Money Management – Getting the trading edge

Money management is a method taken from gambling theory and it is a strategy used reduce
the risk of losing all your money whilst maximising your profits. This is accomplished in trading
by assessing the number of markets you are trading, their dependence on one another and
the amount invested into each market. Money management is especially important in
drawdown periods, which are inevitable in any trading system, where your account loses
money before making new highs.

Therefore, money management is a decision you make about finding the best point between
what you are happy to risk and the profit you are happy to leave on the table. Money
management is more personal than many realise. You need to sit back and ask yourself the
question, “am I able to carry on trading when I am down X%”.

The principles governing money management

This section of the guide will highlight the main principles that influence your money
management strategy and in turn determine your likely drawdown and profit potential.

1. Position size, or % risk per trade.

The chart below is based on the historical back testing of one of our trend following trading
system. It illustrates the effects of changing your position size, in terms of % risked per trade,
on the drawdown you are likely to experience during future trading. Notice how as you risk
more and more of your account per trade, the closer you are to forcing your account to reach
$0.00 (or 100% drawdown). Based on the back tested system we trade; our accounts would
eventually hit zero when our risk per trade is at approximately 8%. This is because the position
size is so large that you would lose your entire account before you reached a profitable period
again.

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 How position size effects drawdown
100% Account blown at 100% drawdown
90%
80%
Drawdown (%)

70%
60%
50%
40%
30%
20%
10%
0%
0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00%
Position Size (% risk per trade)

However, increasing the % risked per trade increases the profitability of your trading. The
chart below illustrates the compound annual growth rate (CAGR), essentially the average
annual percentage return, of the same trading system for various position sizes. For example,
choosing a % risked per trade of 5% will provide you with a CAGR of 160%, this kind of return
would make you extremely rich.

However, looking back at the first graph above, you can see that a 5% risk per trade means
you would reach a point where you are likely to lose 80% of the value of your portfolio. In
addition, as this data is based on back testing, which is only a model and does not guarantee
future results, there could be a situation in the future where your maximum predicted
drawdown is exceeded. As 80% is dangerously close to 100% drawdown, this could mean the
end of your account.

This again highlights why choosing your position size is a personal choice. Our trading systems
have a position size which provides us with a maximum possible drawdown of 50%. This
allows us to gain a good CAGR, whilst minimising the chance our drawdown will reach 100%.
In addition, from experience we have found we are able to deal with losing 50% of our
accounts and continuing to trade. Many people would not have the discipline to handle a
period like this, so be honest when you think about what level of drawdown you are
comfortable with.

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 How position size affects CAGR
200%
180%
160%
140%
CAGR (%)

120%
100%
80%
60%
40%
20%
0%
0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00%
Position Size (% risk per trade)

2. Psychology

Much of this is discussed in our specific trading psychology guides, but essentially this is a
trader’s capacity to keep on trading through drawdown periods. You may think you are happy
with a 70% drawdown, but ask yourself if you could keep on trading if your account reached
$100,000 and then subsequently fell back to $30,000.

3. Market Diversity

This is the principle of distributing your money across a range of unrelated markets;
essentially don’t put all your eggs in one basket. One simple method to achieve diversity is by
choosing unrelated foreign exchange pairs. For example, choosing AUDUSD and CHFJPY.

The table below shows the dependencies of a few currency pairs. Where a correlation factor
of 1 means the currency pair moves in completely the same direction, a factor of 0 means
there is no correlation between the currencies and a factor of -1 means the currencies move
in exactly the opposite direction.

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 Adapted from http://www.forexhit.com

You can see this clearly on the charts. Let’s take GBPUSD and EURUSD as an example from
the table above and check the dependence on the charts. You can see from the chart below
that it is common for these two currency pairs to follow each other’s movements, they
correlate with one another, therefore the correlation factor is 0.90 as explained in the table
above. This is good when both currency pairs are trending as you will be making trading profit
in both markets from your trend following strategy. However, when both markets are
consolidating, it will be as if you are losing twice in the same market as the correlation
between these pairs is so high.

To counteract this phenomenon choosing a variety of currency pairs and commodities is

necessary to promote market diversity. A variety of markets with correlation factors from 1
to -1, not just currencies with all 0’s, 1’s or -1’s. Have a few, but not too many, markets with
factors close to 1’s or -1’s is absolutely fine as this adds profitability, assuming your risk to
reward is above 1:1 (explained later), to your system when a certain currency is trending.

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Another method of creating system diversity is to choose different classifications of markets,
not just foreign exchange markets. There are two primary market types which you should
look to incorporate in to your portfolio.

A. Fundamental Driven Markets: These are foreign exchange markets where trading is
not the predominant reason why the price moves. This main reason price moves is
related to larger macroeconomic forces.
B. Speculator Driven Markets: These are markets related to stocks and commodities in
which trading speculation has the overriding effect on price movement.

Because of this, in our trading strategies, which can be found in our systems guides, we invest
in both commodities and foreign exchange markets to ensure classification diversity.

One last point to mention is that during system testing it is likely you will find a market which
is not profitable over the testing period. So, should you remove or keep this market in your
portfolio? Markets change as their underlying fundamentals change and when speculator
opinions change. Therefore, in your testing period this market could be the worst performing
market but in the future, it could become the best traded market in your portfolio. Think of
the markets as dynamic, they will change, and the way to remain adapted to this change is
through diversification.

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Risk to Reward

Risk to reward is another extremely important factor in trend following strategies. It

underpins our teachings in the other guides, especially our stop loss, exit strategies and
drawdown guides. Risk to reward allows a system to be extremely profitable without that
same system having a good win %, where these systems can easily make profit when the win
rate is as low as 35%.

We will revisit the histograms from the loss aversion guide to explain this phenomenon. These
histograms are based on our own back tested system using 2,268 trades over a period of
almost 15 years for 22 different markets. As you can see there are 1,247 losses and 1,021
winners giving a win rate of 45%. On first glance this system looks like it would not make any
profit as you would lose more times than you would win.

However, your loss is capped at -$100 because you are an intelligent trader and you have set
a stop loss which you would never change. Let’s pretend, for this example, your account size
is $10,000, so this is a risk of 1% of your account each trade, a very sensible risk level. You also
have an exit strategy which allows you to take more profit than your initial risk amount of
-$100. Therefore, you can take profits in the region of $50 - $950 as shown below. This is how
risk to reward works. Say your next trade makes a profit of $300, that is a risk to reward of
$300:$100 or 3:1 (convention tells us to call it risk to reward when its actually the opposite
way around). This means you have gained back 3 losses. This allows you to lose more trades
than you win, because you make much more profit when you win than when you lose with
other trades that close due to your stop loss with the predetermined risk level of -$100.

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Now let’s look at this on a larger scale in terms of actual profit gained over the trading period
for the same system. As I mentioned the win % is 45%, meaning you lose 55% of the time. The
profit lost in this system is therefore any trade which closes below $0.00. Here there is $8,000
lost by trades which close between -$100 and $0.00 and $103,000 lost by trades due to the
trade being closed at the stop lost using the predetermined risk level of 1%. Therefore, the
total lost without position scaling is -$112,000. This is why losing is so hard to deal with, see
our psychology guides for more on how to handle this.

However, because we are letting the potential maximum equity gained per trade exceed the
potential maximum equity lost (i.e. the risk to reward is bigger than 1:1) the system can make
an extremely good profit even though the win % is below 45%. Our unscaled net profit,
basically the sum of all the categories, is $43k. When scaled this ensures the $43k is
transformed into millions.

The can be confirmed by using a quick example. Notice that in the trade distribution graph
above, the number of trades that made $250 was 103 total trades. This number looks
insignificant when compared to the number of trades than turn a profit of $100 and even
smaller when compared with the 1,027 trades that are stopped out. However, look at the
profit distribution chart below, the trades which make $250 have the greatest effect on the
profitability of the system. This is because they offer a risk to reward of 2.5:1. This risk to
reward means that a mere 103 trades can generate $23,000, clearly showing the power of
holding your stop loss, allowing your profits to run with an exit strategy and using the risk
to reward to your advantage.

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Position Scaling

As mentioned in the previous section the this system could generate a profit of $43,000 over
a period of 15 years. I think you can agree that this is not life changing or worth committing a
significant amount of time to. This is where position scaling comes into fruition. Position
scaling enables your profits to move from the thousands to the millions.

Position scaling means using your portfolio as a dynamic indicator of the amount of money
you can risk. For this example, let’s use a slightly higher risk level of 2%. As explained, a larger
position size % gives a slightly higher drawdown but also increase the CAGR (compounded
annual growth rate) of the system. Your position size must always remain a fixed percent of
your total portfolio value for every trade. If you choose a risk level of 2% per trade, this rule
must be applied to every single trade (I/e, don’t risk 5% on 1 trade, 1% on another etc.)

For example, let’s say your initial account size on day number 1 of your trading career is
$10,000, therefore at 2% risk the amount you risk per trade is $200. Now let’s assume some
of the trades you are currently in make profit and you make $1,000 in a day. Therefore, any
new trades you place on day number 2 must have a risk value of 2% of $11,000. Your new risk
per trade is $220. To ensure you scale your position effectively you need to update your equity
each day and recalculate your risk per trade. Luckily, you can do this easily in our Trade
Tracker we provide you, but be sure to update the equity value every day you make a trade.

The graph below allows you to visualise the difference between having fixed risk amounts and
using position scaling. For an unscaled system, we can assume that the final profit would be
$86,000, as we are using a constant risk per trade of $200 as opposed to $100 in the previous
example. Scaling the position size with a 2% risk per trade produces a final profit of
$15,000,000. This confirms the power of position scaling.

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Price Shocks

Price shocks are rare events due to a sudden change in supply and demand. Often ignored by
many traders as abnormalities in trading and something one should not worry about.
However, these price shocks can completely wipe out your account if you are using a position
size which is too high. We do not ignore these rare events and understand that our position
size needs to account for sudden price shocks.

Price shocks are dangerous on weekends, market holidays and contract rollovers/expiry’s.
Just because the market is closed, does not mean the price will remain the same over the
weekend or holiday. If a big event happens on the weekend the price can gap up or down (see
gap guide). Your stop losses are next to useless over the weekend and will not close your
position at your predetermined stop loss price. Therefore, your exposure is larger than 2%, or
whatever you’ve chosen to be your risk per trade.

The chart below illustrates this problem. This is the chart for CHFJPY, with a big price shock
on the 15/01/2015 resulting from the unpinning of the Swiss Franc from the EUR. Although
this did not occur over the weekend, because the price moved so fast at the time, there was
significant slippage (the difference in price between your stop loss and you’re actual close out
price). We can therefore use it as an example. Let’s say you entered a sell trade on the
Bollinger break out at a price of 115.58 and you set a stop loss at 118.00 with a $100 risk. This
is a pip risk of 242 pips, or $0.41 per pip. The price shock then happens two days into the
trade and your stop loss is missed (assuming it’s a weekend). The price is suddenly at 138.00

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or a 2242 pip loss. This equates to a loss of $926. This is 9.3 times bigger than your initial stop
loss which completely ruins your risk to reward edge.

Actual loss due to shock: 2242 pips or $926

Risk: 242 pips or $100

Sell at 115.58

However, as these events are rare, especially over weekend, to counteract price shocks our
systems are initially designed to have a maximum drawdown of 50%. As mentioned at the
start of the money management guide, position size is the easiest method to control
drawdown size and reduce risk associated with price shocks. More recent examples of price
shocks include Brexit and the Donald Trump winning the US Election.

In addition, market diversity comes into to play here. This example was common for all CHF
currency pairs. Imagine a system which included 5 currency pairs all with CHF as part of the
pair. If each pair also lost $926 you would lose $4,630 in a single day. Next assume your
account size is $10,000, this is an almost instant 50% drawdown. Therefore limiting the
number of currencies in your portfolio to a maximum of 2-3 can prevent your account being
destroyed in a single day.

On the flipside, price shocks can also work in your favour, if you are positioned in the same
direction, and can result in a huge profit in a short period. Since price shocks are, by definition,
unpredictable events, do not let their existence deter you from trading. Provided you have
good money management, through position sizing and diversification, you should live to trade
another day and these may actually present opportunities. For example, during the US
election we were positioned on the wrong side of the price shock. However, as we traded the
price action during the market panic, we actually made 40% on our account in a single day
(instead of losing 20%).

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Pyramiding

Pyramiding is essentially the technique of adding more positions as the market moves in your
favour. Each position subsequently added has less risk than the initial position when you first
entered the trade. This is best explained using examples so let’s look at the charts.

Let’s assume this system has a maximum number of 3 available pyramids, and each pyramid
level (new position) is added after a single stop loss width i.e. the price width between the
entry price and the stop loss. The initial position is $100 of risk, the second position is $75 of
risk and the final position is $50 of risk, hence you are pyramiding the position size. Once the
profit exceeds a stop loss width you enter a new position, position number 2. You then move
the stop loss of position 1 to the entry price of position 1, therefore removing any risk you
had in position 1. Let’s break this down using the chart example below:

1. Enter a buy position on the Bollinger break out at a price of 106.75 with a $100 risk.
You set the stop loss at 105.00 giving you a value of $0.57 per pip of your position.
Note that because you set your stop loss at 105.00 your stop loss width is 1.75. As you
are pyramiding after a stop loss width your next pyramid point is 106.75 + 1.75 =
108.50. You first position should be at +100% profit at this level.
2. The price then exceeds the 108.50 mark and you add your second position with a $75
risk. The stop loss width is the same giving you a stop loss for position number 2 which
is the same as the entry price for position number 1, 106.75. This gives you a per pip
value for position number 2 of $0.43 per pip. However, you are now exposed by $175
due to the two position, position 1 & 2. To counteract this, you would move the stop
loss of the first position to the entry price of the first position, so move it from 105.00
to 106.75. This would move the risk on your first position from $100 to $0. This is the
advantage of pyramiding because now you have 75% of the initial risk and one position
already in profit with a second position looking to further to profit per pip.
3. This process is then repeated for the third and final position. The third position will be
entered at 110.25 with a stop loss of 108.50 and a risk for this position of 50$. This
gives a per pip value of $0.29 per pip. The stop loss of position one and two is then
moved to the entry price of position two (or the stop loss of position three) which
removes any risk associated with both positions one and two. Once the third position
is added you have half the initial risk and have already made profit from the first and
second position. All this is illustrated in the graph below.

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1st =567 pips 2nd =392 pips 3nd =217 pips

3rd position: Buy at 110.25

2nd position: Buy at 108.50 & 3rd Position stop loss: 175 pips risk of $50

1st position: Buy at 106.75 & 2rd Position stop loss: 175 pips risk of $75

1st position stop loss at 105.00: 175 pips risk of $100

There are however disadvantages to pyramiding. The first being that each new position you
add increases your average price. If you take the previous example your weighted average
price by the time you enter the third position becomes:

106.75 ∙ $100 + 108.50 ∙ $75 + 110.25 ∙ $50

= 108.10
$100 + $75 + $50

This means the price you enter, on average, is worse than simply entering the initial position,
at a price of 106.75, with a larger risk. Furthermore, as you are moving your stop loss each
time, you run the risk of being stopped out of all your positions and missing the move entirely.

Pyramiding also locks up more of the capital in your portfolio because you have to purchase
three positions at a lower average price. The lower average price means you need more
capital to produce the same amount of profits. This can be explained with a simple example.
For the pyramid example above, you would have made $554 in total from all three position
and to do this you would have used $225 of your portfolio. If you wanted to only use a single
position you would only need to $171 to produce the same profit of $554. By not pyramiding
you free $54 of your capital to make profit in other markets you invest in. This is the main
reason we do not personally use pyramiding in our systems.

Instead, we use correlated markets to produce the same effect. For example, we trade both
EURUSD and EURGBP markets. They are both based on the EUR, and so follow very similar
(but not exactly the same, due to differences between GBP and USD movement) price action.
For any significant trend in the Euro, we will receive an exit signal in both EURUSD and

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EURGBP markets. They may not be on the same day, but the most significant moves will
produce signals in both markets. As such we are effectively pyramiding (adding a position on
the same market for the same trend), but have the benefit of not having to adjust our stop
losses, and also some market diversity associated with the variations between GBP and USD
price movements.

References

Faith C.M., 2007. Way of the Turtle. New York: McGraw-Hill

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