Archive for March, 2009

Money Management – The Asymmetric Effect

Tuesday, March 31st, 2009

In a previous post I explained that one factor making it more difficult to trade a small account for capital growth, as opposed to a larger account for revenue, is that you are obliged to take on more risk. However, there is another more subtle problem that compounds the difficulty.

Suppose I take two trades where risk is 2 points ($100) and profit potential is 5 points ($250). The first trade wins and the second one loses. 

Consider how this impacts a small account of $6.5K, and a larger account of $35K, assuming for this example that we are prepared to risk 3% of our capital on any one trade.

Small Account

First Trade:     Amount we can risk = 3% x 6,500 = $195. Dividing by the estimated trade risk ($100) shows we can trade 1 contract. The trade wins $250, increasing capital to $6750 (ignoring trading costs).

Second Trade:     Amount we can risk = 3% x 6,750 = $202.50. Dividing by the estimated trade risk ($100) shows we can now trade 2 contracts. The trade loses $100 per contract, reducing capital to $6550 (ignoring trading costs).

The two trades net just $50. In real trading, we would do well to break even.

Large Account

First Trade:     Amount we can risk = 3% x 35,000 = $1,050. Dividing by the estimated trade risk ($100) shows we can trade 10 contracts*. The trade wins $250 per contract, increasing capital to $37,500. 

Second Trade:     Amount we can risk = 3% x 37500 = $1,125. Dividing by the estimated trade risk ($100) shows we can now trade 11 contracts. The trade loses $100 per contract, reducing capital to $36,400.

The two trades net a very respectable $1,400, less costs.   

*  In practice, there may be insufficient capital to trade 10 contracts, depending on the margin levels set by your broker.  

What Happened?

In both accounts we took two identical trades, one winner and one loser. The winner won more than twice as much as the loser. This produced a nice gain for the large account, but virtually no gain at all in the small account!

The problem occurs when the first win increases capital to the extent that more contracts can be taken on the next trade. With the small account, we move from 1 contract to 2, with the large account we go from 10 contracts to 11.  

The small account increases the number of contracts traded by 100%! When the next trade loses, the loss is nearly as large as the previous win, and profit is negligible. 

With the larger account, the number of contracts increases by just 10%, so the impact of the subsequent loser is nowhere near so great.

The greater the number of contracts you are trading, the less impact the asymmetric effect has on your results. Somebody trading a $100K account with 1.5% risk would barely notice it.


30 March 2009

Tuesday, March 31st, 2009

I took a small loss.  

This project has begun with a string of losses, which is discouraging, particularly as there was an expensive mistake which turned a good winner into a loser. However, risk management has not been too bad, so I’m still well in the game.

Having traded this way for a week, I can say that there are things I’m enjoying, and things that aren’t so good…

The number one thing I enjoy is trading the thirty minute window. It’s more pleasant than hanging around through an entire session, and it enables me to really concentrate a limited trading period. When I first started traded grains, I used to stick to the first 30 minutes, but then I allowed that period to expand because you can find a few more trades if you do. Now, I’m remembering why trading the first half hour was so good!

The other thing I’m enjoying is trading the one minute bars. This is a new departure for me, as previously I’ve stuck with 2 minute bars. However, 1 minute bars are a good complement to trading the 30 minute time frame. The greater number of bars means one of my trading patterns is more likely to form during the trading period, and the shorter time frame means that stops are tighter – making it easier to find trades within the chosen risk parameters. I’ve been able to slightly simplify my normal entry rules, and have found good parameters for fixing target and stop loss levels.

Things I dislike about the style I’m using are the measures taken to try to reduce the size of losses. During the early part of a trade, I’ve been moving stops in close and, if stopped out, I’ve been taking additional trades when further setups form. The rationale has been to protect the tiny capital base at all costs.

Unfortunately, this doesn’t suit my personality. In my normal (revenue) trading approach I enter a trade, automate my exits with oca orders, and leave the trade to work out. What I’m doing now feels quite different – and I hate it! It encourages me to watch the market, to take setups which might not be strictly according to my rules, and to over-trade. We can’t have that – so from now on it’s back to one trade per day, and no adjustment of stops.

That means the losses may be larger, but I’ll rely on the fact I’m using a 3% risk factor (rather than the 5% used in my previous attempt) to keep me safe. 

 

 

 

 

 

27 March 2009

Friday, March 27th, 2009

 

I took another loss today.  Certainly not an auspicious start to my project this week!

I have learned a couple of lessons. Let’s see what next week brings.

 

26 March 2009

Friday, March 27th, 2009

I took a small loss on this short trade today.

25 March 2009

Wednesday, March 25th, 2009

No trade today. For this project,  I am trading just the first 30 minutes of each session.

When I revenue trade with a larger account, I am prepared to wait out at least the first 2 hours of the session for a trade, and end up with a trade in about 90% of all sessions.

I’m not sure what the trade percentage will be trading just the first 30 minutes, but I expect it won’t be much over 50%.  Still, that will be plenty for capital growth, providing about half the trades are winners. One of the keys in this exercise is patience!

24 March 2009

Wednesday, March 25th, 2009

 

 

I found no trade in the first 30 minutes yesterday. (A short opportunity did appear later in the session.)

I’ve been trying to settle on a graphic that shows relevant information each day, and have succeeded in arranging the trading windows so that I can capture it all in a single screenshot.

When I do trade, the top line will show the P&L for the day (in US dollars), and also my AUD account balance. Beneath that I will display a 5-minute chart of the day’s action. Finally, at the bottom, you will see a list of the day’s trades.

Even on days when I don’t trade, the Australian account balance will fluctuate a bit. That is because, although the account is designated in AUD, my broker actually holds it in two components (AUD and USD). As the exchange rate varies, the value of the USD component changes.

 

 

 

 

23 March 2009

Monday, March 23rd, 2009

20 March 2009

Friday, March 20th, 2009

Sometimes I hate publishing my trading results.

In this session, I picked a nice opening short trade – and inexplicably clicked the wrong button, with the result that I was long, not short. 

By the time I noticed and closed the position, I was down 3.25 points plus trading costs.

I closed at AUD10,276 yesterday, and I’m at AUD10,016 after today’s session.

I have made that mistake once before, but it was a long time ago.  The extra speed of the 1-minute chart time-frame probably contributed to the problem, combined with a bit of rustiness because I’m just coming off a trading break.

Still, as I have often stated, perfect performance of your plan is a prerequisite for success in this business, and this was far from perfect! Excuses don’t cut it.

The 30 minute window closed without any further opportunities.

 

19 March 2009

Thursday, March 19th, 2009

Well, the Fed prints money, the US dollar dives, and grain prices shoot up.

May wheat traded over 3K contracts in the first minute of the session, rising in price nearly 30 cents over yesterday’s close. Unfortunately, things then froze up and I was presented with no opportunities in the next half hour.

That’s OK. My account balance stands at AUD10,276 and has suffered no setbacks. I traded according to my plan, and resisted the urge to over-trade.  There are a few blessings there.

See you tomorrow.

Day Trading for Revenue – or Capital Growth?

Thursday, March 19th, 2009

Hello to all my readers!

This is my first post for a long time, and it will be the first of many. Now that my book is on the shelves and a recent family marriage is over, the decks are clear for regular blogging, and I am really looking forward to it.

So on to today’s topic…

As a trading career develops, it may ramble through many stages.  Personally, I tried a little of this, a bit of that, educating myself through a process of trial and error.

I had no trading style, and no clear goals. I had no idea which styles suited my personality and which styles would drive me crazy. Sometimes I was a long term investor, sometimes a day trader, sometimes a swing trader.

Sometimes I traded equities, sometimes equity options, sometimes pure futures and sometimes futures options. I was a directional trader, a delta neutral options trader, a seasonal spread trader, an option buyer, a premium seller.

Only in recent years have I focused on the grain futures markets and built the trading style which matches my personality and meets my specific needs.

I learned that I am impatient for results and need quick feedback. I am risk averse and hate being exposed to a leveraged market position one second longer than I absolutely have to be. Above all, I need to win steadily, rather than make money through occasional big wins interspersed with long losing periods.

My main need from trading is to secure a consistent income stream, with the emphasis on consistent.

Trading income is never like earning a salary. There are good weeks and bad weeks, good months and bad months, and with some trading styles there are good years and bad years.

I wanted a solution which had few bad weeks, and where bad months are almost unheard of. I find it almost impossible to maintain good trading discipline when my system is not winning steadily, even though it may be in an entirely predictable and expected drawdown.

All trading systems have losing spells as markets gyrate, change and evolve.  During losing spells,  account equity goes into drawdown.  A system with "positive expectancy",  and sensible risk management processes, eventually comes out of drawdown, and equity growth resumes. Quite early on, I realized that if I need a steady income, I need a system which trades frequently.

The logic is simple. Assume your account normally goes into drawdown for an average run of 5 trades. Further suppose you have the choice of three strategies, with the same theoretical returns over the long term, which have average trade durations of 1 day, 3 weeks, and 3 months respectively. Clearly the average drawdown in the first system lasts 5 days, in the second system 15 weeks, and in the third system 15 months!

Think about that! On average, when the third system is working normally, you are likely to have spells of 15 months, or longer, where you make no money! Occasionally, it will compensate with a stellar period, a home run, where the long term profits are made.

That kind of system may suit a patient, longer term investor, but it is of little value to a person hoping to trade for a living, unless they have enough capital to live on during those long financial droughts, and admirably tenacity to sit out long bad spells without losing motivation.

Assuming each system has the same theoretical profit potential, the third (slow) system will make a lot more money over an extended period of years. Why? Because its trading costs will be so much lower than in the higher frequency strategies. Frequent trading costs in the day trading system are likely to consume at least half the potential profits.

Given my personality traits, and my requirement for a consistent income stream, I was more or less constrained to the day trading option.

A day trader can trade more than once a day, potentially shortening the drawdown period further. Imagine a fourth strategy with the same potential as the others discussed above, which trades 10 times per day. The length of the average drawdown is reduced to half a day, which is good, but beware of the probable huge escalation in trading costs that may turn that theoretically high expectancy strategy into a losing proposition.

To cut a long story short, the trading style I evolved for myself was based on placing one good trade each day. I found trade setup patterns which win just over half the time, and I manage trades so that my average win is about twice my average loss. As long as I control risk by not taking too large a position in any one trade, this has worked well for me.

I think of my trading style in this way. It is like being taken to the casino and granted one bet each day where the odds are significantly in my favour. I accept that just because the odds are in my favour does not mean I will never have a string of losses. So I must manage risk in a professional way, to ensure I can weather these little storms. I understand that I must not succumb to the other temptations of the casino, particularly the urge to place unplanned bets. This is sometimes referred to as over-trading.

It is a technique geared to my requirement for a consistent revenue, as near to the notion of a normal salary as I can get.

Using the methods described in my book, I am most relaxed when I start each month with about US30K in my account, risk no more than 1.5% of my capital per trade, and trade whichever commodity (beans, wheat or corn) is in the 400 to 700 price range, with a preference for wheat when there is a choice. My goal is to make a minimum of 10% per month on capital invested. I withdraw profit and reset the capital to US30K at the end of each month.

So I am very much day trading for revenue. I trade to meet my needs. I was fortunate to retire early from a former career with a decent nest egg. My wife has a good job. Trading produces money for luxuries. And, as an added bonus, it allows me to be at home to enjoy and care for our little boy.

Now, there is no reason why these same techniques should not be used for capital gain. In theory, all that is required is to let the profits ride each month, so that the compounding effect kicks in and capital growth is exponential.

In practice, there would probably be difficulties. I cannot say for sure, because I have never done it. But I expect the techniques I use to trade five or six contracts would have to be substantially modified if I were trying to trade fifty, a hundred, or more contracts at a time. I suppose it might be a pleasant problem to experience.

At any rate, even though I’ve never tried it, it seems reasonable to assume that simply compounding my profits should lead to fast capital growth, if I start from my existing capital base.

However, many people are in a different position and have very different needs. They are attracted to trading for its lifestyle benefits, but are undercapitalized. Often they cannot afford to spend a lot of time on their trading.  Their need is to build a small stake into a big one. While doing so, they intend to keep working their normal jobs. If successful, they hope to leave their jobs and become full time traders.

It should come as no surprise to find that this is not as easy as it sounds. A few months ago, I decided to use my methods to grow a small account of AUD10,000, into a substantial one of AUD50,000. I planned to trade exactly as I do in my revenue trading model. The only difference was that I would need to increase my acceptable risk per trade from 1.5% up to 5%, because otherwise most trading setups would violate my risk parameters and very few trades would be taken.

Despite an excellent start (up 9% on first day) this account did not do well, and I abandoned the effort when the capital dropped well below AUD6,000.

So what went wrong? Essentially, it was that 5% figure.

Sure, the market did run into a lean spell and losers were more frequent than usual. But with a 1.5% risk figure you can ride out a run of losses with equanimity. That is not the case when you risk 5%. Trading those months with my normal revenue generation style, I would have made acceptable positive returns each month. Instead of which, I destroyed nearly 50% of the equity in the small capital account.

Much of the problem was psychological. I found the extra volatility in the equity curve very difficult to cope with. I very much wanted the project to succeed, so began second guessing some aspects of the system. That is a sure recipe for disaster. Once you stop entering and managing trades exactly according to your predefined plan, you are no longer trading a system at all.

No experience in life is wasted, including this one. I made the fundamental mistake of concluding that the smaller capital base could be compensated for by increasing my risk parameter. But clearly it was not enough to simply take a successful revenue producing system (with its 1.5% risk tolerance), boost the tolerance to 5% so it would still allow me to take the same trades, and plan to let profits ride to obtain compound growth. Before getting back into this project, some research was required.

The small capital account is a very different animal. I had not fully appreciated how much the small equity base needs fanatical, stringent protection.

So, it was back to the drawing board. I remained satisfied with the fundamental elements of my system – the trade setups, the risk management, the placement of stop loss and profit target levels. Eventually, though, I began to see that there could be considerable advantages to developing a more defensive trade management plan.

I researched losing trades to see if there is a good predictor of failure which can be used to trigger an early exit from the trade. (This differs from my current practice, where I let the market trigger the target or activate the stop.) Obviously, an early exit from a bad trade, somewhere near break-even, is going to be much gentler on account equity than letting it hit the stop.

(The flip side is that, inevitably, some trades that go on to be winners will be exited early at break-even. That must be anticipated and accepted as a cost of protecting the small capital base.)

Another area I looked at is the amount of time required for the trading activity. I mentioned that many people are time poor – they cannot spend hours at a screen waiting for a trading opportunity. This is where the grain markets provide some wonderful opportunities. With primary trading sessions of just 3.75 hours there is already a huge advantage over the popular index futures contracts, or currency markets.

Even better, the best trading opportunities in grain markets often occur during the first 30 minutes of the main trading session!  

I found that this period (0930 – 1000 US Central Time) provided ample opportunity to meet my goals, especially if I tightened my trading timeframe by using 1-minute trading charts.

In summary, I am now ready to begin the project again.
    •    I have a clear plan based on executing the techniques described in my book.
    •    I must risk more per trade than the 1.5% that I am comfortable with. I will cap it at 3%.
    •    To keep the equity curve as smooth as possible, I have modified the trade management strategy to exit some trades at break-even.
    •    I will trade one minute charts, speeding things up considerably and putting an even greater emphasis on implementation excellence (no mistakes!).
    •    I will confine trading to the opening 30 minutes each day, but not limit myself to one trade per day. In other words, if two valid setups occur within the 30 minute window, I will trade both.
    •    I plan to monitor slippage costs. If they eat to far into profits, I am prepared to use a modified entry technique to eliminate slippage at the entry, accepting that this will cause me to miss some trades.
    •    This project is all about capital growth, so I will not draw any profits from the account until the target is reached.

The account is funded and I am starting the project at once. Not without trepidation, I might add, having been burnt once and fully realising the fragility of the tiny account in a high octane market. But the trading plan is good and hopefully my execution will be up to standard. Whatever the outcome, I will record real-life results in my trading diary, as well as my usual comments on various aspects of the trading process.

You can follow my progress by clicking the link at the top of the page (right hand side) which takes you to the next post.