Money Management: An Alternative Approach for the ‘Real World’

By: Russell Sands

The following is an excerpt from Russell Sands' Turtle Secrets

It has never ceased to amaze me how many money management, certainly one of, if not the most important aspect of successful trading, is continually neglected by all those who purport to ‘teach’ people how to trade successfully.

The body of this is shamefully plagiarized from a periodical to which I subscribe entitled Blackjack Forum.  Those who know me, know that I used to play cards professionally for a while before I started in the trading business.  The truth of the matter is that mathematics and statistics, especially those that are related to such tops as Risk of Ruin, are exactly the same for any ‘gambling’ scenario, whether it be playing Blackjack or trading futures.

A common axiom of betting strategy is something called Kelly Criteria.  In layman’s terms, Kelly says you should always bet that fraction of your bankroll which is equal to your statistical advantage in the game you are playing.  For example, if you ascertain your advantage (exception) on a given trade to be two percent, then you should risk two percent of your bankroll on that trade.  In casino type gambling, Kelly is the correct mathematical solution to the problem of how to optimally maximize your chances of doubling your bankroll in the shortest possible time frame, while simultaneously minimizing your chances of completely busting out.

Now, we get away from mathematics and into the real world.  In the real world, there is a crucial difference between optimizing your chances as opposed to your system’s chances.  Continuing with the casino gambling analogy, while there is no doubt that Kelly betting is the optimal system for money management, it may not be the most correct way for you to trade.  This difference arises from the fact that a human being is not a computer, having such differences as a limited time frame (your career) in which to play the game, and a constant interaction with the market on a financial and emotional level, which will tend to affect your decision making processes.

The reality is that you can’t trade continuously, and you can’t trade forever.  After a certain period of time, regardless of the results, you will become burned out and start making incorrect decisions.  It is undoubtedly true that our subconscious produce the most intense level of self-destructive impulses when we are losing.  No matter how well you trade, eventually you will hit a losing streak.  And when you are losing, errors will come from fear, depression, and other negative emotions.  You will eventually suffer bouts of indecision so extreme that the simple idea of picking up the phone and placing a stop order becomes an insoluble dilemma.  (Hint: time to take a vacation).

Optimal performance is much more likely if you impose some time related to other limitations on yourself.  While it is true that this idea runs counter to playing for the ‘long run’, there are some offsetting advantages.  Most notably, you can gauge your progress relative to an expected financial distribution.  You will be less likely to chase your losses indefinitely and play while psychologically distressed, and you will also be less likely to exploit a winning streak by over-trading and/or acting sloppy or haphazardly due to overconfidence.  You will also be mentally aware that your trading has a beginning and ending period, thus helping you not to exceed the limits of your mental and physical endurance, and balancing trading with the rest of your life.

The bottom line is that trading is not, as so many people think, a test of finding the holy grail of technical analysis, but rather, it is a test of one’s personal emotional discipline.  You must continually force yourself to make correct decisions and perform optimal actions in the face of utter chaos and the entire gamut of self-destructive impulses; fast markets, unexpected reports, failed breakouts, continual losing streaks.  Part of you wants everything to slow down, part of you wants everything to happen faster, part of you wants to run and hide, and part of you wants to throw up your hands and turn everything over to the Deities of chance and fate.  If you haven’t experienced all of these crazy feelings at some point in your trading career, don’t worry, you will!  You just haven’t been trading long enough yet.

Given all of this, it might be wise to approach the betting size question from the perspective of wanting to limit risk of loss to levels which are psychologically manageable to one’s own personal abilities.  This level will be different for every one of us.  It will certainly be the case that some partial level of ruin, as opposed to complete ruin (or even 50% ruin) is the loss criteria most relevant to our ‘psychological management strategy’.  After all, as a practical matter, the game becomes unsalvageable long before we approach complete ruin.  Even a partial loss necessitates a down-scaling of unit sizes, reducing the win rate, and making a return to par a much lengthier proposition than the downfall from par was (similar to Paul Todor Jones’ cynical but truthful statement that “everything gets destroyed a hundred times faster than it’s built up”).

From a psychological viewpoint, bankroll fluctuation is one of those things that can achieve a stranglehold grip on our conscious (and subconscious) mental state in a relatively short period of time.  As an example, does any of the euphoria of winning steadily for months remain if you just gave back all of your open profits in the past couple of days?  On the other hand, who remembers the pain and self-doubt of losing money day after day if you catch one good trend and make it all back and then some?  The ‘here and now’ is everything, and all of your emotional responses to events and market conditions are based on your current mental and financial situation.  And while it is true that limiting severe draw-downs will also necessarily limit the magnitude of large winning streaks, trading for a living does not mean always trying to hit home runs as much as it means grinding out the game on a steady basis day after day and trade after trade.

So where does all of this leave us?  Basically, what I would propose is finding a way to trade smaller, in order to reduce the equity swings and thus remain emotionally more stable.  The way to do this would be to set yourself a ‘false’ risk of ruin level, not only less than 100%, but probably less than 50% as well.  Ask yourself the question, “if I lose X percent of my capital, will I become worried, will my decision making ability begin to suffer, will I be on the verge of becoming unglued?  For a conservative person, the answer would probably be in the neighborhood of 25%, for a true professional with supreme self-confidence and nerves of steel, the answer is probably about 40%.  Anything worse than that, and not even the best of us would be able to make the come back psychologically (well, maybe 50% for Richard Dennis, but he isn’t really known to be risk-averse).

When thinking about money management schemes the concept most key to follow is that your overall strategy should be guided by that factor most relevant to your long term success in trading; which is not profitable technical analysis, but rather the ability to control your emotions and optimize your mental processes.  What is the optimal mathematical way to calculate position sizes may not be the proper way for you to trade.  Success is equal parts of intellect, applied psychology, practice, discipline, bankroll, self-understanding, and emotional control.  In order to trade for a living, you must develop both a high tolerance for personal limitations and the discipline not to exceed them.  In the final analysis, only you can determine how large or fast to trade.