Money and Risk Management

Mel Dickover
4 August 2005

Random Entry trading game

On 5 Min YM chart, flip coin, heads go long, tails
go short.
If next bar up goes in your direction, hold.
Exit when a bar closes below (above if short) close
of previous bar.
Done by tick replay occasionally on Woodies site.
Always makes money (not a lot)
Why it works:
Equal number of longs and shorts
Lets profits run, cuts losses short.

More profitable than 90% of day traders

Cutting losses short

For a trader with a system that gets 62.5%
winners, profitability varies with risk
In 16 real trades with 10 winners

For 10% risk/trade 19.2% loss

For 5% risk/trade 13.8% profit
For 2% risk/trade 28.8% profit

The most important part of trading

Money management is what you do starting

at entry

Position sizing, stop loss, targets or exit signals,

scaling in and out, portfolio management,
managing the various risks

More important than technical analysis,

Applies across all trading techniques technical

or fundamental

Perspective: Probabilistic
A trading system
time frame, market,
indicators

Market flux and flow

Filter

Edge

text
text
Patterns

(setups)

Edge: indication of a higher

probability of one outcome over
another

Way to exploit the

edge

Money
management

Trades entry, stop, target, exit

Technical analysis can provide an edge.

Money management can exploit your edge to manage risk and maximize profit.

Trading with an edge

Goal become the casino
have an probability edge
take lots of trades
win over time

No amount of analysis can predict the

outcome of individual trades
no way to be meaningfully right or wrong
about a trade.
like being right about a dice throw.

What are the properties of the

trading system
Expectancy
(P win)*(win size) (P loss) *(loss size)

Different stops, exits, and position sizes

give different trades, profitability
different system

Need different stop/exit rules for different

style scalp, swing, position

What if Im not doing well?

Edge could be negative worse than
random
Poor money management
Counterproductive trading behavior patterns
based on emotion
inevitably mixed up with money management

How do I know what the problem is?

Is the edge real?

We can find out by
Back testing
Walk forward testing
Paper trading

Poor money management

Most trading systems depend of a small percent of
trades for most of the profit
Take profit too soon and we lose
We can go broke taking a profit

Not take all the trades

Miss the big profit trades

Bad stops, bad risk/reward ratio, poor exit

strategy, poor risk management
Personal trading statistics are our diagnostic tool

The real trading system

A trading system
Way to exploit the
edge

Edge

Market flux and flow

text
text
Patterns

Filter

(setups)

Money
management

Traders beliefs,
emotions,
behavior

Just because it doesnt work in

practice does not mean it wont work
in theory
Trades entry, stop, target, exit

Why we dont follow the plan

Why
dont we dont take all the planned trades
dont we take the planned exit?
do we take unplanned trades?

We see patterns in the noise that make us think we know

what will happen
Skinners occasional reinforcement may keep us doing it

Fear causes us to try to confirm with factors outside our

plan
Losses cause us to doubt our plan
As a consequence, our statistics are no longer valid and
thus our money management scheme is no longer
descriptive or predictive
we have introduced random results into our plan

Counterproductive trading behavior

One way to quantify the effect of these behaviors
is to compare personal statistics from paper
trading to those from real trading
The difference in profitability is due to the
emotional effect of fear and greed, and of the
cognitive traps that trading involves
We wind up not following our plan

Flinch curve why no mental stops

Ability to act
On stop loss
Unable to act
On stop loss
signals

Zone of
indecision

Catastrophic loss
Closed immediately

Able to act on stop loss

signals

Level of dollar loss

Personal statistics: the key

Need to adapt your plan to your nature and behavior.
Lots of different trading systems for the same signal
Different stops or targets mean different trading systems with different
profit-abilities and draw downs
Edge may vanish as market changes or too many traders use it

Without personal statistics, we cannot do meaningful money

management or market adaptation
Without a trading plan, we cannot collect meaningful statistics
Trading plan is a formal, written description of our edge and trade
management strategy that eliminates discretionary ambiguity
Without personal statistics
it is difficult to diagnose and fix poor money management or trading
behavior
It is difficult to generate belief in the system strong enough to allow us to
continue through runs of losses

Learning and adapting

A trading system
Way to exploit the
edge

Edge

text
text
Patterns

(setups)

Money
management

Traders beliefs,
emotions,
behavior

Revisions

Trades entry, stop, target, exit

Personal
statistics

All in/out versus partial profits

Most pros take partial profits
Math shows all in/all out is more profitable
Taking profits gradually is because of
psychological reasons
Higher win rate even though less money
Smaller drawdowns

Approach to risk

Capital is protected by managing risk

Risk management is stop loss
Trading survival comes from stop loss rules
Trading success comes controlling of
risk:reward of trades
risk:reward targets come from personal
statistics based on your system

Risks to manage

Individual position risk

Risk of ruin string of losses
Sector risk (e.g. oil dependency)
Event risk (e.g. 9/11)
Cumulative/portfolio risk
Technology/infrastructure risk (e.g. lose Globex or Comcast)

Risk cannot be nullified by analysis

or by time, e.g., buy and hold

Individual position risk

Risk = entry stop
Except for gaps around your stop

Stop should set risk below your flinch point

Options are sometimes used instead of stops

Risk of ruin
Risk of ruin example
With 55% edge, 10% risk/trade, risk of ruin = 13.8%
With 2% risk/trade, risk of ruin = .004%
This is why the martingale players disappear over time
never double down or add to losing positions

Experts recommend the that no more than 2% in

any of an account risked in a single position.
Could survive 194 losses in a row and still not be wiped
out

Sector Risk
30% - 35% of a stocks price behavior is
due to sector
Need to diversify into multiple sectors
preferably sectors with opposite behavior to
hedge risk

Event risk
Earnings announcement, CFO indicted,
9/11, etc.
Prices gap around stops

Hedge with a mixture of longs and shorts

Use a more sophisticated options strategy
See MPLAYs presentation on Woodies web
site
Possible to100% define/control risk

Cumulative portfolio risk

In a $100,000 IRA, using 2% risk, assume
we have 7 positions with $2,000 risk each.
cumulative risk of $14,000.

Cant hedge with shorts in an IRA

Scaling scheme shown later may help

Technology risk
Day traders need alternate connection to
broker if ISP goes down.
Day traders need alternative broker to hedge
futures positions if exchange goes down
I have seen this happen to Globex

Handling these risks is part of a good

trading plan

Strategies for investors

Assumes longer term, trend following type of
trader
Using ADX, Darvas boxes, Guppy Multiple Moving
Averages, or the like to keep in the trade to exploit the
trend

Trading is about protecting capital all the time, not

just at entry, where stop loss is set.
How do we keep maximum profits, without the
guarantee of an exit signal at the top?

Fixed percent risk investing

Risk related to trading capital, not
individual trade
2% of trading capital rule
automatically adjusts to account size

Once stop point is selected, number of

shares can be computed
2% of capital/(entry stop)
e.g., $2000/(56-52) = 500 shares

Risk/reward filter
Reward/risk needed depends on our hit rate
From chart, find significant resistance
Reward (probable) = resistance entry

From chart, find nearest support to entry

Generally, this sets the stop
Risk = entry stop

2:1 reward/risk ratio implies break even with 50%

hit rate
Personal statistics tell you what your hit rate is,
lets you calculate what r/r you must have

Profit @ risk stop

How can we protect profits and take an exit as
close to the top as possible?
Apply same 2% risk from beginning of trade to the end
of the trade still fixed risk
Particularly good at protecting profits in fast rallies and
momentum or swing trades

In trend trades, apply profit @ risk when other

indicators suggest end of trend may be near.
Normally, use your systems exit signal to get out
profit @ risk stop just for stopping erosion of profits if
signal is slow

Whats wrong with sell half?

Selling half at less than 100% gain leaves both
profit and capital at risk
Zero cost averaging strategy
At 30% gain, sell enough shares to recapture the
original investment
Profit stays in remaining shares

Zero cost averaging

gets better return on capital for lesser risk
frees original capital for another trade
sets mind free from fear so you can stay in for rest of
trend

Strategy comparison
buy & hold

Sell during
trend

Rising
market

Falling
market

half < 100%

zero > 30%

profit

at risk

at risk

Reduced
risk

capital

at risk

Part protected

protected

profit

at risk

at risk

Reduced
risk

capital

at risk

Part protected

protected

profit

at risk

at risk

Very reduced
risk

capital

at risk

at risk

protected

Pyramiding a position to exploit the

trend
Easier to exploit one winner than to find another
Risk varies with time during the trend

Young trend

Robust trend

Risk of trend collapse

Mature trend

Trend collapse

Recommended scale-in
1 or 2
positions

1 to 3
positions

gradual

Always 3
positions
Young trend

sudden

Robust trend

Risk of trend
collapse

Mature trend

Trend collapse

Pyramiding strategies
Adding constant position size
Adding constant dollar size (dollar cost
averaging)
Guppys Grow Up strategy
Goal is to balance position size with trend
collapse risk
His spread sheet shows that this gives best
return on capital and best risk control.

Guppys Grow Up Strategy

Youthful trend
3 trades, same dollar size, as we become
increasing certain a trend has begun
Smaller stop out if we initially are wrong

Robust trend
1 to three at dollar size, as risk grows

Mature trend
Each trade 1/3 dollar size

Portfolio risk: the perils of diversity

More positions mean more cumulative portfolio risk and
only a few positions have the highest return
With 15-20 positions, get market results
With the 2% rule, would you rather have
15 positions (cumulative risk 30%) and average return
of 30%,
5 positions with a cumulative risk of 10% and a return
of 40-50%
Better to pyramid into fewer positions in chosen sectors
William ONeil (IBD) say 4-5 positions for $100K
account

Toward a trading plan

We now have a possible set of mental tools to
create a trading plan by combining our trading
strategy with money management
Need to formally define our edge, gather
personal statistics on that edge
Compute reward/risk and define stop rules
Develop an approach to quantifying risks and
handling them
Develop rules to exploit trends

References
Guppy, Daryl Better Stock Trading - Money and Risk Management
www.guppytraders.com
Spreadsheet packs for investors
www.woodiescciclub.com
Random entry tick replay
Option strategy for controlled risk (MPLAY)
Spreadsheet, other good stuff
Stridsman, Thomas Trading Systems and Money Management
Kaufman, Perry Trading Systems and Methods
for the math minded
Douglas, Mark Trading in the Zone
Traders Log lite version is free
www.members.optusnet.com.au/~traderslog/