Money Management Algorithms
Money management is often the third dimension of trading that can be easy to neglect. Money management can encompass three different categories; position sizing, risk control, and equity curve management by using our money management algorithms as a trading systems approach.
Position sizing will determine the number of contracts to trade per trading system entry signal. Since we focus on day-trading strategies with fixed dollar stops, our position sizing will be determined based on margin requirements and maximum draw down for each trading system or portfolio that is traded. For example, if the suggested capital for a trading system portfolio is $25,000 and a trading account balance is $50,000, then the maximum number of units for that portfolio would be two. This is the most aggressive approach for position sizing. As profits or deposits are added then additional units can be traded in multiples of $25,000. A more conservative trader or futures investor may only want to trade one unit per $50,000 or $100,000.
When position sizing individual systems, it is important to look at the draw down plus margin requirements to determine the minimum amount of capital needed to trade each trading system. Using the minimum amount of capital is the most aggressive approach. When day-trading, the exchanges provide lower margin requirements so that less capital is required, since the position is not being held overnight.
It is possible to write algorithms for position sizing. There are some trading algorithms that show a geometric increase in the number of contracts based on increasing profits creating exponential equity curves. Aggressively increasing the number of contracts as fast as possible based on the most minimal capital requirements can create large amounts of volatility in the equity in a trading account. Position sizing an account this aggressively can be an all or none approach and can create an account blowout with one small mistake.
Risk control is based on how much money or the percentage of your account to risk on any one trade or any one system. It can also be the amount of money that will be at risk in any given day, week, month, or year. Individual trade stop losses are common. The same principle of individual trade stop losses can be applied to a system or portfolio as well. If the worse case drawdown in a system is $5,000, a system stop loss could be a multiple of the worse case draw down. For example, some traders may only risk the worse drawdown on a trading system while others will risk 1.5 to 3 times the historical worse case drawdown. Risking at least the worse case drawdown should be the minimum commitment when trading an individual system or portfolio. It does not make much sense to start trading a system or portfolio and then stop after one month because there was a losing month. Most trading systems and portfolios will have losing streaks and losing months.
It is possible to use an equity curve management algorithm to systematically determine when to start and stop a system (see below). Also, if you are the system developer and the market begins to act distinctively different than for the reasons in which the system was designed then that can be a valid reason to discontinue trading a system. The last reason mentioned requires more experience in the markets and a greater understanding of the system and how it works in the markets. An example of this type of system could be intermarket analysis. Recent trends in the market show a direct correlation between the US Stock Market and the Euro Currency. Many have used the Euro Currency as a leading trend indicator to the US Stock market while the 30 Year Treasury Bonds and US Dollar Index have been inversely correlated and tend to trend in the opposite direction of the US Stock market. Lately it appears the fundamental reasons for this occurring have begun to change and the stock market and dollar index are more correlated while the stock market and euro currency are less correlated. Shifts in volatility can also create changes in the market and tend to create more challenges in determining how to trade a system that the actual direction of the market.
To summarize risk control, example of risk management could be:
Maximum trade risk: 0.5%-2% per trade
Daily risk: 2-5% per day
Weekly risk: 3-5% per week
Monthly risk: 5-10% per month
Annual risk: 10-50% per year
These are only examples and a list of how to establish risk control. It varies greatly based on an individual traders risk tolerance and capitalization. If a trader comes to the market with a $10,000 account, risk tolerance on a percentage basis should be pretty high as most systems trade with at least $300 to $500 stop losses (3-5% per trade based on a $10,000 account). Many individual futures trading systems also have a $4,000 – $5,000 maximum draw down which would be 40-50% of the account balance.
Equity Curve Management and our Money Management Algorithms
Our money management algorithms are designed to trade the equity curve. Equity curve management can improve risk management and reduce draw downs so that less capital is required to trade a strategy or portfolio.
Some of our latest money management research and strategies include systematic equity curve management strategies such as letting the basic system trade in simulation mode so that it will continue to generate an equity curve. The money management algorithm will only allocate real trades when the trend of the equity curve is up. Another example of one of our systematic money management algorithms is to stop trading at a pre-defined draw down and then to start again once there has been a run up of a predetermined amount from the equity curve lows.
Note that the second equity curve also requires the moving average of the equity curve to be in an uptrend. To accomplish these equity curve management strategies successfully we use DLL’s to generate the trades in one window, and then pass the information from the trading to a second window that has a strategy that uses the original rules in addition to the equity curve management rules.
Our equity curve money management strategies currently include three different equity curve strategies:
1.) Trade the equity curve only if it is above its moving average
2.) Stop trading the equity curve if it goes into a pre-defined drawdown (set as an input) and then start trading if it goes into a run up of a pre-defined amount from equity valley lows.
3.) Combine rules one and two.
The New York Scalper includes two different equity curve/money management algorithm strategies:
1.) Trade only on days after there is a $100 of loss or more in the original strategy.
2.) Begin trading the money management version intra-day if the original system is down $300 or more.