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Old 08-29-2012, 05:05 AM   #1

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Trading Account Management Discussion

I thought about calling this thread "Secret Trading System Revealed!" or "Strategy Guaranteed to Make X Return" because I know that for many, the idea of money management in trading holds little interest. I decided against it though because "you can take a horse to water, but you can't make it drink" so to speak. More than anything I hope to get a proper discussion going to highlight the importance of paying proper attention to the figures and trading accordingly and discuss ideas. I hope this thread can be a place where more experienced traders can share their ideas and newer traders can learn and ask questions.
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Old 08-29-2012, 05:10 AM   #2

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Re: Trading Account Management Discussion

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Originally Posted by Soultrader »
One of the top trading secrets is money management. All traders have heard of it and some may think they actually know it. But how many traders practice sound money management?

Most traders lose mony because they lack money management, do not have enough knowledge of the market they trade, do not have a sound trading methodology, and trades a market that does not fit their style.

If the average win per trade is greater than the average loss per trade, a 50% winning trading setup can make you money. But excess risk, greed, poor psychology, and the failure to understand probabiltiies can take an account with a 60% winning methodology to ruins.

There are several money mangement models. In this thread, Im going to discuss just the basics of account sizing and peek-to-trough drawdown.

Alot of new traders fail get into the trading business hoping to make a million by the end of the year with a $5,000 to $10,000 account day trading. This is an unrealistic goal. Day trading is a business of grinding profits everyday. Consistency is the key to survivial and learning to ring the register often. One of the main reasons why new traders go bust is their account size. A $5,000 to $10,000 is too small to practice sound money management. A 10 point YM loss is equivalent to $50 per contract. $50 is 1% for a $5,000 account. 3 losses a day and a trader has just lost 3% of his account. Now 3% may not sound like a big deal but take a look at the data below:



The percentages really start to change after a 30% drawdwn. A 50% drawdown requires a trader to double up just to break even. A gambler mentality tells a trader to double up his position to make back a loss. This is one of the worst habits a trader can have. Frustration and lack of emotional control will cause a trader to double his size on the next trade in hopes to break even. At first this may work, but it leads to bad habits and will lead to bust.


Peek-to-trough Drawdowns

Let's say you are a fund manager managing other peoples money. Your initial fund size is $500,000. In the first month, you managed to increase the $500,000 to $750,000 for an impressive 50% gain. Now the next month you dont have any good trading signals. However, your portfolio goes down to $600,000 in value. You have not made a single trade that month, however your accout has gone down from $750,000 to $600,000. the peak-to-trough drawdown would be (peak = $750,000 and trough = $600,000) $150,000 or 20%. This has occured without a single losing trade that month.

Your clients are only concerned about this 20% drawdown. If they simply withdrew their money the month before, they would of been $150,000 richer. The third month, your $600,000 account goes down to $525,000. Thus the peek-to-trough drawdown is now $225,000 or 30%. From industry standard, your annual rate of return of is 5% (up only $25,000) with a 30% peek-to-trough drawdown. This data will label you as a terrible money manager.

In calculating risk vs reward, we need to look at the peek-to-trough percentage. If your annual rate of return is 5% a year with a 30% peek-to-trough drawdown, your risk-to-reward ratio would be 5/30 or 0.166. This is a terrible ratio. Make sure to keep this in mind when day trading. Although at the end of the day you may have been up, what was your drawdown? If you are trading with a $5,000 account and your account goes back and forth from $4,500 to $5,100, are you practicing good money management? Do you have good trading strategies and setups? Is it worth the stress of seeing your account fluctuate to $4,500 just to make $100?

I hope this makes sense. Money management is everything in trading. We are in the business of risk. Happy trading
I had a quick look at what was on TL already and there seems to be a reasonable amount. If anyone has a particularly useful thread to add, please post it. Anyway, I came up with this one from James, the founder of TL. Pretty useful post really. 12 replies. 12 flippin' replies. I'm not surprised but it does seem somewhat of a shame. But there you go.
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Old 08-29-2012, 05:23 AM   #3

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Re: Trading Account Management Discussion

So I'll get started with some really, really simple basics just to make it clear that MM and sticking to your risk limits and max daily losses are very important.

First simple chart. Following on a little from James' chart, here is effectively a risk of ruin chart:-



It's assuming a 10k account and no margin for simplicity. The point is that very quickly as a greater original % of the account is risked per day (or per trade), the number of losing days in a row that the account can withstand drops dramatically. This doesn't take into account commissions even, so you can see how important having an appropriately funded account is.
Attached Thumbnails
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Old 08-29-2012, 05:43 AM   #4

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Re: Trading Account Management Discussion

Next, I've just taken a random set assuming a goal of taking 2 points per day on a $10k account. The number of contracts traded is the account balance/$5000 i.e. 2 to begin with. The max daily loss is set to 4 points per contract - so initially on 2 lots a max loss should equal $400. Just for ease, I am talking about ES where 1 point = $50/contract, but it applies to anything. I've randomized the data to get roughly +2 points/contract average per day. On the second column, I've turned 1 -4pt max loss per day to between 6 and 12 points once a month (used 200 traded days for a year and 17 days/month ish) to simulate a loss of control by a trader. I've not accounted for whether a big loss would negatively affect trading on subsequent days or not, neither have I addressed whether the max loss is appropriate- clearly if your max loss is 4 pts but you frequently go over and finish up for the day, you daily loss limit could need to be tweaked. Anyway, this is how an account is affected when trying to build it up over the course of a year:-

Attached Thumbnails
Trading Account Management Discussion-2012-08-29-loss-limit-example.jpg  
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Old 08-29-2012, 05:48 AM   #5

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Re: Trading Account Management Discussion

Just to clarify, the difference in number of points per contract over the 200 days is 47 or 12% less. But when you look at the final balance, the difference is substantial. It's $131,650 lower or 39% less because of how many contracts were traded. Now this is in a world much closer to 'perfect' than many would recognize, so you can only imagine how it's a problem for the average trader if it's not looked after properly.
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Old 08-29-2012, 05:53 AM   #6

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Re: Trading Account Management Discussion

Anyway, like the title of the thread suggests if you want to comment on or ask questions talk about a different aspect of MM then please do so!
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Old 08-30-2012, 04:19 PM   #7

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Re: Trading Account Management Discussion

Negotiator,

Thank you for posting this subject matter, and reminding all of us how important MM really is. I would like to share a couple of comments that may be of some use to others beginning their education.

It is my opinion that ones education on the topic of MM should come first, prior to anything even closely associated with trading setups, etc. My path did not start this way, but I certainly wish that it had. Without MM, you have the very highest possibility that your equity will not last. For example, a good entry system without good MM equals very high probability of a ruined account. Even a good entry and exit system without good MM equals a high chance of a ruined account. Everything else less worthy (from a systems quality perspective) equals a ruined account.

How does one take steps to develop a proper MM strategy for themselves? .....Education.

There are many threads and posts here on TL that are very helpful in the quest of educating ones self on a proper MM strategy. I found many of them helpful (here and other areas of the public domain). However, I was unable (at the time) to differentiate which opinion being represented was valid or not (one that would hold up to actual long term testing). There are many people on this forum who have quite different ideas on the topic of MM, and not all of them would pass statistical or mathematical study (my attempt at being gracious).

I also recommend looking at published works to further educate oneself on this topic. I had my eyes opened a number of years ago to the importance of this matter when I read through some books that I would recommend for anyone who has not delved into this topic. The first book that I read that discusses this topic is 'Way of the Turtle' (Faith). In it the author discussed what Negotiator is stating above, on the possibility of risk of ruin, and the basis for this term.The author discusses several very important concepts in the "Risk and Money Management" Chapter. This should be enough to get your interest up as to the importance of this topic. The next book that I read after this one that was instrumental with my learning the important aspects of MM was "Trade Your Way To Financial Freedom" (Tharp). This was a real eye opener for me at that time, as it instilled in me that I had to have not only a proper MM system (from a statistical probabilities perspective), but one that was a proper MM strategy for me (fits who I am as a person - my psychological profile). This work also allowed me to understand that "my" MM system would dictate a lot of the parameters of what my trading system could look like (and just as important could not look like), based upon my account size and my aversion (or lack of aversion) to risk. One of the more recent books I have read that delves into this topic is "Modeling Trading System Performance" (Bandy). There are multiple examples of MM strategies (and the why's and how's behind them) that one may use on their path of discovery for their proper MM strategy. Lastly, Tharp also has a book called "A definitive Guide to Position Sizing" that remains very helpful in giving one a basis for this topic.

My path took me from searching on the public domain to published works. And I now will not do anything that deviates from my MM system (incur more risk). I am convinced that if I do, I cannot achieve any long term success in the markets. In other words, once I setup my level of risk, which is always done prior to entry, I never increase this level of risk (In fact I do not even think about increasing my risk). I would suspect that others may not be in agreement with this, but I would refer anyone interested to look at a study of statistical probabilities and make their own determination on which system is right for them.

Best wishes . . .
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Old 08-31-2012, 04:39 AM   #8

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Re: Trading Account Management Discussion

Quote:
Originally Posted by TheNegotiator »
Anyway, like the title of the thread suggests if you want to comment on or ask questions talk about a different aspect of MM then please do so!
Drawdown is just a natural part of trading. Just like an airplane must maintain lift regardless of the altitude height, or a ship must stay afloat regardless of how deep the water. When you get to your destination, the heights and depths that were used to get there are irrelevant. The risk returns to zero when no trades are open

Trying to use time like a 4 hour or daily loss limit to artificially stop out what you think is or is not an acceptable loss doesn't respect that the market may have its own point of view on how far prices will trend. A much more accurate stop loss would be based on a range of prices, which can be adjusted depending on how many positions you take on. Once you reach your profit target (or stop loss), the drawdown in between didn't matter.

Drawdown only matters in terms of knowing the maximum positions you can hold vs amount of available equity, no different that knowing how much gas you need or what your mechanical limits are. I just want to make the clear distinction between determining position limits based on mathematics and overall mechanics of the trading strategy vs fear under the guise of 'preference' or 'risk tolerance'. One is personal, the other is not

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