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Two diff MM same result?

  • #1
  • First Post: Dec 2, 2005 3:43pm Dec 2, 2005 3:43pm
Can anybody help me see the differnces between these two money management methods?

a) I have a trading system and I'm willing to lose up to $5,000 on a $10,000 account. I'll limit my risk per trade to 2%. I'll keep trading until I make $10,000 or lose $5,000.


b) Using the same system, I'll only deposit $5,000 on my account and limit risk per trade to 4%. I'll keep trading until I make $10,000 or lose all, which is $5,000.

To me, these two different money management will produce the same result. For both systems, I risk $5,000 to gain $10,000. Number of lots per trade is exactly the same for both systems since I use 2% risk on a $10,000 account for system (a) and 4% risk on a $5,000 account for system (b).

If these two money management is the same thing, why would I deposit $10,000 on my account? I can gain the same result by depositing only $5,000. Note that I'm only willing to lose up to $5,000 for both methods.

To me this doesn't seem like a psychological difference since I'll either lose $5,000 or make $10,000 in the end.

Any comments will be appreciated!
  • #2
  • Edited 4:27pm Dec 2, 2005 4:20pm | Edited 4:27pm
Quoting jaejmoon
Can anybody help me see the differnces between these two money management methods?

a) I have a trading system and I'm willing to lose up to $5,000 on a $10,000 account. I'll limit my risk per trade to 2%. I'll keep trading until I make $10,000 or lose $5,000.


b) Using the same system, I'll only deposit $5,000 on my account and limit risk per trade to 4%. I'll keep trading until I make $10,000 or lose all, which is $5,000.

To me, these two different money management will produce the same result. For both systems, I risk $5,000 to gain $10,000. Number of lots per trade is exactly the same for both systems since I use 2% risk on a $10,000 account for system (a) and 4% risk on a $5,000 account for system (b).

If these two money management is the same thing, why would I deposit $10,000 on my account? I can gain the same result by depositing only $5,000. Note that I'm only willing to lose up to $5,000 for both methods.

To me this doesn't seem like a psychological difference since I'll either lose $5,000 or make $10,000 in the end.

Any comments will be appreciated!
The difference is leverage. http://dx4dummies.com/images/smilies/nunu.gif

In (a), with $10,000 in your account, 2% risk is $200. Assuming a fixed stop of 20 pips and trading micro lots on the EUR/USD, each pip is worth $0.10. Times 20 pip stop = $2.00 per pip. Divided into $200 yields 100 micro lots. And at $1000 per micro lot your position size is $100,000. Therefore your leverage is $100,000 / $10,000 = 10:1

As you pointed out, your position size is the same for either (a) or (b). Therefore the leverage for (b) is $100,000 / $5,000 = 20:1

Conclusion: Option (b) will give you the privilege of losing your $5000 twice as fast!

Yes, yes, I know you will also make $10,000 twice as fast, but that is faulty thinking. Remember, amateurs look at how much they can make. Professionals look at how much they can lose.

I would suggest you scale your percent risk back until your maximum leverage does not exceed 1:1 if you are a newbie, 3:1 if a novice, 5:1 if you have some experience, and 10:1 if you're crazy like me!!! http://dx4dummies.com/images/smilies/icon_wacko.gif

Dial
sxaxlxvxaxtxixoxnxbxyxgxrxaxcxexdxoxtxoxrxgx
  • #3
  • Dec 2, 2005 4:30pm Dec 2, 2005 4:30pm
On the surface, those two strategies are the same. Option B would never be used by an actual trader, though. The whole point of long-term money management (like risking only 2% per trade) is to make sure you have enough money on reserve to continue trading, even if you hit a long losing streak.

I think that the primary difference between the two strategies you present and an actual money-management strategy employed by a professional trader is the determination to give up after a $5000 loss. A trader with a long term strategy would focus on being able to recover from that loss, and he wouldn't be able to do that with the second scenario. Therein lies the fundamental difference between the two.
  • #4
  • Edited 4:40pm Dec 2, 2005 4:35pm | Edited 4:40pm
Quoting jaejmoon
If these two money management is the same thing, why would I deposit $10,000 on my account?
you wouldnt. you would deposit 5k, or as little as needed to trade the system.

as you guessed, your two MM strategies produce the same result. its just a matter of where you put your cash. cash is very valuable because it collects interest, so you want to manage your trading affairs so that as little cash as possible is in the actual trading account (unless your trading account pays interest, which in FX is very rare). some of the considerations are how quickly you can move your cash around and how much leverage your broker will give you.

i dont treat a single brokerage account as my portfolio. i track my trading in Excel, that is where the portfolio numbers are, each of my trading accounts are only a small portion of the total portfolio. heres the trick...when i am doing my position sizing, i do it on the entire portfolio amount, NOT the amount in the brokerage account. this keeps my position sizing very fluid and consistent. you then have to deal with making sure your accounts have enough cash to cover the margin on your trading. thats why leverage is so damn important.

btw, if you are new to trading you will want to follow dial's advice and trade with as little leverage as possible. but when you get serious about your returns, and you have the skill to deal with leverage, than you will want use as much leverage as you can without causing margin call risk.
Relax and be happy.
  • #5
  • Dec 2, 2005 4:40pm Dec 2, 2005 4:40pm
ahhh...i thread about my fav topic, MM. dialist has already told you the difference...there is only one thing i wanna point out. you want a starting balance to be greater than the drawdown you are expecting. if your drawdown is $4000 (a series of loosing traders is a drawdown), then if you have only $5000 in your account, after the drawdown (when the good period comes) your account is handicapped and you have virtually lost all money..and all chances of recovering it. on the there hand if you start with $10000, after the drawdown you still have $6000 to trade with in the good period.

i am myself learning MM. so what i have said might be wrong as well. so anybody feel free to correct me. i want to learn more MM, but the resources are limited.

gabroo
and i grow...pip by pip.......pip by pip!!!!
  • #6
  • Dec 2, 2005 5:00pm Dec 2, 2005 5:00pm
Quoting merlin
you wouldnt. you would deposit 5k, or as little as needed to trade the system.

as you guessed, your two MM strategies produce the same result. its just a matter of where you put your cash. cash is very valuable because it collects interest, so you want to manage your trading affairs so that as little cash as possible is in the actual trading account (unless your trading account pays interest, which in FX is very rare). some of the considerations are how quickly you can move your cash around and how much leverage your broker will give you.

i dont treat a single brokerage account as my portfolio. i track my trading in Excel, that is where the portfolio numbers are, each of my trading accounts are only a small portion of the total portfolio. heres the trick...when i am doing my position sizing, i do it on the entire portfolio amount, NOT the amount in the brokerage account. this keeps my position sizing very fluid and consistent. you then have to deal with making sure your accounts have enough cash to cover the margin on your trading. thats why leverage is so damn important.

btw, if you are new to trading you will want to follow dial's advice and trade with as little leverage as possible. but when you get serious about your returns, and you have the skill to deal with leverage, than you will want use as much leverage as you can without causing margin call risk.
Great post Merlin! I like your method of maintaining your portfolio in excel.

Your post gives me an opening to ask a question. How many multiples of your maximum required margin do you keep in your brokerage account. For example, let's say you routinely use $1500 margin in open trades, but on occassion you may briefly use as much as $2000. So, if $2000 is the max you'll ever use, you still need a little extra unused margin for breathing room. Do you keep 10% more than the max, i.e., $2200, or perhaps 50% more than the max, i.e., $3000?

Another question regarding your comment about having skill to deal with leverage. How much leverage are you talking about here? I'm okay (sorta) with up to 10:1. More than that always gets me pissed off at myself when I lose.

I suspect strongly that this has to do with your ideas on predictable cash flow, with my guess being, the more stable the predictablity, the higher leverage you can use, within the uncertaintly limits imposed by the markets of course.

So, how high do you go, and how do determine that height based on stability of predictable cash flow? (If that's even what you're basing it on)

Dial
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  • #7
  • Dec 2, 2005 7:39pm Dec 2, 2005 7:39pm
Quoting diallist
The difference is leverage. http://dx4dummies.com/images/smilies/nunu.gif

In (a), with $10,000 in your account, 2% risk is $200. Assuming a fixed stop of 20 pips and trading micro lots on the EUR/USD, each pip is worth $0.10. Times 20 pip stop = $2.00 per pip. Divided into $200 yields 100 micro lots. And at $1000 per micro lot your position size is $100,000. Therefore your leverage is $100,000 / $10,000 = 10:1

As you pointed out, your position size is the same for either (a) or (b). Therefore the leverage for (b) is $100,000 / $5,000 = 20:1

Conclusion: Option (b) will give you the privilege of losing your $5000 twice as fast!

Yes, yes, I know you will also make $10,000 twice as fast, but that is faulty thinking. Remember, amateurs look at how much they can make. Professionals look at how much they can lose.

Dial
Sorry Dialist but this is not actually correct. You won't lose your money twice as fast - you will lose it at the same rate!!

If I risk 2% of $10,000 then I will lost $200/trade.

If I risk 4% of $5,000 then I will lose $200/trade.

It then takes me 25 trades to lose the allocated $5,000.

The amount of leverage that you use is not relevant it is the amount that you risk on each trade. I don't know how many times I have said this on this forum!!

In fact, your position sizing would decrease much more rapidly in the second case. After 5 trades in case 1 you would have lost $200, $196, $192, $188 and $184 for a total loss of $960. In case 2 you would lose $200, $192, $184, $177 and $170 for a total loss of $923. This means you actually lose your money slower in case 2 then case 1 assuming that you consider your float to be $5000 rather than $10,000.

Another difference between the difference between the 2 strategies is that you wouldn't be able to lose the full $5,000 in the second example but you would in the first. You would simple run out of margin and not be able to open a new position - it would be pretty much the full $5,000 that you would lose though.

I would suggest the way to handle the situation would to do something like Merlin is suggesting. Put $6k or something in the account and leave $4k in cash in you bank earning interest. Risk 2% of your allocated trading capital (in this case $10k) and keep a running balance of you allocated capital.

Simon
  • #8
  • Dec 2, 2005 8:59pm Dec 2, 2005 8:59pm
Quoting DrRock
In fact, your position sizing would decrease much more rapidly in the second case. After 5 trades in case 1 you would have lost $200, $196, $192, $188 and $184 for a total loss of $960. In case 2 you would lose $200, $192, $184, $177 and $170 for a total loss of $923. This means you actually lose your money slower in case 2 then case 1 assuming that you consider your float to be $5000 rather than $10,000.

Simon
Now THIS is the "real" difference between those two strategies. That's a great insight I haven't seen!! Thanks Simon!!

As DrRock said, for 5 straight LOSING trades, we lose the following amount in series:

Case1 (2% risk per trade on $10000 account) :
-$200, -$196, -$192, -$188, -$184; Total = -$960

Case2 (4% rish per trade on $5000 account):
-$200, -$192, -$184, -$177, -$170; Total = -$923

It shows that you lose less for Case 2.

Now, I have done some calculations and I found an amazing result.

For 5 straight WINNING trades, we gain the following amount in series:

Case1 (2% risk per trade on $10000 account) :
+$200, +$204, +$208, +$212, +$216; Total = +$1041

Case2 (4% rish per trade on $5000 account):
+$200, +$208, +$216, +$225, +$234; Total = +$1083

It shows that you make more for Case 2. HUH!?? For 5 losing trades you lose less for Case 2, but for 5 winnong trades you make more for Case 2!?? How can this be?? If my math is correct, why would I EVER put $10,000 in my account (with -$5000 drawdown limit) just to make less than what I can make with a $5,000 account??

COMMENTS!!!!!
  • #9
  • Dec 3, 2005 12:46am Dec 3, 2005 12:46am
Quoting merlin
you wouldnt. you would deposit 5k, or as little as needed to trade the system.

as you guessed, your two MM strategies produce the same result. its just a matter of where you put your cash. cash is very valuable because it collects interest, so you want to manage your trading affairs so that as little cash as possible is in the actual trading account (unless your trading account pays interest, which in FX is very rare). some of the considerations are how quickly you can move your cash around and how much leverage your broker will give you.

i dont treat a single brokerage account as my portfolio. i track my trading in Excel, that is where the portfolio numbers are, each of my trading accounts are only a small portion of the total portfolio. heres the trick...when i am doing my position sizing, i do it on the entire portfolio amount, NOT the amount in the brokerage account. this keeps my position sizing very fluid and consistent. you then have to deal with making sure your accounts have enough cash to cover the margin on your trading. thats why leverage is so damn important.

btw, if you are new to trading you will want to follow dial's advice and trade with as little leverage as possible. but when you get serious about your returns, and you have the skill to deal with leverage, than you will want use as much leverage as you can without causing margin call risk.
Merlin, in your reply to the above quote, you mentioned you track your portfolio numbers using excel. Could you assist me with how you actually track it. An excel over view attachment would be grealty appreciated.

"Teach me to pip, and i'll pip for the rest of my life"
  • #10
  • Edited 1:44am Dec 3, 2005 1:32am | Edited 1:44am
DrRock,

Thank you for your insightful post! It made me think a little deeper and I enjoyed that! In fact, at first, I was almost swayed to agree with you that leverage is not relevant. Almost, but not quite.

Case 1:
$10,000 - $960 = $9040
Drawdown = 9.6%
Recovery = 10.62%

Case 2:
$5,000 - $923 = $4077
Drawdown = 18.46%
Recovery = 22.64%

Case 3: (Just for fun :-)
First loss = $625 * 32% = $200 (See? Same amount risked)
After five losses in a row we have
$625 - $534 = $91
Drawdown = 85.44%
Recovery = 587%

WW! In case 3, we lost even less money! Only $534 in five trades!

Now I admit it will take the same number of trades to recover in all three cases. And, as jaejmoon points out, for case two, five winning trades in a row for both cases will result in larger profits for case 2, and really large profits for case 3. Just proves what everyone knows, the larger the risk, the greater the reward. As Ed Seykota says, "How much heat can you stand?" Heat being Ed's word for leverage.

From my viewpoint how many dollars you risk on one trade is only one way of looking at risk. It is also important to consider how much drawdown you are willing to risk to get the greater reward.

Again, Ed Seykota has also said that increasing "heat" will increase reward, but only to a certain point. After that it starts destroying accounts.

And let's not forget the psychological/emotional element. Which is easier to stomach; a larger or smaller drawdown?

DrRock, again I say thank you for your insightful, thought provoking and enjoyable post. But I still say leverage is a relevant risk factor.

Dial
sxaxlxvxaxtxixoxnxbxyxgxrxaxcxexdxoxtxoxrxgx
  • #11
  • Dec 3, 2005 1:35am Dec 3, 2005 1:35am
Quoting jaejmoon
It shows that you make more for Case 2. HUH!?? For 5 losing trades you lose less for Case 2, but for 5 winnong trades you make more for Case 2!?? How can this be?? If my math is correct, why would I EVER put $10,000 in my account (with -$5000 drawdown limit) just to make less than what I can make with a $5,000 account??

COMMENTS!!!!!
Good observation, jaejmoon.

See my post #10 of this thread.

How much "heat" can you stand?

Dial
sxaxlxvxaxtxixoxnxbxyxgxrxaxcxexdxoxtxoxrxgx
  • #12
  • Dec 3, 2005 4:07am Dec 3, 2005 4:07am
Hi,

Thanks to DrRock for a great post on risk and leverage.

Quoting diallist
From my viewpoint how many dollars you risk on one trade is only one way of looking at risk. It is also important to consider how much drawdown you are willing to risk to get the greater reward.

...And let's not forget the psychological/emotional element. Which is easier to stomach; a larger or smaller drawdown?...

But I still say leverage is a relevant risk factor.
I agree with everything except that the risk/drawdown/leverage should be applied to your 'portfolio' of 10,000 rather than the amount the in 'trading' account as mentioned by Merlin.

Case 3 reminds me of <... looks it up...> Randy McKay in The New Market Wizards, where he risk 5-10% of portfolio initially. If he loses that then he'll risk no more than 4%, then 2% and keeps reducing while losing, going from 3,000 contracts to 10 and then back again, varying his trade size by 300:1.

It would be interesting to work out for a sequence of wins and losses if case 3 would be better under any particular circumstances. It's added onto my todo list ... sometime in the New Year It would be great if someone had a go at exploring that before then

Best regards
Alan
  • #13
  • Dec 3, 2005 5:12am Dec 3, 2005 5:12am
Quoting diallist
DrRock,

Thank you for your insightful post! It made me think a little deeper and I enjoyed that! In fact, at first, I was almost swayed to agree with you that leverage is not relevant. Almost, but not quite.

Case 1:
$10,000 - $960 = $9040
Drawdown = 9.6%
Recovery = 10.62%

Case 2:
$5,000 - $923 = $4077
Drawdown = 18.46%
Recovery = 22.64%

Case 3: (Just for fun :-)
First loss = $625 * 32% = $200 (See? Same amount risked)
After five losses in a row we have
$625 - $534 = $91
Drawdown = 85.44%
Recovery = 587%

WW! In case 3, we lost even less money! Only $534 in five trades!

Now I admit it will take the same number of trades to recover in all three cases. And, as jaejmoon points out, for case two, five winning trades in a row for both cases will result in larger profits for case 2, and really large profits for case 3. Just proves what everyone knows, the larger the risk, the greater the reward. As Ed Seykota says, "How much heat can you stand?" Heat being Ed's word for leverage.

From my viewpoint how many dollars you risk on one trade is only one way of looking at risk. It is also important to consider how much drawdown you are willing to risk to get the greater reward.

Again, Ed Seykota has also said that increasing "heat" will increase reward, but only to a certain point. After that it starts destroying accounts.

And let's not forget the psychological/emotional element. Which is easier to stomach; a larger or smaller drawdown?

DrRock, again I say thank you for your insightful, thought provoking and enjoyable post. But I still say leverage is a relevant risk factor.

Dial
Aahhh Dialist, you have introduced a different variable - % drawdown. This wasn't in the original posting. He simply said he was willing to lose $5,000 - nothing about drawdown. I agree that % drawdown in the second and third cases is going to be larger but that wasn't a concern stated. Although, if you consider your float to be the full $10,000 rather than the individual $5,000 in the account, after the same number of trades you will have a smaller % drawdown (on the full $10,000) in the latter cases than the former cases.

You don't even mention leverage in your analysis so how can it be of any relevance. I am thinking that maybe I should start a new thread to discuss risk management and leverage as I see it.

Simon
  • #14
  • Dec 3, 2005 6:04am Dec 3, 2005 6:04am
let's say you have lost 4000$.
now you have 6000$ left (MM1) or 1000$ left (MM2).
to rebuild the balance you need to make 66% profit (MM1) or 400% profit (MM2)
it is needless to say which one is more probable.

in other words the power of money resting on your account and helping you to survive is with you!!!
time is money! Z
  • #15
  • Dec 3, 2005 6:29am Dec 3, 2005 6:29am
Quoting Zazzy
let's say you have lost 4000$.
now you have 6000$ left (MM1) or 1000$ left (MM2).
to rebuild the balance you need to make 66% profit (MM1) or 400% profit (MM2)
it is needless to say which one is more probable.

in other words the power of money resting on your account and helping you to survive is with you!!!
Zazzy,

That is what my initial thoughts were too. However, you wouldn't end up in that position because after x number of trades MM1 might have $6000 left but MM2 might have $2000 because of the differences. And since you risk is twice as much you would actually recover it quicker. Do some calculations to see how many trades is takes to lose $4000 in MM1 and how many with MM2 and then how many trades is takes you to make back the $4000.

We also need to remember that we are not discussing a typical money management scenario. The orignal posting specified a $ amount will to lose as opposed to a % amount.

Simon
  • #16
  • Dec 3, 2005 6:44am Dec 3, 2005 6:44am
Thought I would add some data to this discussion.

Attached is a chart which shows the drawdown in $ that you would get after 30 losing trades with both MM methods. You will see that the 1st strategy has a much larger drawdown after 30 trades - $4500 compared to $3500. However, strategy 1 takes 1 few trade to get back to breakeven after - 31 trades instead of 32 (after consecutive profitable trades). If we keep trading successfully, after another 27 trades strategy 1 has a $7,200 profit and straegy 2 has a $9300 profit (or -ve drawdown as in the chart).

This indicates to me that strategy 2 doesn't drawdown as quickly, recovers just as fast and makes more money in the long run.

Simon

PS the pink line is strategy 1 and the blue line is strategy 2.
Attached Image
  • #17
  • Last Post: Dec 3, 2005 7:23am Dec 3, 2005 7:23am
Hi,

Just a thought

It's interesting that Randy McKay's method of 'rapidly reducing' percentage risk of the 'total portfolio' approximates trading at a 'constant high' percentage risk of a 'partial portfolio' as illustrated by Diallist case 3.

Best regards
Alan
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