In trend following, the trader attempts to capitalize on large price movements over the course of several months. Trend followers enter trades when markets are at historical highs or lows and exit when a market reverses and sustains that movement for a few weeks.

Traders spend a lot of time developing methods to determine exactly when a trend has begun and when it has ended; however, all the approaches that are effective have very similar performance characteristics. Trend following generates excellent returns and has done so consistently for as long as anyone has traded futures contracts, but it is not an easy strategy for most people to follow for several reasons.

First, large trends occur fairly infrequently; this means that trend following strategies generally have a much higher percentage of losing trades than winning trades. It may be typical for a trend following system to have 65 or 70 percent losing trades.

Second, in addition to losing money when there are no trends, trend-following systems lose when trends reverse. A common expression that the Turtles and other trend followers use is “The trend is your friend until the end when it bends.” The bends at the end can be brutal both on your account and on your psyche.

Traders refer to these losing periods as drawdowns. Drawdowns usually begin after a trendy period ends, but they can continue for months when markets are choppy, and the trend-following strategies continue to generate losing trades.

Drawdowns generally are measured in terms of both their length (in days or months) and their extent (usually in percentage terms). As a general rule, one can expect drawdowns for trend-following systems to approach the level of the returns. Thus, if a trend following system is expected to generate a 30 percent annual return, you can expect a losing period in which the account may drop 30 percent from its highs.

Third, trend following requires a relatively large amount of money to trade using reasonable risk limits because of the large distance between the entry price and the stop loss price at which one would exit if the trade did not work out.

Trading with a trend-following strategy with too little money greatly increases the odds of going bust. We will examine this problem in much greater detail in Chapter 8, “Risk and Money Management.”

Popularity: 7% [?]

There are some differences in applying the Fixed Ratio method, or any money management method for that matter, to stock trading. The difference, however, is not that the markets are inherently dissimilar. The most important fact to understand about money management, and specifically the Fixed Ratio method, is that this is a numbers game. We are not playing the markets or any aspect of the markets. Nor are we necessarily applying money management to the method or system that we are trading. We are applying money management to the net sum of the profits and losses generated by the markets, methods, or systems producing those profits or losses. Therefore, it doesn’t matter whether the $500 profit came from IBM stock or the soybean market-$500 has the same value in any market.

Since we are playing a numbers game, we can completely ignore the markets and/or methods being applied and concentrate on the numbers being produced. With the stock market, however, applying the Fixed Ratio method is slightly different for two basic reasons. First, there is a large disparity in margin allowances and between stocks and commodities. Margin in commodities can sometimes be less than 10 percent of the value of the underlying market. One S&P 500 index contract (which is a futures contract in the stock market) is currently worth $318,000, but to trade one contract in that market requires less than $20,000. Margin is only about 6 percent of the value of the contract. Stocks, on the other hand, only allow a 50 percent margin rate. Therefore, if you buy $50,000 worth of IBM stock, you must have $25,000 in the account. Later, we discuss how this margin difference affects the application of money management.

The second major reason for the difference in application is the ability to trade odd lots. It used to be very hard to find a broker who would actively trade 103 shares of a stock or 17 shares of a stock; now you can find them all day long. Odd lots are exactly what they sound like, a position size other than a nice round number. The most common size was 100 shares, which is also the value of one option in stocks. One option is on the value of 100 shares. Nonetheless, this ability to trade odd lots allows for highly efficient money management application.

These are the two major differences when applying the Fixed Ratio to trading stocks, but before continuing, I need to stress that this type of money management is not for buy-and-hold strategies. Buying and holding is a method of investment. You might consider a trading account to be an investment; however, the trades themselves are normally based on active buying and selling. WalMart stock bought back in the 1970s and held today is definitely an investment. Money management requires increasing and decreasing the size of the trade as the equity increases and decreases. Buying and holding usually does not use margin, and increasing an existing position would actually fall under the category of pyramiding. So, if you are only buying and holding stocks, this section generally will not apply to you.

Popularity: 13% [?]

Proper money management should address two basic topics, risk and reward. A trader cannot address one without addressing the other and expect to benefit from money management. This was one of the main problems with the Fixed Fractional methods. Any variation of the method either addressed the growth without the overall risks (i.e., optimalf) or it addressed the risks (i.e., risking less than 3 percent on each trade), which would inadvertently leave the potential reward faltering like a bird with one wing. There were attempts to address both of these topics somewhere in between the 3 percent or less variation and the optimal f variation. However, the efficiency of doing so was flawed by the characteristics of the method itself. Therefore, no matter what fixed fractional method is applied, either the risk, the reward, or both are inadequately addressed.

The goal behind developing a new money management method was to start by addressing both the risks and rewards of money management in general. As stated earlier, for any situation with a positive outcome, the only type of money management that should be used is an antimartingale type method. This means that as equity increases, the size of the investment or trade should also increase. As equity decreases, the size of the investment or trade should also decrease. This is opposite of the martingale type where size increases as equity decreases and vice versa. Therefore, the type of money management must stay the same as for the Fixed Fractional. Using that as a beginning point, I began to list the pros and cons of the method. My list looked something like this:

Pros :

1. Geometric growth was possible with higher percentages.
2. Risk could be maintained with lower percentages.

Cons :

1. Using higher percentages subjected the account to catastrophic risks.
2. Using lower percentages took too long to implement and therefore was inefficient.
3. Using a percentage in between did not properly proportion the reward potential with the risk potential.

After contemplating these pros and cons for awhile, I decided that the root of the problem was that the method required unequal achievement. It was illogical for the Fixed Fractional method to require more profits from the system or strategy at the beginning and less and less profits as the equity increases. If anything, I concluded, it should be the other way around. A money management method should require fewer profits at the beginning (hence be more efficient) and more profits as the equity increased (which would address the risk).

At first, I tried different ideas for increasing the required amount to increase contracts, but I wasn’t completely satisfied. Then it dawned on me that the answer is in the relationship of number of contracts being traded to the amount of profits required to increase to an additional contract. And, that relationship should remain fixed. If the money management required $10,000 in profits trading one contract to increase to two contracts, than it should require $20,000 additional profits when trading two contracts to increase to three. Hence, this relationship was a fixed ratio of contracts to required profits. This is how the Fixed Ratio method came to be and how it earned the name Fixed Ratio.

The Fixed Ratio method has only one variable, the delta. This variable simply fits into the mathematical formula of the method and determines how aggressively or conservatively to apply the money management. The lower the variable, the more aggressive the application. The higher the variable, the more conservative the application. There is no bell curve with the Fixed Ratio method.

Popularity: 7% [?]

After you have completely stopped trading, go back to the very first day you ever laid eyes on the market and write down the methods, systems, strategies, and trades you have ever made. This does not mean list every single trade you have ever taken. However, if you have ever opened an account for the sole purpose of writing options, summarize the experience. Write down as much detail as possible including what events lead you to start trading a particular method, the account size you started with, why you started with that account size, the type of trading, the frequency of trading, whether you enjoyed taking the trades (or hated it). Write down how long you traded the method, whether you stuck with it, (if not, why), the size of drawdowns as well as drawups. Don’t forget to include time variances. How long did the drawdowns last compared with the drawups? How long did you stick with the method? Finally, write down when you quit trading the method, what the final outcome of the experience was (gain/loss) and what you did with the account afterward.

Once you have done this for every single experience, consider the mistakes that you made over and over again. Some traders never ever stick with the method. Others simply get distracted by other “things” to do in the market. Regardless, you will know where your weaknesses and strengths are in trading after completing this summary. You will also know which type of trading you enjoyed the most. Some enjoy winning often and don’t mind a big loser every now and then. Others like longer term trading, and still others like being able to research every single trade before placing it. Later when finalizing your plan, you will be able to look back at this and determine what type of trading you should be doing.

Popularity: 8% [?]

The largest loss can be defined in two ways. First, it is the largest single losing trade in a particular system or method. Second, it is the largest single losing trade that will be suffered in a particular system or method. As a result, it can be thrown in the category of drawdowns. The largest loss cannot be predicted, even when stops are used in the market. If I am long the Deutsche mark (DM) and-have a $1,000 protective stop in on the trade, what happens when the market opens down $3,000 below where my stop was? I’ll tell you what happens, I lose $4,000.

Depending on the largest losing trade size, it may or may not be devastating to an account. However, most of the time, the largest losing trade is smaller than the largest drawdown. Therefore, in comparison, the largest losing trade may do the account some damage, but it won’t do near the damage that the largest drawdown will do. When you prepare for the largest drawdown, you should be adequately prepared to suffer the largest loss as well. That is how I look at the two subjects in the realm of money management. One will do more damage than the other and therefore I will prepare for that one.

Popularity: 10% [?]

The obvious definition of an antimartingale money management method is exactly the opposite of the martingale methods. As an account increases, the amount at risk placed on future trades also increases. The main characteristics of antimartingale methods are that it causes geometric growth during positive runs and suffers from what is called asymmetrical leverage during drawdowns. Asymmetrical leverage simply states that as an account suffers losses, the ability to make up those losses decreases. If a 20 percent drawdown is suffered, a 25 percent gain is required to get back to even. A 10 percent drawdown requires an 11.11 percent gain to get back to even. The formula for this is:

[l/(1 - % loss)] – 1 = Required % gain

In many cases, asymmetrical leverage does not affect trading. For example, if a trader trading the absolute minimum available in the bond market (which would be a single contract of the bonds traded in Mid-American Exchange) suffered a 20 percent drawdown, the required gain would still be 25 percent of the new account balance, but the ability to achieve the extra 5 percent has not diminished. This occurs because even though the percentage required to recoup the percentage loss of the account increases, the amount of capital to recoup the amount of capital lost remains the same. Therefore, asymmetrical leverage does not play a role in the performance of the account.

On the other hand, it plays a huge role when traders apply certain money management techniques. For example, if a trader decides to trade one contract for every $10,000 in the account, then a single contract would be traded from $10,000 through $19,999. At $20,000, contracts would increase from one to two. Suppose that the very first trade after increasing to two contracts is a loser for $1,000. Since there were two contracts on this trade, the actual loss comes to $2,000 and the account goes to $18,000. According to the money management rules, a single contract has to be traded once again. The trader must now incur two, $1,000 winning trades to get the account back to where it was just prior to suffering a $1,000 loss with two contracts. Here, the amount of capital required to bring the account back to even remains the same, but the ability to achieve that amount has decreased by 50 percent. That is asymmetrical leverage and it can be detrimental. Later in this book, I present some ways to avoid it or at least diminish its effects in the practical realm of trading.

The positive aspect of the antimartingale money management method is that it places the account in a position to grow geometrically.

When I started my research into the money management arena, only one type of money management was generally accepted in the industry. That method is called Fixed Fractional trading. Fixed Fractional trading is an antimartingale money management method. Fixed Fractional money management simply states that on any given trade, x% of the account is going to be allocated, or at risk. The coin flip example allocated lo%, 25%, 40%, or 51% of the account on every flip of the coin. Chapter 5 in this book provides a detailed explanation of the Fixed Fractional method so I am not going into detail with it at this point. You should note, however, that the Fixed Fractional method takes on many different names. Regardless of their names or how the methods are explained, the following are all Fixed Fractional money management methods:

• Trading one contract for every x dollars in the account. I used this example earlier when describing asymmetrical leverage (1 contract for every $10,000 in the account).
• Optimal fi This is a formula made popular by Ralph Vince. The “f” stands for fraction. It is the optimal fixed fraction to trade on any given scenario. The coin flip example yielded $36,100 by risking 25 percent of the account on each flip. This percentage represents the Optimal f of that particular situation. No other percentage will yield more than the $36,100 in that example. However, Optimal f for one set of trades is not necessarily Optimal f for another.
• Secure fi This is just a “safer” mode of the Optimal f.
• Risking 2 percent-3 percent on every trade. This money management practice is common among trading advisers and fund managers.

After doing extensive research on the Fixed Fractional method, I was not satisfied with its characteristics. Therefore, I developed something called the Fixed RatioTM money management method, which has nothing in common with any type of Fixed Fractional method except that all these methods are types of antimartingale money management.

These are the basic methods from which most other specific money management ideas are derived. The martingale methods are not discussed here in any more detail since they are never recommended in this blog.

Popularity: 12% [?]

A margin requirement is simply an amount of money required for collateral to place a trade, commonly used in the futures arena or in writing options. This amount is set by the exchanges on which the markets are being traded and is usually determined by the value and volatility of the underlying market. There are no set formulas among the exchanges to determine margin requirements. Each margin requirement is subject to change for any reason, at any time, without prior warning. For example, the required margin to trade the S&P 500 used to be $10,000. However, due to the volatility in that market, the margin requirement was somewhere around $20,000. The current value of one S&P contract is approximately $270,000. Therefore, you can benefit from the movement of a $270,000 instrument with only $20,000 in your account. The catch is that if the value decreases from $270,000 to $250,000, you will lose your entire $20,000.

There are a couple of things to remember when associating margin with trading and in particular, money management. Actually, there is only one thing to remember about that . . . don’t. The exchanges did not set these margins with the intention of helping you and me (the traders) out with our trading. They set the margin rates for their protection and their financial gain. That being the case, do not base any trading decision on margin requirements . . . ever. Simple as that. Rarely, if ever, will recommended money management techniques be more aggressive than the margin required to implement them.

The current margin requirement for trading a full bond contract is $3,000. If I open an account for $3,000 because that is the margin requirement, and then trade a contract in the bond market, the very day that position goes against me, my broker will be calling me for additional funds to place in the account. If I don’t send it, the position will be liquidated.

The question then is, what is the proper amount to start a trading account and still be able to apply proper money management principles? There is no magic answer to this question; however, there is a logical minimum. The main reason that new businesses fail is under capitalization. That is also the case for traders who get involved with leveraged instruments. Then there are those who would just as easily lose $500,000 as $5,000 if they had it. They fall under the category of being well capitalized but having absolutely no money management planning whatsoever.

You should consider three factors before deciding what amount to use to open an account. The first is not the margin, but the drawdown you are willing to permit with the strategy you have decided to trade. If the margin requirement for trading the bonds is $3,000 but the strategy will most likely suffer a drawdown of $5,000 through the course of trading, you’re dead in the water.

The second factor that should be considered is the margin. If the drawdown will most likely be at least $5,000 and the margin is $3,000, you know you cannot start the account for less than $8,000. Even if you were not going to consider the third factor, you would still want to give yourself some room for error in the drawdown expectation. This is explained later in this chapter in the section “Drawdowns.”

The third factor to consider is the ability to continue trading after realizing the expected drawdown. What good is it to fund the account with an amount equal to the expected drawdown plus margin requirements if this renders you incapable of continuing to trade once the drawdown is realized? I personally like to triple or even quadruple the margin plus expected drawdown figure.

Quadrupling this amount does several things. First, it allows me to stay in the game should my system or trading method fail to meet my profit expectations. I can regroup, reevaluate, and continue trading what I am currently trading or change methods. Second, it gives me the psychological ability to take all the trades, even while I am in a drawdown. Although this  article does not address the subject of psychology  and trading, the emotional effects of suffering a number of losing trades takes its toll on the trader’s ability to trade. The reason I do not deal with this subject is that I believe discussing it is a waste of time. If a trader is weak in this area (as I am) and cannot execute trades because the fear of losing causes second guessing, then the answer is to find someone to take the trades for you. Rather than spending countless hours and dollars on trying to find that event in your childhood that prevents you from taking the trades, delegate the weakness. Concentrate on the strengths and delegate the weakness. I know because it has worked for me for several years now.

The third thing that is gained from quadrupling the margin plus expected drawdown is that it gives a cushion for error. If I erroneously calculated the expected drawdown to be $5,000 when it should actually be expected at $10,000, this precaution keeps me from blowing myself out of the game.

This is simply a beginning point. The same amount of capital is not required to increase the risk on any given trade. Many traders determine an amount to begin with and then conclude that the best money management approach would be to increase the amount to risk on any given trade after the account has doubled. This is a completely illogical application of a money management strategy. Some traders believe that because they approach trading very conservatively their method, as illogical as it may be, is still the only way for them. They are wrong. Do not fall into this type of thinking.

Popularity: 7% [?]

This is one of the most common questions I receive, as well as one of the most common areas for serious mistakes by traders. Traders tend to believe that they do not need to address money management until sometime in the future, after they are making money. They want to “prove” that a particular strategy will work before they decide to apply any money management methods. This can be a costly mistake. Recall the trader who made $70,000 without applying money management just to prove that the strategy was going to make money first. It cost him about $600,000 in profits during that year. I could probably rest my case with that example, but I want to explain the “whys” here.

First of all, proper money management will not come into play unless there are profits in the account. Remember that with the antimartingale type methods, as the account grows, the amount to be risked on each trade also increases. Therefore, the application of proper money management requires some degree of success or proof that the strategy makes money. However, that amount of proof is nowhere near the $70,000 level. That is one of the reasons for this mistake. Traders want to prove that the method makes money, but they wait too long.

Second, there is little additional risk in applying money management from the beginning instead of not applying it at all. That additional risk is associated with asymmetrical leverage, which has already been touched on. That additional risk is realized only if the account makes it to two contracts, immediately drops back to one and continues to suffer a drawdown below the original starting account size. If the starting account balance was $20,000, was scheduled to increase to two contracts at $25,000 and suffers a $1,000 loss right after that increase, the amount lost is an additional $1,000. If the account continues to drop below the original $20,000, there will be a one time loss of $1,000 that would not have been there if the money management had never been applied. The flip side is the potential $500,000 in profits you are risking by not applying proper money management. Let’s see, a $1,000 risk to $500,000 reward ratio . . . hard decision!

Third, if the account follows the scenario described in the previous paragraph, the scenario did not turn out to be a positive expectation. As stated earlier, no money management scheme can mathematically turn a negative expectation into a positive gain.

If you are actually risking your money in the markets, you most likely are doing so with a strategy that has a positive expectation. In that case, you should apply money management from the beginning based on your expected performance. The only reason a trader should not apply proper money management principles from the beginning is if that trader actually expects to lose. And, if that is the case, why trade?

Popularity: 7% [?]

The 10 Keys of Successful Trading

• Key 1: Equity Management
• Key 2: Buy and Sell Signals
• Key 3: Bulls vs. Bears – Introduction to Highs, Lows, Support and Resistance
• Key 4: Price Swings
• Key 5: Fibonacci Ratios
• Key 6: Trends and Trendlines
• Key 7: Trading Trends with Fibonacci Ratios
• Key 8: Trading Trend Reversals or “The King’s Crown”
• Key 9: Trading Consolidation with Fundamental Announcements
• Key 10: Protective Stop Losses and Murphy’s Law in Trading

It is the mission of the trader to become a financially successful long-term trader. This can be achieved when the trader adopts and accepts The 10 Keys of Successful Trading. The trader must commit to live by the three disciplines that create the successful trader.

1. The trader must believe in The 10 Keys to Successful Trading and merge them into his personality. His success is dependent on creating a trading plan, and maintaining the discipline to TRADE THE PLAN!
2. The trader must commit himself to continued education and learn as much as he can about technical analysis and the psychology of successful trading. He must use logic, and not his emotions, in trading. The trader must learn to trade in control, not out of control!
3. The trader must map out a sound plan of equity management to insure a return on his investment. A successful plan is to trade no more than 20% of a margin account and risk no more than 5 to 10% of that account on any single trade.

Popularity: 11% [?]

A Trader must understand what each order is and does and what part it plays in capturing profit. As a Trader on the FOREX you use three types of orders: a Market Order, a Limit Order, and a Stop Order. The two primary orders you should use for entering and exiting the market are a Limit Order and a Stop Order. Once you have placed your order to enter the market, there are two procedures to that your need to understand. These are: One-Cancels-the-Other (OCO) and Cancel-and-Replace. Properly executing your orders and understanding these procedures play a very big part in your profitability.

Remember: all good carpenters carry a toolbox. The sharper his tools and the more skilled he is at using them, the more effective he is. The sharper you are as a trader the more effective and profitable you will become.

The following explains in detail what each order does. You must clearly understand what each order does before you start to execute your orders.

Market Orders: A Market Order is an order that is given to a broker to buy or sell the currency at whatever the market is trading for at that moment. It can be an entry order into the market or an exit order to get out of the market. Traders use Market Orders when they are ready to make a commitment to enter or exit the market. You must be very careful when using Market Orders in fast moving markets. In fast rallies or down reactions you can gain or lose many points to slippage before you receive your fill.

Trading is an auction where there are buyers (bidders) and sellers (offerers). The bid is the “buy” and the “ask”, or offer is the sell. Slippage is defined as: when a trade is executed between a buyer and seller and the resulting buy or sell transaction is different than the price you saw just prior to order execution. With Market Orders you will lose on average one to six pips, if not more, due to slippage. Market Orders are rarely filled at the exact price you are expecting. We Recommend caution when entering or exiting with a Market Order.

Limit Orders: Limit Orders are orders given to a broker to buy or sell currency lots at a certain price or better. The term Limit means exactly what it says. You will buy at that exact limit price or better a large majority of the time. Limit Orders are used to enter and exit the market. They are generally used to acquire a specific price, avoiding slippage and unwanted order fills (execution price) which can happen with Market Orders.

When you sell above the market, it is a Limit Order. When you buy below the market, it is a Limit Order. A limit order will be executed when the market trades through it. Seventy to ninety percent (70% to 90%) of the time, if the market is trading at your Limit Order it will be executed. The market must trade through you specified Limit Order number to guarantee a fill. The computer will notify you within seconds of your fill. You do not have to call your broker to see if you have been filled.

Stop Orders: Stop Orders are orders placed to enter or exit the market at a desired specific price. When you buy above the market, it is a Stop Order. When you sell below the market, it is a Stop Order. Stop Orders turn into Market Orders when the market trades at that price. Stop Orders as well as Market Orders are subject to slippage, while Limit Orders are not.

The majority of Stop Orders are used as protective Stop Loss Orders. It is the order you place with your entry order to insure an exit when the market goes against you. A good trader never trades without a protective Stop Loss Order. They are orders executed to get you out of the market when your trade has gone against you.

One Cancels the Other (OCO): Whenever you enter the market, you must exit the market at some future time. An OCO order is a procedure and means one-cancels-the-other. Once you have entered the market, you should place a protective Stop Loss Order and have in mind a projected profit target. That projected profit target can be your Limit Order. If you simultaneously place both Limit and Stop Loss Orders when you enter the market, you can OCO them and walk away from your computer. What does that mean? At some future point in time either your Stop Order or Limit Order will be executed, automatically canceling your opposing order. If the trader is so sure about the trade, he can execute an OCO order and walk away from the trade. The computer will than manage the trade.

Cancel/Replace Orders: A Cancel/Replace Order is a procedure and not an entry or exit order. By definition it is when the trader cancels an existing open order and replaces it replace it with a new order. A cancel/replace order is primarily a strategy of trading and is predominately used after one has taken a position in the market and wants to stay in the market locking in profit. For example: you buy Swiss at 1.410. Your protective Stop Loss Order is 1.390. The market moves in you direction as projected. You now want to reduce your potential loss, so you cancel your Stop Order at 1.390 and replace it to 1.410 where you got in. You are now in a trade with no risk. As the market moves further north in your direction, you now want to lock in more profit. You cancel your 1.410 Stop Loss Order and replace it with a new 1.440 Stop Loss Order. You now have locked in 30 Pips in profit. You are in an all-win, no-risk trade. You keep canceling and replacing your Stop until you are finally stopped out.

Popularity: 5% [?]