Double or triple your return without increasing risk: sound too good to be true?
The answer is to trade concurrent (or overlapping) uncorrelated positions.
Let me try to explain the underlying mathematical principles, by using a casino based analogy.
Let’s assume that a casino operates one Roulette table, which provides N trials (spins of the wheel) per hour, and that this results, on average, an hourly profit to the casino of X% of its capital base. It should be obvious that, if the casino adds a second table, so that both are operating concurrently, the number of trials per hour will increase to 2N, and hence the profit to 2X%.
From a money management angle, the big question is: does the casino now need to double its capital reserve, in order to maintain the same risk of drawdown?
The answer is “no”, because the risk of drawdown remains unchanged, no matter how many tables are added. Here’s why.
The probability of gain or loss on each individual trial is (of course) the same. Moreover, the distribution curve of outcomes over N trials is unchanged, regardless of the time frame over which the trials are held. As an example, if 100 trials are executed, it doesn’t matter whether we run 1 trial per day, 1 per hour, 1 per minute, or 1 per second, the probability of obtaining a certain outcome (e.g. 10 successive losses) is identical, except that at 1 per second we’re going to reach any given outcome 86,400 times as quickly as 1 per day. Extrapolating, if the 100 trials were executed concurrently, the risk of drawdown still remains the same, while profit or loss will occur 100 times as quickly than if the trials were consecutive. We are simply leveraging time.
Hopefully it is apparent that we can apply the same rationale to trading. By trading two uncorrelated positions concurrently, we (assuming positive expectancy) double return without increasing risk. By trading three positions, we triple return, and so on. However, the key is this: the trials must be completely independent of each other, i.e. the outcome of one trial must in no way influence on the outcome of another. In other words, 0% correlation.
-- Trading ten simultaneous positions that are 100% correlated, with 2% risk per position, results in a total net exposure of 20%.
-- Trading ten simultaneous positions that are 0% correlated, with 2% risk per position, results in a total net exposure of 2%.
This whole discussion again further highlights the fact that money management does not alter expectancy; it simply accelerates or decelerates the rate at which one attains financial freedom, or total ruin. Expert money management on its own is not enough. Like the Roulette game where the casino sets the odds so that it invariably has an edge, one must somehow employ a system of entries and exits that delivers positive expectancy. However, in an activity like FX where price movements are the result of complex “intangibles” like economics and sentiment, then unlike Roulette, the probabilities of each trial outcome can never be precisely calculated.
For more information, read Chapter 8 of Dr Ryan Jones' book The Trading Game: Playing by the Numbers to Make Millions.
The answer is to trade concurrent (or overlapping) uncorrelated positions.
Let me try to explain the underlying mathematical principles, by using a casino based analogy.
Let’s assume that a casino operates one Roulette table, which provides N trials (spins of the wheel) per hour, and that this results, on average, an hourly profit to the casino of X% of its capital base. It should be obvious that, if the casino adds a second table, so that both are operating concurrently, the number of trials per hour will increase to 2N, and hence the profit to 2X%.
From a money management angle, the big question is: does the casino now need to double its capital reserve, in order to maintain the same risk of drawdown?
The answer is “no”, because the risk of drawdown remains unchanged, no matter how many tables are added. Here’s why.
The probability of gain or loss on each individual trial is (of course) the same. Moreover, the distribution curve of outcomes over N trials is unchanged, regardless of the time frame over which the trials are held. As an example, if 100 trials are executed, it doesn’t matter whether we run 1 trial per day, 1 per hour, 1 per minute, or 1 per second, the probability of obtaining a certain outcome (e.g. 10 successive losses) is identical, except that at 1 per second we’re going to reach any given outcome 86,400 times as quickly as 1 per day. Extrapolating, if the 100 trials were executed concurrently, the risk of drawdown still remains the same, while profit or loss will occur 100 times as quickly than if the trials were consecutive. We are simply leveraging time.
Hopefully it is apparent that we can apply the same rationale to trading. By trading two uncorrelated positions concurrently, we (assuming positive expectancy) double return without increasing risk. By trading three positions, we triple return, and so on. However, the key is this: the trials must be completely independent of each other, i.e. the outcome of one trial must in no way influence on the outcome of another. In other words, 0% correlation.
-- Trading ten simultaneous positions that are 100% correlated, with 2% risk per position, results in a total net exposure of 20%.
-- Trading ten simultaneous positions that are 0% correlated, with 2% risk per position, results in a total net exposure of 2%.
This whole discussion again further highlights the fact that money management does not alter expectancy; it simply accelerates or decelerates the rate at which one attains financial freedom, or total ruin. Expert money management on its own is not enough. Like the Roulette game where the casino sets the odds so that it invariably has an edge, one must somehow employ a system of entries and exits that delivers positive expectancy. However, in an activity like FX where price movements are the result of complex “intangibles” like economics and sentiment, then unlike Roulette, the probabilities of each trial outcome can never be precisely calculated.
For more information, read Chapter 8 of Dr Ryan Jones' book The Trading Game: Playing by the Numbers to Make Millions.