Half-Baked Money Management (or, "How to Not Lose Your Shirt")

And thus this thread comes into existence.

The ideas presented here are my beliefs. I have adopted many of them from Van Tharp, many of them from his outstanding book "Trade Your Way to Financial Freedom." As Dr. Alexander Elder writes in his book "Come Into My Trading Room":

I find Van K. Tharp's writings to be imminently clear, even when he goes into technical detail and mathematical calculations. His way of thinking is logical, and it vibes well with me. Thus, my beliefs have been greatly influenced by his. He does not pull a lot of stuff out of the air and try to convince people of a particular way--he is very open in his thinking and rather presents logical information that the reader can draw their own conclusions from.

Much of the information in the following few posts will be based on his ideas and beliefs, and I present them to you here for your consideration. I am only skimming the surface, and highly encourage you to read his book mentioned above--do not be fooled by the commercial-sounding "financial freedom" in the title. This book is the real deal, and it will likely change your trading life forever. If nothing else, just go to the bookstore and read the first chapter. Chances are you won't be able to walk out of the store without it.

One more thing--nothing here is really complex or new to the world. Some people will read it and say, "well, duh." But my hope is that some will read it and say, "I had not thought of that before--maybe I can use this."

I will keep this thread closed for a few days after this initial post so I can have time to post some things, and then will open it up for public posting.

I have adopted two of Tharp's beliefs as my own, and these have forever changed my outlook and perspective on trading:

1) Trading is 100% psychological
2) Position sizing is the most important aspect of any trading system, because only it can help us meet our objectives

As for the first belief, if yours differs, I encourage you to read Mark Douglas' book "Trading in the Zone" and challenge your own beliefs on this. It is 100% on psychology, and is beautifully written.

With the second belief, the immediate confusion comes from the fact that most traders, including forex traders, really don't know what a trading system is. See for yourself in the "Trading Systems" section of ForexFactory. You will see a plethora of "systems," many of which primarily focus on entry. A few more focus on exit. However, hardly ANY will focus on position sizing, or how much to risk. Instead, you get some vague, no-brain answer like "enter with 3 lots, take off 1 lot after 50 pips profit, take another lot at 100 pips, and let the last lot trail." Later we'll see why that's a quick way to lose your shirt.

Most systems you see touted as systems primarily focus on one thing: being right. As Douglas says however, "the best traders are not trying to be right or trying to avoid being wrong." Who cares if you're right or not? Can you buy a house with "I was right on that trade!"? Of course not. Can you go to your local grocery market and buy milk with a good win/loss ratio? No! Equity, money, moolah, capital, greenbacks, benjamins--whatever your word for money is, that should be what we primarily focus on increasing. That is why position sizing is so important, and why so many traders lose, and why they do it so quickly--a lack of focused attention on how much they trade with.

A system has two primary components: expectancy and position sizing.

When it comes down to it, trading is really only a game of probabilities--nothing is for sure in trading. You do NOT know what will happen next. Let me repeat that, and see if it harmonizes with your own beliefs. No matter how confident you are in yourself, in a setup, or an entry, the market does NOT care what you think, and you can be wrong at any time. However, just as card games are based on probability, good players can still win, because they find an edge and exploit that. Expectancy tells us the probability, given our past history, of how much we can expect to win or lose on any given trade.

It tells us how well we can expect a system to perform; note, this is NOT how much money we can make; it is simply how well the system works. Expectancy is the average return per trade as a multiple of the initial risk on the trade. Here's how we get expectancy. On any given trade, we determine upfront the initial risk, whether that be in pips, ticks, points, or whatever you like. We will call this amount "R," for "Risk." When the trade is over, we calculate profit or loss as a multiple of R by dividing the profit or loss by the initial risk. So, if our stop loss was 50 pips, and we made a profit of 75 pips, then our R-value for this trade is 1.5R (we made one and a half times what we risked to begin with). If, given a 50 pip stop loss, we wound up with a 20 pip loss (we moved our stop as the trade went out way, but we still had a loser), then our R-value is -0.4R.

After recording this information for many trades, add all the R-values up and then divide by the number of trades to get the average R-value. This is the expectancy. Expectancy tells us the average profit or loss on a trade as a function of how much we risked. An expectancy of 2.5R would mean that on average, we will make two and a half times what we risk on a trade. An expectancy of -0.5R means that we lose half of what we risked on average--better than a full loss, but not a profitible system.

Once we have our expectancy, we calculate how often our system produces a trade. Given two systems, one with an expectancy of 2.5R and another with 0.5R, which one would you rather have? Well, that depends on opportunity to trade. If the 2.5R system produces one trade per week, but the 0.5R system produces two trades per day, or ten trades per week, in one week our 2.5R system will have given us, on average, a one 2.5R trade. But the 0.5R system will have given us ten 0.5R trades, for a total of 5R, producing double what the 2.5R system produced.

This is expectancy.