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Money Management 101

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  • First Post: Jun 17, 2007 10:25pm Jun 17, 2007 10:25pm
As it is mentioned here on ForexFactory, there are three “M”s that each trader should be working on constantly:

Method, Mind, and Money Management. My intention here is to open a discussion about the second “M”.

Almost every trader knows about the importance of Money Management in trading business yet it seems that this concept is not understood and well implemented by majority of traders. There is no doubt that having a sound trading system is vital in trading but is it enough too? Why majority of traders focus heavily on finding the best system and indicator but put less time/energy on learning money management techniques?

I felt that there is a need for some efficient and yet easy to understand text on the subject and decided to take action. Relax I am not going to teach math here, I just want to chat about money management techniques, reciprocate ideas and basically learn by open discussions, because I believe without money management I can never be successful in this endeavor. Hope you guys will find it useful too.

Thanks,

Moh
I want to break out the discussion by talking about profitable systems. How do we know if a trading system that we are trading or going to trade is profitable in the first place?

Mathematical Expectation (ME) is the concept that helps us to determine if a system is profitable in the specific market system that we are trading it or not.

ME (in gambling they call it player’s edge) is the amount you are expecting to gain or lose on average on each trade.

Consider a system that has a 50% chance of winning $2 and 50% chance of losing $1. The ME is computed by multiplying each possible gain or loss by the probability of that gain or loss and then summing these products together.

In this case the ME for the above system would be:

(.5 * 2) + (.5 * (-1)) = .5

meaning the ME is gaining 50 cents per trade. This principle explains why systems that try to change the sizes of their trades relative to the number of wins or loses are not successful. The summation of negative trades is always negative. So the first fundamental thing to remember when designing a system is having a positive mathematical expectation. If your system has a negative ME all the money management techniques of the world is useless. In the next post I am going to talk about the degree of freedom and its effects on ME.

Thanks,

Moh
I truly believe that any successful trading system apart from being mechanical or not needs to have some sort of decision-making capability. Ideally you would have an intelligent system that can learn from its past experiences and gradually evolve but more on that later.

Your trading algorithm would have at least one type of parameter, trigger, whatever you want to call it to generate a buy or sell signal. In addition you usually incorporate another parameter or trigger to get you out of the market either with profit or some loss. The point is the number of rules and conditions that you can come up with to either get you in or out, or deal with open trades are endless. What you should always remember is every parameter you add to your trading system consumes some statistical freedom.

The key to ensuring that you have a positive mathematical expectation is a high degree of freedom. This is accomplished not only by eliminating, or at least minimizing the number of optimizable parameters, but also by minimizing as many of the system rules as possible. Every parameter you add, every rule you add, every little adjustment you make to your system decreases its degree of freedom.
Mmcimandi, I would have to agree 100% with your last post. The more I stream-lined my "system", fewer indicators, fewer "rules" as you say, the better my system became.

I very quickly discovered, after much trial and error, simplicity is a wonderfully effective "indicator", if you will, in itself! And, as you pointed out, having the FREEDOM! to move and adjust can be an awesome tool to use.
mmmm?

Isn't it Four Ms instead of 3 Ms?
Method
Mind
Money
Management

Seriously, these are some good thoughts that can help us all.
Thanks,
Quoting mtcdavs
Mmcimandi, I would have to agree 100% with your last post. The more I stream-lined my "system", fewer indicators, fewer "rules" as you say, the better my system became.

I very quickly discovered, after much trial and error, simplicity is a wonderfully effective "indicator", if you will, in itself! And, as you pointed out, having the FREEDOM! to move and adjust can be an awesome tool to use.

That is right mtcdavs. The most important effect of this is that you can calculate and measure your mathematical expectation without all those parameters and rules. Only then you can truely determine if this is going to be profitable or not and if you should capitalize on money management.
Quoting KudzuFX
mmmm?

Isn't it Four Ms instead of 3 Ms?
Method
Mind
Money
Management

Seriously, these are some good thoughts that can help us all.
Thanks,

lool. That was a good one kudzufx. Certainly with no Money there will be no Money. Thanks for the comment. Actually I am going to continue talking about lots of topics here. My main goal is to keep it as informative and simple. I will be talking about performance monitoring techniques related to position sizing, deversification and a lot more. And I am sure I can learn alot by guys like yourself.

Thanks

Moh
Human beings vary in nature. Some people tend to be more conservative that’s why their main objective is to cut their losses short. On the other hand there are traders that can tolerate bigger drawdowns. The key is to find the specific strategy that works for you. Just remember if your system has a negative ME it is only a matter of time until you get wiped out. Give your system some space. It really doesn’t matter how profitable your system is as long as it is profitable, because by using money management techniques you can maximize your rewards but you can never turn a loser system into a winner. Ideally you will have a very primitive and simple system that generates marginal profits. Now you have something you can work on and make it better.

The problem with most traders is that they spend hours on running the system with different rules and parameters to find the best combination. This is completely counterproductive. Instead you should channel your energy towards increasing the certainty of your system because as I said before money management can help you optimize your trading results. And the benefit is it doesn’t matter what instrument or market system you trade. Quite contrary is having dozens of parameters and playing with them constantly to see which combination has performed better in the past. It limits your efforts to only that specific market system.

comments???

Thanks,

Moh
Quoting mmeimandi
What you should always remember is every parameter you add to your trading system consumes some statistical freedom.

The key to ensuring that you have a positive mathematical expectation is a high degree of freedom. This is accomplished not only by eliminating, or at least minimizing the number of optimizable parameters, but also by minimizing as many of the system rules as possible. Every parameter you add, every rule you add, every little adjustment you make to your system decreases its degree of freedom.
Hi Moh,

Welcome to the Factory, and thank you for the excellent initial posts.

I particularly agree with your quote above, and I especially like the part I've highlighted in red. Sometimes, a well turned phrase is all it takes to trigger comprehension. Degree of freedom is indeed an important concept, and I am happy to see someone broach the topic, especially someone with your clarity and eloquence.

Dial
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Quoting mmeimandi
Human beings vary in nature. Some people tend to be more conservative that’s why their main objective is to cut their losses short. On the other hand there are traders that can tolerate bigger drawdowns. The key is to find the specific strategy that works for you. Just remember if your system has a negative ME it is only a matter of time until you get wiped out. Give your system some space. It really doesn’t matter how profitable your system is as long as it is profitable, because by using money management techniques you can maximize your rewards but you can never turn a loser system into a winner. Ideally you will have a very primitive and simple system that generates marginal profits. Now you have something you can work on and make it better.

The problem with most traders is that they spend hours on running the system with different rules and parameters to find the best combination. This is completely counterproductive. Instead you should channel your energy towards increasing the certainty of your system because as I said before money management can help you optimize your trading results. And the benefit is it doesn’t matter what instrument or market system you trade. Quite contrary is having dozens of parameters and playing with them constantly to see which combination has performed better in the past. It limits your efforts to only that specific market system.

comments???

Thanks,

Moh
Moh,

How do you "increase the certainty of your system"? What do you mean by this?

BTW, I find this thread to be very useful and informative. Thanks.
Quoting diallist
Hi Moh,

Welcome to the Factory, and thank you for the excellent initial posts.

I particularly agree with your quote above, and I especially like the part I've highlighted in red. Sometimes, a well turned phrase is all it takes to trigger comprehension. Degree of freedom is indeed an important concept, and I am happy to see someone broach the topic, especially someone with your clarity and eloquence.

Dial
Thanks Dial for your encouraging quote.

Actually I read through your thread on Money Management and learned alot from it.

Thanks again.

Moh
Quoting superalf
Moh,

How do you "increase the certainty of your system"? What do you mean by this?

BTW, I find this thread to be very useful and informative. Thanks.
Hi superalf,

By cetainty of the system I was trying to point to one my initial posts on Mathematical Expectation.

What I mean here is before you even think about money management you need to make sure that your system has a positive ME. Let me give you an example. Suppose you are playing roulette and you bet on one number in roulette. In this case your ME is:

((1/38) * 35) + ((37/38) * (-1) = -.05263.

This means if you bet $1 on one number in roulette you would expect to lose, on average 5.26 cents.

Conclusion is playing this game with this system is doomed to fail. Therefore the only game you have a chance at winning in the long run is a positive ME game. Same is true in trading. If the system that you have designed is a looser in nature (that is, it is loosing money on average per trade) then you cannot employ any money management techniques to save yourself.


I hope this is more clear now.

Thanks,

Moh
Trading is usually assumed to be an “Independent Trials Process”, meaning the outcome of one process is not dependent on the outcome of prior processes. Coin toss is an example of such process.

There are a number of “Position Sizing” methods that use this principle as their cornerstone.

On the other hand, there are some methods that consider trading to be a “Dependent Trials Process”, known as "Martingale” methods. For example decrease the position size after a win or increase it after a loss. These are used mostly in gambling.

As a trader I generally assume that dependency does not exist in the marketplace for the majority of market systems. When trading we will usually be operating in an environment where the outcome of the next trade is not predicated upon the outcome(s) of prior trade(s).

However this does not mean that we have to completely abandon the idea of dependency. We just have to make sure that we fully understand it and exploit it as best as we can in our trading strategy.

Thanks,

Moh
Quoting mmeimandi
...
...If your system has a negative ME all the money management techniques of the world is useless. ...
...
Moh
Hi Moh,

First of all thanks very much for starting this thread. I believe we really need to take MM serious and continue this discussion just like those dedicated to trading systems. I even suggest that FF moderators dedicate a sub-forum to this topic.

Anyway, I've not read all the posts in this thread but as I move along, I'll respond to every post that I feel I have something to add or I have a question to ask.

To begin with I highlighted one of your sentences that refers to the importance of ME or rather Mathematical Expectations. It's good to know that MM is the key to enhance a potentially winning system.

Good Luck,
Al
Quoting mmeimandi
Trading is usually assumed to be an “Independent Trials Process”, meaning the outcome of one process is not dependent on the outcome of prior processes. Coin toss is an example of such process.

There are a number of “Position Sizing” methods that use this principle as their cornerstone.

On the other hand, there are some methods that consider trading to be a “Dependent Trials Process”, known as "Martingale” methods. For example decrease the position size after a win or increase it after a loss. These are used mostly in gambling.

As a trader I generally assume that dependency does not exist in the marketplace for the majority of market systems. When trading we will usually be operating in an environment where the outcome of the next trade is not predicated upon the outcome(s) of prior trade(s).

However this does not mean that we have to completely abandon the idea of dependency. We just have to make sure that we fully understand it and exploit it as best as we can in our trading strategy.

Thanks,

Moh
Great post.Hope to find more good article such this.
Quoting mmeimandi
...
...
The problem with most traders is that they spend hours on running the system with different rules and parameters to find the best combination. This is completely counterproductive. Instead you should channel your energy towards increasing the certainty of your system because as I said before money management can help you optimize your trading results. And the benefit is it doesn’t matter what instrument or market system you trade. Quite contrary is having dozens of parameters and playing with them constantly to see which combination has performed better in the past. It limits your efforts to only that specific market system.

comments???

Thanks,

Moh
I'd like to add that in my opinion a successful system is the one that its parameters do not limit its flexibility.
Quoting mmeimandi
...
There are a number of “Position Sizing” methods that use this principle as their cornerstone.
...
Moh
Could you elaborate?

Thanks
Quoting braveheart
Great post.Hope to find more good article such this.
Thanks braveheart.

Stay tuned. I am going to continue the dependency post in a bit.

Thanks,

Mohammad
Quoting aparsai
I'd like to add that in my opinion a successful system is the one that its parameters do not limit its flexibility.
Al,

You are absolutely right. If using parameters gives your system more alternative ways to enter, exit, etc. by all means go ahead and use them.

My point was about those system that are so tied up in rules over rules that have you say, how on earth this system is going to trade anything.

Thanks,

Moh
Quoting aparsai
Could you elaborate?

Thanks
I am definitely going to write about position sizing in detail. In fact I believe no money management discussion is ever complete without saying something about Position Sizing.

Thanks,

Moh
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