<b>"Optimal-A"</b>
Traders of all markets and methods tend to fixate on the entry, exit and management of trades. Obviously that part is critically important⦠lest there be no further progress from there. Once a trader gets the hang of their chosen approach, attention is usually turned toward how much money to risk, how many contracts to work, etc.
There is absolutely nothing wrong with just a static, linear approach to managing trades. Pick a number of shares or contracts and go. Simple as that, right? Well, it can be and thatâs just fine. But itâs not an optimum use of capital at all.
I realize this basic info below is old hat to many traders here. I also expect it is all brand new to a number of traders as well. Very seldom is this type of stuff covered in public, versus the old clichéâs of trade four contracts, peel three off at x-partial profit and let the fourth run for distance, etc. By no means do I want to talk down towards the veteran traders, nor do I want to talk over the heads of others. Weâll try to cover the basics first in this installment, then build on from there.
<b>%Risk Scale</b>
First thing we need is a trading approach that works. Our trading approach for this optimal money management must have a positive expectancy, i.e. it needs to make money. News flash, right? If we donât have that, the remainder of this exercise is futile.
#1: In addition to that, it needs a win/loss ratio very near 50% (or better) accuracy.
#2: Needs to win roughly one out of two trades, and the distribution of such should be fairly balanced. If our method wins 60% of trades but frequently endures ten-trade consecutive loss sequence , thatâs not nearly good as a method which wins 48% of the time but seldom loses three trades in a row.
Now, logic dictates that a 60% correct trading approach would not have drawn-out drawdowns. Iâve seen it happen, especially in mechanical systems. Just pointing out the fact that such strings of sustained losing trades can exist in a high %correct approach.
#3: Our trading approach must have at least a 2/1 profit to loss ratio result. A negative profit to loss trade size scale is unsustainable over the course of time in my opinion anyways. For managing accounts in optimal fashion, we must have a positive balance of profit to loss results per trade.
Iâve been told by way more than a few traders they were taught (and use) tactics such as +2pt ES target / -2.25pt ES stop or worse, a +10pt YM profit / -20pt YM stop for scalping tactics. Those dogs will not hunt over the course of time: try that scale of profit to loss long enough and total ruin is inevitable. Period, end of story.
The higher our profit to loss ratio is, the better. That said, itâs pretty tough to beat a 2/1 ratio in ES and possibly 3/1 ratio in ER. Just 2/1 ratio of profit to loss is fine, with balanced distribution of win â loss results being equally important.
<b>Risk 101</b>
To recap, itâs critical to know your average win â loss patterns of distribution AND what your average profit/loss ratio is. Mechanical system traders have this data compiled in their reports. Method = discretionary traders need to figure this data out manually or spreadsheet fashion. Sounds like a lot of work? Who ever told you making money thru trading is easy? (laugh)
Hereâs where we begin our lesson with hypothetical data for sake of discussion.
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ET Method Of Trading
Symbol: $ET emini futures (fictitious)
Value: $100 per index point
Trading Exchange: EliteTrader.com :>)
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If we are accomplished $ET emini traders, we already have our data points to work with. We know that over any long period of time thru all market conditions averaged out our win/loss ratio is 50% and our profit/loss ratio is 2/1. The worst-loss string of consecutive trades ever was five, although we know it could be more in the future.
O.K. so far? Ya with me? Great!
Our initial trading account balance is $10,000. I realize thatâs paltry change to many of the big-gun traders here, but it took some of us rednecks quite awhile to save this much up. Had to sell a few of our coon hound pups and some of the antique Skoal can collection, plus our granddaddyâs coin collection to raise the cash. The coins fetched $9,400 from that dealer in the big city, good thing we had those pups and antique Skoal cans to make up the difference.
So⦠weâve got $10,000 to work with and we donât want to risk more than 5% on any given trade. That would be -$500 per trade initially, and the dollar risk amount decreases if our account goes backward. By the same token, the dollar risk amount increases with account growth.
We are trading $ET emini futures. They move in $100 per contract increments, and we use -$100 per contract initial stops on each trade. With -$500 per contract as our designed risk, we can trade five contracts (five at -$100 each on a stop) with the $10,000 initial balance.
If our account balance goes to $12,000 from there, we trade six contracts, If our account balance goes to $15,000 from there, we trade seven or eight contracts.
Should we hit a string of losses and account balance goes from $15k back to $12k, we drop our trade size down to six contracts again. If the balance slips to $10k, we scale back to five contracts there.
<b>Sliding Scale</b>
What does this all accomplish? It keeps us working our capital to max efficiency per the selected level of initial risk. We reduce position size when account is declining, not increased risk like so many traders do. When account size is growing, likewise is the trade position size.
Now, adverse risk is mathematically contained, to a degree. First & foremost we must be sure our trading approach is what we believe it to be. Gotta have a rather smooth win/loss sequence and favorable profit to-loss-ratio for this scale to work well. The scale will not work if our profits are small and losses large, relative.
The scale is designed to reduce overall capital risk during adverse periods for our protection. Sticking with a static number of contracts with account balance at $30,000 and $15,000 alike is far from optimal. Somewhere in that curve, we had too many or too few contracts at work. Imperative to long-term success is adherence to the contract scale, never over-riding contract size to make up for losses during drawdowns. The contract scale will take care of that for us⦠and helps protect (never eliminates) risk of ruin.
<b>One Component Only</b>
This part of managing an account is critical to rapid, methodical growth. It can be detailed as specific amount of contracts (shares) traded on each turn with each new equity point in the curve. It can also be more generalized, like trading five contracts per $10,000 balance and seven at $15k, ten at $20k and fifteen at $30k respectively.
There are some inherent and a few personal self-management points one needs to be aware of. Weâll cover potential downside, pitfalls and limitations in the next visit here. Letâs all digest the basics, first.
In order to trade a small â modest or even large account with most efficiency, correct application of trade size is vital. Along with the contract scale discussed above there are others aspects of managing dollar risk while maximizing weâll add on ahead. This is not the entirety of a mechanical, managed account method I use. It is the basis from which to build on, further details to follow.
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Hope this helps!
Austin</b>
