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Strategies & Market Trends : Befriend the Trend Trading -- Ignore unavailable to you. Want to Upgrade?

To: Dr. Stoxx who wrote (6987)	5/10/2000 12:19:00 PM
From: Dr. Stoxx	Read Replies (1) \| Respond to of 39683

To ALL: Here is a system for money management that was PM'd to me. I've only included an excerpt (though you get the full system here) because there is some subscription information that it would not be right to post on a public thread. I would welcome your comments (I have my doubts): ___________________________________________________________ The Kelly Criterion (which was formulated to maximize clean transmission rates through noisy phone lines) reduces every trade to an even money proposition based on average expectation. To find it, keep a record of every trade you make. The last 20 to 50 will provide a broad enough sample to quantify your track record with reasonable accuracy. But in general you should increase your sample size with your trading frequency. Naturally, the larger number of trades you use the more confidence you will have that your edge is an accurate result of your trading skill and not just some recent "good luck." Remember the old adage, "Don't mistake a bull market for brains." Calculate the absolute values of your gains and losses and also calculate the percentage of your trades that were winners. Find the average (%) gain of your winners, and the average (%) loss (absolute value) of the losers. Subtract the latter from the former. (If the result is negative, put your money in a savings account). Let's say your average winner is 24% and your average loser is 8%. Subtracting the two gives 16%. Now, if your trades are successful 50% of the time, your average expectation is 50% * 16%, or 8%. That is how much of your bankroll you can risk on a given position. Depending on your sample size, your probability of never going broke will be in the range of about 90-95%. (By "going broke" I mean losing all of your risk capital ? not, for example, your house.) In practice this means that on any given trade you will not allow your loss to be greater than that 8% --not of that trade's commitment, but of your total risk capital. To size a particular position correctly, you will calculate your exit point before engaging the trade and adjust your trade size so that the decline to that exit point will be less than 8% of your bankroll -- ahem, capital --, or less. To carry the hypothetical case further, let's say you have $200,000 to invest. The maximum you can risk on a trade is 8% of this, or $16,000. You find a great buy at $32 with a natural exit point at $29. This means you will hold your possible loss to a maximum of $3 per share. Your optimum position for this transaction is $16,000 /$3 or 5,333 shares. You would probably round this down to 5,000 shares. Your dollar outlay at $32 a share would be $160,000. In other words, you would put 80% of your risk capital into this one trade. This is a much higher number than produced by most conventional advice on trading, which must offer more conservative advice on position sizing because it is done without the confidence provided by the Kelly calculation. Think about how fast your capital will grow if your expectation on each trade is 8% of your bankroll -- or even as little as 2%, if your trades are frequent. Because they do not calculate their edge, most successful traders have an edge that is significantly higher than what they risk on a given position. This means that they are leaving far too much on the table. This strategy is innately conservative in another way: when the market shifts out from under your favorite winning system, you will be forced to choke back on your position sizing (or raise your exit points). And when you have the market in a chokehold, you will be sure to shake the maximum out of it. Kelly betting will produce some huge fluctuations in your capital. There will be times when you will have several positions go against you at the same time and each of them might take out your maximum risk, but you will find an occasional series of 3 and 4 straight winning trades will top your capital back up, pronto. By the way, after you inaugurate this procedure, your goal in trading becomes not making money directly, nor being right with greater frequency, but maintaining, and increasing, that edge. ___________________________________________________________