of trading and investing. Even when it is not overlooked, it is often misunderstood and unnecessarily made overly complicated.
There are several aspects of successful money management. They all share the same goal - to control our exposure to the markets. This is the only thing that we have complete control over in trading.
Most futures traders focus solely on trying to maximize returns. In reality, however, no one can predict the markets. No one knows which trades will be the big winners and which will be the losers. Successful commodity traders focus on playing defense. They focus on keeping their money and staying in the game through the use of advanced money management techniques.
In our commodities trading, we strive for one major accomplishment at the end of each year. Simply put… we strive to be able to continue trading next year. If you can consistently do this, you will make money trading... lots of money!
We control our exposure to the markets on three levels:
Initial Trade Risk (position exposure)
Sector Correlation Risk (sector exposure)
Portfolio Heat (total portfolio exposure)
These levels of controlling market exposure apply to taking new trades. We also need to manage exposure on our existing trades. This is accomplished through:
Managing our trailing stops
Resizing positions
Switching positions
After we have incorporated sound money management strategies into our commodities trading, we can use some advanced money management techniques to enhance our returns. We can achieve this through:
Position Sizing or Betsizing
Knowing when to add money or trading the equity curve
Dynamic Portfolio Selection
Maximizing exponential growth rates (Kelly Formula)
We can increase our edge by enhancing returns with these advanced techniques. Remember, however, that our main goal is to control and manage our exposure to the market. Enhancing returns using these strategies is only secondary.
Many futures traders make this mistake and get a little carried away with trying to maximize their returns. There is a fine line between creating a greater edge and optimizing a strategy to the point that it will not work as expected in the real world.
The core of our money and risk management strategies are built on most of these techniques. They create the foundation for controlling our risk. There is no need to overly complicate them. For the most part, they are common sense. Most traders however, to their own peril, choose to ignore management techniques. Why do they choose not to use them?
Traders often get caught up in the emotions of commodities trading. Not only do fear and greed take control of their trading, but also hope and panic. It is impossible to be a successful futures trader when these emotions take over. Traders with wild emotions change their tactics consistently. This is a good way to lose your money.
Nobody likes to play defense. Proper money management should be boring. We all want to catch that next big trade. But, we don’t know when it will come. We need to protect ourselves, stay in the game, and the market will eventually pay us for it.
It also takes a lot of hard work and specialized trading platforms to calculate your exposures every day and make the required, necessary adjustments to positions in your account. If this was easy, everyone would be rich.
Our strategies incorporate the techniques described above plus some additional highly-advanced proprietary money management and risk management strategies. It is a trading advantage that benefits our clients greatly.
Money management is the key to successful commodities trading. Trading requires discipline. In trading, we need to let the amount of money in our account dictate to us how we are going to trade. This is called trading within our means or… money and risk management.
Money management is one of the most crucial and yet one of the most overlooked aspects of trading and investing. Even when it is not overlooked, it is often misunderstood and unnecessarily made overly complicated.
There are several aspects of successful money management. They all share the same goal - to control our exposure to the markets. This is the only thing that we have complete control over in trading.
Most futures traders focus solely on trying to maximize returns. In reality, however, no one can predict the markets. No one knows which trades will be the big winners and which will be the losers. Successful commodity traders focus on playing defense. They focus on keeping their money and staying in the game through the use of advanced money management techniques.
In our commodities trading, we strive for one major accomplishment at the end of each year. Simply put… we strive to be able to continue trading next year. If you can consistently do this, you will make money trading... lots of money!
We control our exposure to the markets on three levels:
Initial Trade Risk (position exposure)
Sector Correlation Risk (sector exposure)
Portfolio Heat (total portfolio exposure)
These levels of controlling market exposure apply to taking new trades. We also need to manage exposure on our existing trades. This is accomplished through:
Managing our trailing stops
Resizing positions
Switching positions
After we have incorporated sound money management strategies into our commodities trading, we can use some advanced money management techniques to enhance our returns. We can achieve this through:
Position Sizing or Betsizing
Knowing when to add money or trading the equity curve
Dynamic Portfolio Selection
Maximizing exponential growth rates (Kelly Formula)
We can increase our edge by enhancing returns with these advanced techniques. Remember, however, that our main goal is to control and manage our exposure to the market. Enhancing returns using these strategies is only secondary.
Many futures traders make this mistake and get a little carried away with trying to maximize their returns. There is a fine line between creating a greater edge and optimizing a strategy to the point that it will not work as expected in the real world.
The core of our money and risk management strategies are built on most of these techniques. They create the foundation for controlling our risk. There is no need to overly complicate them. For the most part, they are common sense. Most traders however, to their own peril, choose to ignore management techniques. Why do they choose not to use them?
Traders often get caught up in the emotions of commodities trading. Not only do fear and greed take control of their trading, but also hope and panic. It is impossible to be a successful futures trader when these emotions take over. Traders with wild emotions change their tactics consistently. This is a good way to lose your money.
Nobody likes to play defense. Proper money management should be boring. We all want to catch that next big trade. But, we don’t know when it will come. We need to protect ourselves, stay in the game, and the market will eventually pay us for it.
It also takes a lot of hard work and specialized trading platforms to calculate your exposures every day and make the required, necessary adjustments to positions in your account. If this was easy, everyone would be rich.
Our strategies incorporate the techniques described above plus some additional highly-advanced proprietary money management and risk management strategies. It is a trading advantage that benefits our clients greatly.
Management Techniques (money)
By Dan Blystone
The Kelly Criterion
The Kelly Criterion was originally developed by John Kelly while working for AT&T’s Bell Laboratory. When the method was published in 1956 it was embraced at first by the gambling community, and was then discovered as an effective money monagement tool by the investing world.
The Kelly Criterion looks at two major inputs:
W – The probability that a given trader/system will be a winner.
R – The Win/Loss Ratio – amount gained from winning trades divided by amount lost from losing trades.
These inputs are used to calculate the Kelly percentage in the following equation:
Kelly % = W – [(1 – W) / R]
The Kelly percentage is interpreted as reflecting the size of positions you should be taking. For example a Kelly percentage of 0.08 suggests that you should take an 8% position in the securities in your portfolio.
The formula specifies the percentage of the current portfolio to be used in a given system.
Interpreting the Results
The Kelly percentage is interpreted as reflecting the size of positions you should be taking. For example a Kelly percentage of 0.08 suggests that you should risk 8% of your portfolio using that system. The formula specifies the percentage of the current portfolio to be used in a given system. In gambling the formula specifies the percentage of the current bankroll to be bet at each iteration of the game. Kelly’s formula was applied by Edward O. Thorp, both in blackjack and in the stock market.
Optimal F
Ralph Vince’s optimal-f method is one method of finding the optimal amount to risk on each trade to maximize profits. It is used to find the fraction of equity to risk on the next trade. Optimal f is a money management scheme that assists in determining the correct position size at a given time. Ralph Vince analyzed many systems as computer programmer for Larry Williams, winner of the 1987 World Cup Championship of Futures Trading.
Optimal f Formula
Number_of_shares = (Optimal_F * Current_Capital / starting_risk_per_unity_of_assets)/Security_Price where starting risk = maximal loss at trade(in %).
The Martingale System
A money management system where the dollar values of investments continually increase after losses, or the position size increases with lowering portfolio size. The principle behind the Martingale system is that statistically you cannot lose all the time, and therefore you should increase the amount allocated in investments, even if they are declining in value, in anticipation of a future increase.
The Martingale system is commonly compared to betting in a casino. When a gambler using this method loses, he or she doubles his or her bet. By repeatedly doubling the bet when he or she loses, the gambler will (in theory) eventually even out with a win. Of course, this is assuming the gambler has an unlimited supply of money to bet with.
Anti Martingale System
A system of position sizing that correlates the levels of investment with the risk and portfolio size. Contrary to the Martingale system, the anti-Martingale accepts greater risks during periods of expansive growth, and an increasing market exposure, with larger equity.
2% Rule
The 2 percent rule is a basic tenet of money management. Even if the odds are stacked in your favor, it is inadvisable to risk a large portion of your capital on a single trade. The 2% rule states that you should never risk more than 2% of your account equity on a single trade. Market Wizard Larry Hite “Never risk more than 1% of total equity on any trade. By only risking 1%, I am indifferent to any individual trade.”
6% Rule
The 6% rule, outlined by Alexander Elder in ‘Come into my Trading Room’ states that if the value of your account falls 6% below it’s closing value the prior month you should stop trading for the rest of the month.
Recovering Lost Equity
Consider the following percentages required to recover from significant percentage losses in your account: 25% Equity Loss requires a 33% return to recover former equity value. 50% Equity loss requires a 100% return to recover former equity value. 75% Equity loss requires a 400% return to recover former equity value.
The table above reflects how difficult it is to recover from large percentage losses of your equity.
Stop Loss Strategies
Equity Stop. In this scenario the trader risks a fixed percentage of their equity on a trade and uses this to determine the placement of the stop loss order. Chart Stop. This technique uses technical analyis such as support and resistance levels to determine the position of the stop loss order. Volatility Stop. This method uses volatility as a measure of where to place the stop loss order – in a highly volatile setting the loss should be wider and in a lower volatility setting the stop should be tighter. Average True Range and Bollinger Bands® are two indicators that can be used in determining the postion of the volatility stop loss order.
Position Sizing Turtle Style
The Turtles used a volatility based constant percentage risk position sizing algorithm. See: http://www.traderslog.com/forum/showthread.php?t=7017
The Kelly Criterion
The Kelly Criterion was originally developed by John Kelly while working for AT&T’s Bell Laboratory. When the method was published in 1956 it was embraced at first by the gambling community, and was then discovered as an effective money monagement tool by the investing world.
The Kelly Criterion looks at two major inputs:
W – The probability that a given trader/system will be a winner.
R – The Win/Loss Ratio – amount gained from winning trades divided by amount lost from losing trades.
These inputs are used to calculate the Kelly percentage in the following equation:
Kelly % = W – [(1 – W) / R]
The Kelly percentage is interpreted as reflecting the size of positions you should be taking. For example a Kelly percentage of 0.08 suggests that you should take an 8% position in the securities in your portfolio.
The formula specifies the percentage of the current portfolio to be used in a given system.
Interpreting the Results
The Kelly percentage is interpreted as reflecting the size of positions you should be taking. For example a Kelly percentage of 0.08 suggests that you should risk 8% of your portfolio using that system. The formula specifies the percentage of the current portfolio to be used in a given system. In gambling the formula specifies the percentage of the current bankroll to be bet at each iteration of the game. Kelly’s formula was applied by Edward O. Thorp, both in blackjack and in the stock market.
Optimal F
Ralph Vince’s optimal-f method is one method of finding the optimal amount to risk on each trade to maximize profits. It is used to find the fraction of equity to risk on the next trade. Optimal f is a money management scheme that assists in determining the correct position size at a given time. Ralph Vince analyzed many systems as computer programmer for Larry Williams, winner of the 1987 World Cup Championship of Futures Trading.
Optimal f Formula
Number_of_shares = (Optimal_F * Current_Capital / starting_risk_per_unity_of_assets)/Security_Price where starting risk = maximal loss at trade(in %).
The Martingale System
A money management system where the dollar values of investments continually increase after losses, or the position size increases with lowering portfolio size. The principle behind the Martingale system is that statistically you cannot lose all the time, and therefore you should increase the amount allocated in investments, even if they are declining in value, in anticipation of a future increase.
The Martingale system is commonly compared to betting in a casino. When a gambler using this method loses, he or she doubles his or her bet. By repeatedly doubling the bet when he or she loses, the gambler will (in theory) eventually even out with a win. Of course, this is assuming the gambler has an unlimited supply of money to bet with.
Anti Martingale System
A system of position sizing that correlates the levels of investment with the risk and portfolio size. Contrary to the Martingale system, the anti-Martingale accepts greater risks during periods of expansive growth, and an increasing market exposure, with larger equity.
2% Rule
The 2 percent rule is a basic tenet of money management. Even if the odds are stacked in your favor, it is inadvisable to risk a large portion of your capital on a single trade. The 2% rule states that you should never risk more than 2% of your account equity on a single trade. Market Wizard Larry Hite “Never risk more than 1% of total equity on any trade. By only risking 1%, I am indifferent to any individual trade.”
6% Rule
The 6% rule, outlined by Alexander Elder in ‘Come into my Trading Room’ states that if the value of your account falls 6% below it’s closing value the prior month you should stop trading for the rest of the month.
Recovering Lost Equity
Consider the following percentages required to recover from significant percentage losses in your account: 25% Equity Loss requires a 33% return to recover former equity value. 50% Equity loss requires a 100% return to recover former equity value. 75% Equity loss requires a 400% return to recover former equity value.
The table above reflects how difficult it is to recover from large percentage losses of your equity.
Stop Loss Strategies
Equity Stop. In this scenario the trader risks a fixed percentage of their equity on a trade and uses this to determine the placement of the stop loss order. Chart Stop. This technique uses technical analyis such as support and resistance levels to determine the position of the stop loss order. Volatility Stop. This method uses volatility as a measure of where to place the stop loss order – in a highly volatile setting the loss should be wider and in a lower volatility setting the stop should be tighter. Average True Range and Bollinger Bands® are two indicators that can be used in determining the postion of the volatility stop loss order.
Position Sizing Turtle Style
The Turtles used a volatility based constant percentage risk position sizing algorithm. See: http://www.traderslog.com/forum/showthread.php?t=7017
Scalpers Strategy
Scalpers Strategy
The 15 pip breakout scalper’s strategy is specifically designed to scalp 15 pips on 1 minute time period volatile currency pair charts.
The 15 pip breakout scalping strategy has been developed specifically for trading volatile currency pairs in the one minute time period with the utmost accuracy. The currency pairs that can be traded are the EUR/USD, the GBP/USD, the NZD/USD and the USD/CHF and they should be traded during the European and USA sessions for the most volatility. The stop used is rather narrow at 6 to 8 pips and the target profit is 14 pips or more.
The 15 pip breakout scalper’s strategy is specifically designed to scalp 15 pips on 1 minute time period volatile currency pair charts.
The 15 pip breakout scalping strategy has been developed specifically for trading volatile currency pairs in the one minute time period with the utmost accuracy. The currency pairs that can be traded are the EUR/USD, the GBP/USD, the NZD/USD and the USD/CHF and they should be traded during the European and USA sessions for the most volatility. The stop used is rather narrow at 6 to 8 pips and the target profit is 14 pips or more.
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