ACCOUNT MANAGEMENT

LIQUIDITY

One of the assumptions I used to have about trading was that things worked in a linear fashion. What I mean by this is if someone could turn £1,000 into £10,000 then they could easily turn £10,000 into £100,000. If they could easily turn £100,000 into £1 million then they could easily turn £1 million into £10 million. However I eventually came to an understanding that things don't work in a linear fashion.

One of the reasons why being able to increase an account 10 times is much more difficult as you increase your position size is not only because ones emotional response to increasing position size can significantly affect decision making,  but even more impacting is that the higher your position size the slower it can take for your order to be taken especially if you are dealing in a market where the liquidity is patchy. Sometimes depending on the type of trade you are executing speed could be of significance where a £10,000 order is filled in 1 second but a £100,000 order could take 5-20 seconds in which there is more exposure to the possibility of market moves which could cause your order to be left unfilled.

So one of the big important truths about successful trading is ensuring you operate in markets where there is sufficient liquidity for your trades to be opened and closed quickly if you are operating trades where speed is needed. When I began to see evidence that my trading strategy had evolved to where I would be making profit consistently I began trading in markets where liquidity was patchy.  This resulted in a number of situations where I was unable to close trades as the market had moved against me whilst I was waiting endlessly for my trade to be taken because there simply wasn't enough money in the market.

Consequentially I had to close out my position at a significant loss or I would have completely lost all the size I had put on.

However if you observe and respect the nature of liquidity in the markets you operate in then one of the greatest benefits of trading is scalability. This means as your bank starts to increase you can then increase your position size to generate accelerated profits.

RISK MANAGEMENT

There is no secret that the key to your income in trading is your trading account (bank). Your bank is  a fundamental component of your trading success. Unfortunately I did not respect this during the early part of my trading history which is why I would blow through a number of trading accounts as a consequence of poor risk and money management.  Now I operate with a fundamental rule that I trade no more than 2% of my bank on any 1 trade but I also found it important to have an exposure limit per day. My overall portfolio exposure limit per day is no more than 6% of my bank. So on an account of £5,000 if I hit around a £300 loss in any one day then that is my stop loss to stop trading for that day. Bear in mind that due to the positive expectancy of my strategy that I can go on a winning run where I can make over £1500 per day (providing there are a sufficient high probability trades to take) so my loss potential is limited and restrained but my reward potential on an individual day can be over twice as much.

RISK OF RUIN

One of the other concepts of great importance is the "risk of ruin". Risk of ruin is the probability that youíll lose so much money you can no longer continue trading. This doesnít mean losing all of your trading capital, the ruin point is based on your own personal risk tolerance, so ruin to you could be 15%, it could be 50% or it could be 100% of your trading capital.

It is imperative that you know what your risk is and are willing to embrace it. if you are not willing to take any risk on your account, then you cannot trade, it is as simple as that. Ideally you should be willing to risk at least 25-30% of your account as a maximum drawdown\point of ruin before you must stop trading, and then review your business\trading plan for new objectives and risk parameters to determine if you can still trade, then build a new plan if required.

As traders our job is to avoid reaching our point of ruin. So you must work out your probability of reaching this level of drawdown.

There is a formula for working out your risk of ruin, and ideally you risk of ruin should be between 0 % Ė 0.5%. NOTE: It is mathematically impossible for the risk of ruin being 0.0 percent! So the aim is below 0.5%, which when rounded down is 0%. When you get above 1% and higher thatís when you know you are risking too much, and the risk of ruin is becoming positive, meaning that its only a matter of time before you reach your maximum draw down level! Therefore it is advised that you do not trade until you are comfortable that you can perform (With simulated trading if you are a discretionary trader or on a back-test for an automated system) at a level where risk of ruin is less than 0.5% and ideally towards 0% as possible.

There are a number of ways to calculate Risk of Ruin, however the most common formula is:

Risk of Ruin = (1-(W-L))/(1+(W-L))^ U

(Where W=Probability of winning, L+ Probability of Losing, ^ denoted the power of U + Number of Maximum Risk Trades that may be taken).

Here is an example of trader A with a $50,000 account and is willing to Risk a Maximum drawdown of 30%, which is a Point of Ruin at -$15,000. Lets assume Trader A has proven through his trading that he can gain the following averages: Win% = 60%, Loss% = 40%, Risk per trade is 1% of full account at $500 so max trades he may take and lose sequentially is 30 trades before he reaches the Point of Ruin (Max Drawdown).

So his Risk of Ruin is worked out as follows:

(1-(0.2)/1+(0.2))^30 =

(0.8/1.2)^30 =M

(0.666666)^30 = 0.000005214 = 0% (When rounded down).

Which is a very low risk of ruin! This allows for this trader to take risk comfortably knowing that there is very little chance of ruin. Of course this assumes that the trader keeps performing well! If the win rate and win to loss ratio adjusts over time the risk of ruin may increase\decrease.

Now lets consider Trader B who takes too much risk and is under-capitalised. He has a $10,000 account and is willing to Risk a Maximum drawdown of 30%, which is a Point of Ruin at -$3000. Win% = 60%, Loss% = 40%, Risk per trade is 10% of full account at $1000 so max trades he may take and lose sequentially is 3 trades before he reaches the Point of Ruin (Max Drawdown).

So his Risk of Ruin is worked out as follows

(1-(0.2)/1+(0.2))^3 =

(0.8/1.2)^3 =

(0.666666)^3 = 0.2962954074083 = 30% (Rounded up)

Thatís a big difference, with the same technical performance but a smaller account and more risk. Trader B has a high chance of ruin.

Our main job as traders should be to reduce any chance of ruin. Any probability in favour of ruin is not good! You as the trader are in control of your risk of ruin. Therefore itís essential to position size and manage risk accordingly for each trade and every day so that risk is minimal, and risk of ruin is kept to the minimal.

So lets consider the ways that you can reduce your risk of ruin:

1. Increase your accuracy and obtain a higher win%.
2. Increase your average win to average loss ratio.
3. Reduce the amount of money risked per trade and per day by trading more capital or taking less risk per trade\day.

POSITION SIZING

The other thing I would mention is what when increasing position sizing as your account grows do it in small sequential stops. As humans we have the unique ability to increase our position sizing over and beyond what we should at a time when the market is at its most vicious which then leads to significant loss, emotional torment and the undoing of all the good work that may have taken months to produce.

It may come as a surprise to many traders that adding to position size can be devastating to their trading success and their overall dream of becoming a trader. Increasing the position size at the wrong times or adding in wrong increments can affect the traders mindset in such a way that it can, in a matter of days, ruin all the hard work the trader has done over a long period of time.

When increasing the position size there are two very important things to take into consideration; when is the right time to increase the position size and how much should the trader increase with?

Before answering this question it is important to understand that trading is about the bigger picture, meaning that success and profitability is measured over a series of trades, e.g. 30-50 trades. This is to help the trader stay focused and disciplined and also gives you ways to improve your mindset. Just because the trader loses money on one trade does not mean that the system is not profitable. It is either about having a hit rate above 50% or about making more money on the winners than the trader is losing on the losers. This series of trades is therefore very important to follow when considering increasing the position size.

The answer to the first part of the question above is that you should never consider increasing in the middle of a string of trades. Do not just add after a few winning trades. A common mistake new traders make is adding to position after a few winners only to get stopped out on the next trade and thereby lose all previous profit. This frustrates the trader who then scraps this system believing that the system must be bad and therefore searches for a new system resulting in a vicious circle. The truth is, the system might have been good but the trader will never find out. Always make sure that the system works over a longer series of trades. Set that number before starting to trade and use that same number consistently.

So, when exactly should you increase the position size in order to start becoming a winning trader? The trader should only increase the size after the series of the predetermined trades in order to be sure that the system is still profitable. I trade around 120 times per month times and if overall those trades are profitable as a whole I can then increase my position size. Notice I wrote that I can increase, but I do not necessarily need to. I still need to be comfortable when trading, and this brings me to the next question: how much should the trader increase with? This is another place where new traders make mistakes. Always increase in the minimum size possible. This is to avoid too bigger swings in the mindset. After the trader has taken over 100 trades in a row they are used to the swings the trades will experience.

When increasing the position size the liability will suddenly be bigger and might make the trader nervous so they might not take the next trade after a loss or might exit the trade premature. The trader cannot avoid this completely as they have to increase the size but can limit it by adding in small increments. Another reason why the trader should increase in small increments is that many traders make big position sizing leaps and when they get stopped out they see that they have lost a lot more than they made by trading the previous position sizing. This can result in completely stopping trading this system believing that the system is bad. Then the trader is back to the above mentioned vicious circle.

 
 



 


The key to success in trading is the ability to accept losing a battle whilst knowing you are winning the war

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