David C. Stendahl - Money Management Strategies for Serious Traders

MMoonneeyy MMaannaaggeemmeenntt SSttrraatteeggiieess ffoorr SSeerriioouuss TTrraaddeerrss PPRREESSEENNTTEEDD BBYY DDAAVVIIDD CC.. SSTTEENNDDAAHHLL TThhee IImmppoorrttaannccee ooff MMoonneeyy MMaannaaggeemmeenntt Traders can typically describe the methods they use to initiate and liquidate trades. However, when forced to describe a methodology for the amount of capital to risk when trading, few traders have a concrete answer. Some make vague references to experts that recommended risking one or two percent of portfolio equity on any trade. Others rely on intuition to determine when to increase position size on a particular trade, always risking different amounts. Experienced traders learn that as important as it is to have an effective method to determine when to trade, it is equally important to develop a methodology to determine how much to risk. A trader that risks too much; increases the chance that they will not survive long enough to realize the long run benefits of a valid trading strategy. However, risking to little creates the possibility that a trading methodology may not realize its’ full potential. Therefore, while a positive expectation may be a minimal requirement to trade successfully, the way in which you exploit that positive expectation will in large part determine your success as a trader. This is, in fact, one of the greatest challenges for traders. At RINA Systems, we have had the fortune of working with many experienced traders, and in that process we became increasingly aware of the need for sound methods for applying money management strategies. In fact, it seems that as traders reach a certain level of comfort with a system they begin to realize that a sound money management approach is missing from their trading strategy. Our work in this area has led us to research several strategies for determining position size and ways in which to add to, decrease, and stop out positions. Many of these strategies are well known and readily available in the public domain and others are hybrids that we have built from improving concepts already available. Once you understand the importance of money management, the opportunity to modify many of the well-known strategies to meet your needs is endless. It is our belief that there is really no “black box” formula for money management. That is, different trading strategies and systems require different approaches to money management. In RINA Systems, Inc. Ó 1999 Page 2 addition, we must always consider the trader’s ability to implement a money management strategy given their tolerance for risk and other psychological factors. For example, several strategies that emphasize optimizing the amount of capital to invest often deliver substantial drawdowns. Few traders are comfortable suffering through a drawdown of fifty, sixty, or seventy percent, which is not unheard of for some aggressive strategies. Therefore, it is essential to match the theoretical drawdown with the traders risk tolerance. Finally, and not insignificant, is that a trader’s capitalization may effect their ability to execute a strategy. Even in cases where it might be preferable for a system to utilize a money management strategy, an undercapitalized trader may be unable to implement the strategy due to lack of funds. In this situation the trader would be unable to derive the potential benefits of the strategy. Therefore, apart from the effectiveness of a particular strategy on a given trading methodology, there are two important variables: the psychological preferences of the trader and their level of capitalization. If either of these two factors do not support the money management strategy employed, then it is unlikely the trader will be able to use the strategy effectively. Though seemingly insignificant, this point cannot be overemphasized because as many strategies are developed over large histories of data (in many cases 10 or 20 years of data). The trader needs to have the confidence to remain with the strategy even if positive results do not come immediately. We believe that you will benefit from the strategies presented in this workshop. In addition, we hope we will create a greater awareness to evaluate what type of money management system you are using. Hopefully, we will spur your imagination when thinking about ways in which to use money management. We find that many traders focus too much of their creativity on their trading logic. They would be well advised to devote some attention to determine position size if they are going to take full advantage of their trading methodology. It should be noted that all traders are using some form of money management. Some, though, are not conscious of what type of strategy or method they are using and simply trade by the seat of their pants. Other traders use thoroughly tested strategies to determine position size as well as when to add or liquidate positions which are consistent with their risk tolerance. It is our hope that you will find yourself among the latter group. RINA Systems, Inc. Ó 1999 Page 3 WWoorrkksshhoopp GGooaall The goal of this workshop is to explain the process by which traders can develop, evaluate and ultimately improve the performance of trading systems based on money management strategies. These improvements must be based on an individuals risk tolerance and trading psychology. At RINA Systems we have developed an evaluation and improvement process to address these issues. We believe that money management does not exist in a vacuum. This means that it is essential that your money management strategy be integrated into an overall approach to system design and development. Therefore, before we move directly into the application of various money management strategies we will focus on some elementary issues concerning system design and testing. We believe this is an essential component in our approach to money management. To provide you with an adequate foundation to apply money management we will take you through the necessary evaluation stages that MUST precede the application of any money management strategy. It is a requirement that the trader sufficiently understand a methodology before attempting to improve its performance. The trading systems used in this presentation were provided by Advanced Research and Training. For more information concerning these systems contact them at 888 278 0037 or visit them on the web at www.advancedrtllc.com . To assist in the evaluation process we will use Portfolio Evaluator developed by RINA Systems. Contact RINA Systems at 513 469 7462 or on the web at www.rinasystems.com for more information concerning our products and services. WWoorrkksshhoopp OOvveerrvviieeww · Evaluate our Yen trading system in an effort to determine the level of risk associated with trading this system. · Determine the stability of the system to apply a variety of money management strategies in an effort to improve trading performance. · Perform the same evaluation and money management analysis on our Corn trading system. · Combine our two trading systems into a portfolio for further analysis. Each step in the evaluation and money management stage will be fully disclosed to ensure that every trader has the ability critique and improve trading performance. RINA Systems, Inc. Ó 1999 Page 4 BBrreeaakkoouutt TTrraaddiinngg oonn YYeenn System Description: This system buys or sells the Yen based on market breakouts. If the close breaks above a set look back period the system buys the market. If however the system experiences a close below a set look back periods the system generates a sell signal. The system looks for other market conditions, not described, which go beyond the scope of this presentation. This trend oriented system trades on a frequent basis generating trading signals that are highly profitable and efficient. Yen System RINA Systems, Inc. Ó 1999 Page 5 SSyysstteemm AAnnaallyyssiiss SSeeccttiioonn This section centers on the overall performance of the trading system. This is more of a general snap shot of the total system and should be used to gauge the system’s total performance. It should however not be used exclusively to determine the true worth of a system. System Analysis Exhibit This system is very profitable and extremely efficient given a number risk reward calculations. Pay close attention to Net Profit, Percent Profitable, Profit Factor, Return Retracement Ratio, Sharpe Ratio, K-Ratio, RINA Index and Select Net Profit, these calculations in particular describe the system overall true worth. RINA Systems, Inc. Ó 1999 Page 6 TToottaall TTrraaddee AAnnaallyyssiiss The goal of this section is to evaluate the overall performance of the system by critiquing each trade in general as well as from an optimistic (run-up) and pessimistic (drawdown) perspective. Run-up is defined as the system’s maximum profit potential during the course of a trade. Basically it’s the opposite of drawdown. The greater the run-up the better the performance, assuming the system captures the majority of the move. Drawdown, on the other hand, is defined as the system’s maximum loss potential during the course of a trade. The greater the drawdown the more pain experienced by the trader By measuring these risk reward tools an individual trader can value a system’s profitability in relation to risk. The experience of trading in real time is far different than watching from the sidelines. Unless a trader actually lives through an adverse trading experience, it’s difficult to say how they may react. The best we can offer is an evaluation of both risk and reward to prepare for all possible situations. Total Trade Analysis Exhibit Pay close attention to the systems stable Average Trade, Run-up and Drawdown figures. These particlur calculations describe a very stable system suitable for a variety of different money managemnt strategies. RINA Systems, Inc. Ó 1999 Page 7 TToottaall TTrraaddee SSttaabbiilliittyy Total Trades: Graphs the systems Profit in $ vs. Trade Number for all trades. Blue line stands for the average profit/loss. If applicable, large balls, green (positive) and/or red (negative) appear if the system has outlier trades. Trade 90 on this graphic is a positive outlier. Notice how the trades cluster in and around the bold average trade line. The more clustered the trades the lower the Coefficient of Variation for the average trade. A low Coefficient of Variation signifies a sense of stability to the total trade number. Total Trade Stability Exhibit Notice that dispite the one outlier trade (Trade 90) the majority of the remaining trades are extremely stable. Stability is the key to improving performance through money management strategies. RINA Systems, Inc. Ó 1999 Page 8 AAnnnnuuaall TTrraaddiinngg SSuummmmaarryy This section expands upon the general overview of systems trading performance. In the previous sections the evaluation tools measured performance from the start to end during the test period. The next step is to examine the system over various time periods to ensure consistent performance. After all, what good is a winning system if a trader fails to follow it after its first loss? Remember consistency breeds confidence. A mark-to-market is performed at the end of each test period resulting in a complete and through performance evaluation. Annual Trading Summary What does Mark-to-Market mean? Mark-to-Market is another term for closing the books at a certain time. If a Mark-to-Market is performed on a monthly basis, it means the account is officially closed at the end of each month. It is similar to receiving an account statement from your broker with a bottom line on all open and closed positions. This is important because without a Mark-to-Market it would be impossible to know where profit or losses are to be allocated. Take for example a trade that makes 30% and that begins November 1st and closes January 15th the next year. The Mark-to-Market allocates the proper percentages to each month as a posed to the entire amount at the end of the period. Without this simple accounting function it is impossible to have a thoroughly and complete evaluation. RINA Systems, Inc. Ó 1999 Page 9 MMoonntthhllyy TTrraaddiinngg SSuummmmaarryy This section examines trading performance from a monthly perspective. The graphic below performs a monthly mark-to-market analysis, allowing traders to see their exact profit/loss statement on an on going basis. Monthly Trading Summary Notice that the system is able to link together a number of profitable months in a row while limiting the number of losing months. These periods of extended profitability give money management strategies greater flexibly to increase trading performance. RINA Systems, Inc. Ó 1999 Page 10 EEqquuiittyy CCuurrvvee AAnnaallyyssiiss Viewing a system’s equity curve can also provide some additional insight into its performance. Equity curve charts tally a system’s individual trades to present a time line of trade-by-trade results. The charts examine the same basic monthly, annual or rolling period information as in the Trading Summary, but in a graphic format. A quick review of an equity curve chart can provide the necessary mental security to trade a system. Until a trader sees a system’s equity curve, he or she will never know what’s really at stake. Detailed: This graph offers greater insight into trading performance than a general equity curve graph. It displays net profit on a bar-by-bar basis revealing equity drawdowns and run-ups. Flat or non-trading periods are also shown to present a detailed overview of equity performance. Detailed Equity Curve Notice how steady the equity curve is over the nine year period. Trading systems that exhibit this degree of performance are more accepting to aggressive money management strategies. RINA Systems, Inc. Ó 1999 Page 11 EEqquuiittyy CCuurrvvee AAnnaallyyssiiss ccoonntt.. Underwater: This graph serves as a pessimistic review of equity performance over time. Each black vertical bar represents a new equity high based on monthly data. The negative curve between equity peaks represents the percent retracement from the previous high. In realistic terms this graph details the pain and suffering experienced by the system over time. The duration and magnitude of monthly drawdowns are graphically illustrated in a single equity graph. For additional information refer to “Schwager on Futures: Technical Analysis” by Jack Schwager. Underwater Equity Curve Every trading system expereinces some form of underwater equity curve loss. What is important to notice is the magnitude and duraction of the drawdown. We will use this graphic at the portfolio level to match trading system that off set periods of loss with gain to create well balanced trading portfolios. For more information concerning the Underwater Equity Curve refer to the article Staying Afloat by David Stendahl in the Summer 1999 issue of Omega Magazine RINA Systems, Inc. Ó 1999 Page 12 WWiinnnniinngg ((LLoossiinngg)) TTrraaddee AAnnaallyyssiiss These two sections center on the systems winning and losing trades. The same statistical measures used for total trades are used again on winning and losing trades to fine tune the evaluation process. This section analyzes how a system performs during and after winning (losing) streaks. This information is best used to potential filter out trades or as a measure to add to positions. The goal is to try to add or liquidate positions as the system enters into a winning or losing streak. Winning Trade Analysis Losing Trade Analysis RINA Systems, Inc. Ó 1999 Page 13 TTiimmee AAnnaallyyssiiss This section centers its evaluation strictly from the standpoint of time. The use of time is essential to properly evaluate a trading system. This form of analysis can be used on the entire system or on its individual trades. In either case, time-in-the-market is considered a measure of risk. The longer a position is exposed to the market, the more risk it assumes. Time Analysis Exhibit RINA Systems, Inc. Ó 1999 Page 14 MMaaxxiimmuumm AAddvveerrssee EExxccuurrssiioonn The Maximum Adverse Excursion strategy allows traders to set a stop limit based on a set dollar drawdown level. Once a trade reaches the dollar stop, the strategy liquidates all contracts associated with the trade. John Sweeney, Technical Editor of Technical Analysis of Stocks and Commodities magazine, introduced the concept of Maximum Adverse Excursion (MAE). The strategy was designed to help traders determine appropriate stop levels for trades based on historical testing. Essentially, the strategy evaluates each trade to determine a level of drawdown at which trades typically do not recover. Systems always have some form of drawdown; MAE attempts to differentiate between normal and abnormal drawdown levels. Like support and resistance lines in technical analysis, once the MAE drawdown level has been broken, the trade typically will not recover. Of course, it is possible for a trade to experience an abnormal drawdown only to recover to make a profit. These trades are rare at best and aren’t worth the risk to continue with the trade. For more information on this strategy, refer to Campaign Trading and Maximum Adverse Excursion, both by John Sweeney. MAE Exhibit RINA Systems, Inc. Ó 1999 Page 15 Maximum Adverse Excursion (MAE): This graph is best used to determine intelligent protective money management stops for a trading system. It graphs each trade’s realized profit/loss vs. drawdown in a scatter graph format. The green up arrows represent winning trades and the red down arrows losing trades. Look to place a protective stop in an area that captures the majority of winning trades while simultaneously limiting the systems exposure to large drawdowns. For more complete information concerni