Money Management

Thanks for these links. I went through all of them except the Britannica link that didn't work.

In my understanding, the concept of utility function applied to trading says that each trader / investor may be willing to take a different amount of risk based on his wealth and, more importantly, on his risk aversion.

The sizing methods, like those based on Kelly fractionals, give you an objective evaluation of the probable profit for the risk you're taking.

Being informed on the objective probabilities of profit / risk you'll take your subjective decision function of your risk aversion (utility function).

So, I don't see the immediate applicability of the utility function theory to money management (sizing). At most this could be just a final subjective touch: risk a little more or a little less if you feel so. But your proper sizing should still be based on your trading method's probability of win and average win / average loss ratio.

Do you see this differently? How are you using the utility functions theory in your trading?
Quote from barney_collier:

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Random Entry Trading System

Tom Basso designed a simple, random-entry trading system … We determined the volatility of the market by a 10-day exponential moving average of the average true range. Our initial stop was three times that volatility reading. Once entry occurred by a coin flip, the same three-times-volatility stop was trailed from the close. However, the stop could only move in our favor. Thus, the stop moved closer whenever the markets moved in our favor or whenever volatility shrank. We also used a 1% risk model for our position-sizing system. ...

We ran it on 10 markets. And it was always, in each market, either long or short depending upon a coin flip. ... It made money 100% of the time when a simple 1% risk money management system was added. ... The system had a (trade success) reliability of 38%, which is about average for a trend-following system.

Source: Van K. Tharp , Trade Your Way to Financial Freedomhttp://www.arbtrading.com/entry.htm
 
I want to contribute to this thread. But after reviewing the posts and contemplating my knowledge amassed on the subject thus far, there are few *generalized* axioms I can offer.

The starting point for every newbie trader or newbie strategy is start small. 2% rule is good. 1% is better.

After that, sky is the limit.

Once a trader *completely understands* the rationale behind his edge - why it exists, what occurs before it, the anatomy/profile of a winner, and has hundreds of historical trades under their belt - one has arrived at a place where mm specialized to his/her particular strategy can be applied effectively.

And this is the crux of the whole money management issue - moderate utility can be taken away from applying the general principles of 'max drawdown', risk of ruin, optimal f, kelly yadda etc, but thats it.

The real meat and secrets of mm lie within your OWN strategy. Your own strategy - once its understood inside and out - will tell you where to add, how much, whether to fade or not, where to pyramid. etc.

Its the intimate understanding of ones own strategy that will unlock the secrets of 'money management' for the trader. The general principles thrown around on this thread will just ensure you survive long enough to get there.


That being said, a couple of mm rules Im toying with myself that could have general application:

1) after 15% drawdown, half all bet sizes.

Rationale: After losing 10-15% equity, something is wrong (usually). If the strategy is sound, this usually implies:

a) the market phenomenon the strategy captures has changed somewhat (less volatile, more volatile) and is less stable. Appropriate adjustments can be made.

b) the market phenomenon the strategy captures is not occurring. This isn't to suggest the phenomenon is gone. If one has devised a strategy around a perennial market phenomenon that has occurred since the inception of the markets - 'a trend', 'a range', 'a breakout' etc - one should be fine.

Either way, a trader should proceed with caution and make appropriate capital preservation adjustments.


2) If your strategy exhibits strong serial correlation/dependency between trades, hold off one more win than you normally would before adding real money.

For instance, if you usually wait until the second win to add capital, wait until the third.


3) Fade entries. On the surface, this appears more as entry advice as opposed to money management. But if you get the direction of the move right and the entry wrong, fades increase your hit rate (wins) and bottom line profit (which is the opposite side of the same money management coin - minimizing losses and maximizing wins etc)

I like to split a regular entry into 2 positions - one enters at market. THe other enters on a fade. This way, I've got a good probability of exposure if the market 1) signals entry and never looks back or 2) signals entry then bounces back past my initial stop, turns around, then keeps going.


Of course, there's lots more. Especially related to exits, how to press your winners, winner profiling etc. But these don't fall under the classic definition of money management discussed here.


One last thought to leave with you: "The market trends or ranges. Thats all it ever does"

When you understand this, you will know how to stay profitable.

The market is always reinventing itself. But all it does is trend or range. Therefore, its HOW the market trends or ranges that provides the key to long term profitability.

If we have the skill/ability to 1) notice persisting qualitative changes in how the market trends or ranges and 2) alter our strategy to reflect these changing market conditions, we should be good.


This is my abbreviated take on money management. Would love to hear what other traders think.
 
You have a point. On the other hand different people have different needs. When somebody is wealthy enough to be financially independent, he has other needs than making money: i.e. research, sharing ideas with others, building a name, building a business, etc..
Quote from achilles28:

I have the book. Im highly skeptical. If thats possible, Tharpe and Basso wouldn't be out peddling books and their networth would be astronomical.
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Quote from cnms2:

You have a point. On the other hand different people have different needs. When somebody is wealthy enough to be financially independent, he has other needs than making money: i.e. research, sharing ideas with others, building a name, building a business, etc..
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True enough. I am certainly open to the idea. Some people may really be that altruistic.

But...:) Do you know Tharpe or Basso's net worth?

I suppose the true acid test would be backtesting the strategy. I dont know of anyone - besides tharpe and basso- who have. Although Im guilty on not knowing many traders :)
 
In his book Tharp also writes "Whenever you run a random entry system, yo get different results. This system made money on 80 percent of the runs when it only traded one contract per futures market". It shows the superiority of the percent risk sizing (i.e. 1 %) vs. fixed unit sizing.

Basso's "random entry / 3 ATR trailing stop" system is very simple and I was planing to backtest it myself but I never did. I was planing to run on it random Monte Carlo simulations too.

Quote from bighog:

Backtesting is subjective also...... Cherry picking is alive and well. ...................:D
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I like the Seamless Continuous Trading (SCT) concept that replaces entry / exit thinking with hold / reverse thinking (when it starts raining put on your raincoat, when it stops take it off). I wonder how you calculate your risk under SCT. How do you size your position?
 
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