Source: Wealth Creator Magazine January/February 2006

So, even in the fantastic situation of a trade with a 99% certainty of winning, a sufficiently bad money management approach can doom you to trading failure.

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Money Management and Risk Control

Source: Wealth Creator Magazine January/February 2006

Written by:

Barry Littler has been a professional in financial markets since 1982. Barry has had senior management roles at Westpac, McIntosh Securities, and SG Australia. He has lectured for the Australian Financial Markets Association (AFMA) in technical issues and financial market ethics. www.mdsnews.com/advice

Money management and risk control

Hope for the best, but prepare for the worst. The most important lesson that I have learned about trading is this – respect the market. Never think that your understanding or your approach will always work in every market condition, because you will be wrong.

Rock fishing

A good analogy for Australians is the sport of rock fishing. For those of you who are not familiar with rock fishing, it is a sport in which fishermen locate themselves on rocks the ocean is beating against. On calm days the waves are often almost imperceptible, and on wild days the waves are so large that the fisherman cannot fish. In Australia, rock fishing has the highest mortality rate of any sport, including intense body contact sports such as rugby league and boxing. The reason rock fishing is so deadly to the unprepared, is the novice fishermen get used to a certain intensity of wave force on any given day and stop paying attention to the ocean. They become complacent. Unfortunately, complacency is a grave error because occasionally two or more waves will combine and become a single large and unpredictable rogue wave – able to dash a man into the treacherous water.

Traders must also combat the risk of complacency. This is a particular problem for new traders who have only ever witnessed one type of market, most often this is a bull market. It becomes easy to ignore the possibility of a ‘rogue wave’ and therefore the traders risk size and methods are based on rogue waves never happening. Of course, when the inevitable happens the trader is over exposed and is in a great deal of trouble.

The rogue wave, in markets, is the unexpected move of large magnitude. The equity crashes of 1928 and 1987, were rogue waves of the highest magnitude that swept the global financial system of the day before them. Other recent examples include the Asian crisis, the gold sell off and the tech stock collapse. To be successful in the long run you must be able to survive rogue waves; you must have great defense.

Great defense

Succeeding and surviving in share trading is primarily a matter of having a great defense. It is an old market joke that a speculator who dies rich, has died before their time. This is a commentary on traders who have enjoyed success, but who eventually stopped respecting the market – the result being ultimate failure. So, remember it is your defense that wins through time.

Reflections

A moment’s reflection will make the point. Consider risking all of your capital on one trade with a 99% chance of succeeding. What is the probability of losing your capital? Well it is 1%. However, what if you conducted the same scenario 100 times in a row? Then your probability of losing all of your money rises to about 63%. If you conducted this trade 500 times in a row and reinvested your winnings you would have about a 99% chance of losing all of your capital. The situation worsens if on each trade you have the possibility of unlimited loss.

So, even in the fantastic situation of a trade with a 99% certainty of winning, a sufficiently bad money management approach can doom you to trading failure. On the other hand, the best money management plan possible cannot turn a trading plan that has negative profit expectancy into a winning system. There-fore lets spend a moment discussing what an edge is.

An edge

In technical terms your trading methodology must have a positive expected return. This is a straight-forward concept that works as follows:The mathematical expected return is the amount that you expect to win on average each time you trade. We calculate this expectation by multiplying each possible gain or loss by the probability of that gain or loss, and then summing those products together. For example if you were in a game of tossing a fair coin and you received $2 for heads and lost $1 dollar for a tail then your expected gain would be: Expected gain = (2*0.5) + (-1*0.5) = 0.5

So on average you would expect to win 50 cents per coin toss.

The same concept is the foundation of understanding your trading edge. Each trade has a probability of a gain and a loss. Summing these individual probabilities will give the overall expected average win and loss sizes, and therefore the overall trading edge. It is important to trade only when your research convinces you that there is in fact a positive edge to be had. It doesn’t matter where the edge comes from as long as it is there.

Catastrophic risk

Catastrophic risk event occurs when the trader loses far more than was budgeted for. And in fact a catastrophic event may go so far as to bankrupt a trader. Often catastrophic losses are associated with rare market moves such as the 1987 equity crash, the Gulf war oil shock or the recent sharp down move in the Gold price.

It is important to remember that a rare event is not the same as an abnormal event. The phrase ‘abnormal’ suggests an event that is not part of the very fabric of markets. When, in fact, price shocks are a fact in the trader’s existence.

Means of managing catastrophic risk include:

  1. As discussed choose a prudent level of exposure and do not arbitrarily change your exposure levels for any reason.
  2. Legally sheltering one’s assets. This is not a legal discussion but all traders should consider and discuss with appropriate advisors what legal steps can be taken to shelter one’s assets.
  3. Consider how options that have guaranteed loss limits can be used in your trading methods.
  4. When designing your trading approach, give consideration to how you can limit the number of contract days that the system is exposed to. The logic behind this approach is that the fewer the days that there is an exposure the lower the probability of being in the market when the price shock hits. For example, traders who run always in the market stop and reverse systems, have a 50% chance of being on the wrong side of a price shock when the price shock occurs.