## my journal 2

This is a discussion on my journal 2 within the Trading Journals forums, part of the Reception category; Today I need to study money and risk management, because I realize that I need to automate them better. But ...

Apr 11, 2010, 8:55am   #661

Joined Mar 2003
money and risk management

Today I need to study money and risk management, because I realize that I need to automate them better.

But it's hard. I've been working on this for years and I still have not found a good way to automate it, so that I don't have to constantly monitor how many contracts which of my systems are being allocated. One of the reasons why money management is so hard, besides the fact that I am bad at formulas, is that it's hard to appraise my systems' performance.

The most basic principle would be:

1) Let all profitable systems trade 1 contract.

But then of course, if capital is limited, we should favour the best systems, so I created formulas to appraise which are the most profitable systems and implemented this money management:

2) Let the best systems trade more than the others.

Then I realized that it's not just a matter of how much profit, but also how much they could lose during a drawdown, so:

3) Let the best systems trade more than the others, and measure performance by profit AND drawdown.

Then I realized ROA wasn't enough, and I included Profit Factor.

4) Let the best systems trade more than the others, and measure performance by profit, drawdown AND profit factor.

Then I realized I also want to know how often and how deeply a system incurs drawdowns, so I measured this with my simple formula of average deviation, which is not too bad, I guess. Since alone it would not be a good indicator, I divided profit by average deviation.

5) Let the best systems trade more than the others, and measure performance by profit, drawdown, profit factor AND average deviation.

Now, it would seem my appraisal of performance is complete, and maybe it would, but, with a small capital of a few thousands, strange things happen, like the best systems not trading because risk management doesn't allow them, which brings me to another ingredient: risk management, which in my own vocabulary I use to define my control over losses. I never allow a system to incur a loss bigger than x% of total capital. While I would define "money management" as deciding how much you should allocate to each system based on the "good" side of a system's performance (mostly the profit it makes), I consider "risk management" as something to protect me from excessive risk. Traders use and misuse these two terms in so many ways, and this is the only way I could make sense of them, for now.

So this brings me to the present definition of my risk and money management formulas, which I still don't find satisfactory nor self-sufficient:

6) Let the best systems trade more than the others, and measure performance by profit, drawdown, profit factor and average deviation. Make sure no system can lose more than x% of capital.

In the past I've downloaded, via emule, dozens of .pdf books on money management, but of course they need to be read, which is not easy at all, considering each book doesn't approach it with a quick answer, but needs to be at least 100 pages long (as all books are) so it starts discussing money management from the middle ages, and basically is filled up with a lot of god damn bull****. But that's what you have to do to get your book published: if you can say it in 10 pages, they won't publish your book, so you have to fill it up with bull****. It's like a natural selection all reversed: only the people willing to write bull**** get published. The others are probably writing on forums, but it's quite hard to find their stuff among the sea of smilies and bull**** in forums.

So maybe I will try to see what I can get out of wikipedia, which is probably the best combination of both worlds (academic bull**** world and forum bull**** world).

Obviously I went here first:
http://en.wikipedia.org/wiki/Money_management

But it's no good. Except that it tells me to read this book, which is a good one actually and I have it:
Quote:
 Balsara, Nauzer J. (1992). Money Management Strategies for Futures Traders
Until now, the best wikipedia entry I remember reading on money and risk management was this entry:
http://en.wikipedia.org/wiki/Kelly_criterion

But let's check out "risk management", just in case:
http://en.wikipedia.org/wiki/Risk_management

As I read this stuff, i need to remind myself constantly that I don't give a **** about being an academic and that I should stick to the original point of making money. It's hard to remember this, when everyone writing this stuff is busy making himself look good and knowledgeable. These people don't care to be useful to me: they just want to show off their knowledge. Like the "look elsewhere" user.

Anyway, the wikipedia entry is no good. So we're left with kelly criterion as far as wikipedia.

You see, my problem is that whereas it's easy to see which systems are the best, and I've done that and even automated it, it's not easy, when you have enough capital to allow your good systems (and the others) to trade more than 1 contract, to automate the allocation of these extra contracts.

Maybe I should completely separate the risk from the money management part...

Let's first discuss kelly. Kelly is great, but, with 40 systems, it gets too complicated to use it, at least with my low skills at using formulas.

So let's see if I am at least doing what he considers to be right. Other than the kelly formulas, the most important stuff I found on that entry is:
Quote:
 Reasons to bet less than Kelly A natural assumption is that taking more risk increases the probability of both very good and very bad outcomes. One of the most important ideas in Kelly is that betting more than the Kelly amount decreases the probability of very good results, while still increasing the probability of very bad results. Since in reality we seldom know the precise probabilities and payoffs, and since overbetting is worse than underbetting, it makes sense to err on the side of caution and bet less than the Kelly amount.
This is telling me to stay on the safe side in case I am not sure of my edge and drawdown (and I am not sure), because, if I underbet I will simply increase my capital more slowly. Whereas, if I overbet, I will blow out my account.

Forget the books, as they are too long and too hard to make sense of them. It's best to do it by myself in depth, than to read books superficially. I know what I want - I will figure it out by going back to my excel workbooks.

Let's take care of risk management (as I intend it) first. We want to separate the two completely.

RISK MANAGEMENT

The way I mean "risk management" is just to make sure that if a system incurs its worst possible loss, it won't exceed x% of capital. That "x" will vary depending on how much capital I have: I will define that "x" arbitrarily, even though I am aware that Larry Hite and others have said it should be no more than 1%. But I don't have their money.

I have estimated the worst possible loss by each system as an average of max drawdown (back-tested and forward-tested) and max loss during forward-testing, just in case my forward-testing sample isn't large enough.

I will now also add a rule that says if the foward-testing trades are less than 20, no more than 1 contract should be allowed.

[...]

After much thinking and tweaking, I have reached a solution:

1) I have finally given up on my plan to entirely automate risk and money management. Better to do less but well, than do much more but not well.

2) I have entirely separated risk management from every other column (no connections, no "dependents" functions). Now it calculates just this:
=-s!\$B\$20*s!\$B\$25/mm!C2
Capital multiplied by % of capital allowed to be lost by biggest loss and then divided by biggest expected loss.

If we have a capital of... say 100k and multiply by... say a 5% of capital allowed to be lost by biggest loss, we find out we can only risk 5k with each system. Then we divide it by a max loss of... say 2.5k and we get 2, which means only 2 contracts can be allocated to that system, if we don't want it to cause us a potential loss bigger than 5k. Now this is all automated and it limits our contracts, as it has to do with limiting our risk.

3) Now, on to money management. This is the toughest part, and it's the part I've kept arbitrary, or rather "manual" and "discretionary". It's hard because it's hard to appraise each system's performance. I have set up 2 columns:

A) one is the (automated) rating of my systems, based on my custom index I've spoken about in previous posts. Such index relies Return On Account, Profit Factor, Average Deviation. Each system's index value in turn gets weighed against the best system's value and then multiplied by the highest amount of capital I want to allocate to the best system:

=s!\$B\$23*(P2/s!\$B\$24)/B2
% of Capital allocated to best system times how well a system is doing compared to the best system divided by margin

Say we have a capital of 100k, and we decide to only invest 50% of it on our best system (how is it possible with 40 systems? systems do not all trade at once). We then have to multiply that 50k by how good a system's performance is compared to the best system, let's say our hypothetical system on OIL is only 50% as good, in terms of the mentioned Index. That CL system will then only get 25% of capital. Then we divide 25k by CL's overnight margin of 5k, and we get a result of 5, which is the suggested amount of contracts to be traded.

B) I then decide with my discretionary manual column if everything seems right and I am willing to let the CL system trade 5 contracts. Let's say I do, and have written a 5 to confirm that. That 5 will stay there no matter how much capital increases, so the system will only be allowed to trade 5 contracts until I check on it again and manually change that figure. The A) column, with the Index allocated contracts is only advice to me, but it doesn't affect the trading. The trading contracts get decided by two columns: the one with my manual choice and the risk management column, which in this case would limit contracts to 2 probably, because that very good CL system happens to lose too much.
__________________
Read: E.P. Chan, Cogneau - Hubner, Sewell, Tverberg. Search: expected shortfall, Monte Carlo VaR, extreme value theory. Trade.

Last edited by travis; Apr 11, 2010 at 11:12am.

 Apr 11, 2010, 2:30pm #662 Joined Mar 2008 Re: money and risk management You should look at fixed fractional bet sizing as well. By Ralph VInce. However I'm pretty sure you'll hate his books because they use lots of equations and formulae. Maybe there's a non-maths guide to fixed fractional bet sizing - also known as 'optimal f' where f just stands for fraction. You need a good handle on what your maximum loss could be. Although in theory it is pretty much unlimited. If you don't find anything I can try to outline the idea for you, since I need to refresh myself on it anyway. It's pretty convincing to me that it's the best way to maximize geometric growth of your account and you can operate it across multiple trading systems and markets. However it does have a weak point (the requirement to know the max loss). __________________ What matters most is how well you walk through the fire.
 Apr 11, 2010, 6:43pm #664 Joined Mar 2008 re: my journal 2 OK I won't hassle you about it. It is quite a well known method, I'll see if I can find a graph somewhere. It's pretty easy to see from the explanation he gives, even though he quotes a couple of formulae every now and again to prove he's mathematically competent, that the optimal fraction of your capital is the way to do it. __________________ What matters most is how well you walk through the fire.
Apr 11, 2010, 7:10pm   #666

Joined Mar 2008
re: my journal 2

Quote:
 Originally Posted by travis Better to start immediately with a simple and efficiently automated system, which does NOT solve that remote and unlikely but possible event, than to start two years later because I want to take care of every single problem I might have. Why? Because I could die in the meanwhile, and because i know quite a few programmers who - because they want to do everything perfectly - still didn't place one automated trade with their trading systems after 10 years of talking about it.
by the way, i totally respect waht you say here. Carpe diem.
__________________
What matters most is how well you walk through the fire.

Apr 11, 2010, 7:27pm   #667

Joined Mar 2003

Quote:
Awesome link, but still has a formula in it, which makes it still too complicated for me. But I appreciated the thought of sending me to the dummies.com web site, as it shows you have gotten to know me quite well (with my dislike for formulae). And this guy does make it clearer.

__________________
Read: E.P. Chan, Cogneau - Hubner, Sewell, Tverberg. Search: expected shortfall, Monte Carlo VaR, extreme value theory. Trade.

Apr 11, 2010, 7:32pm   #668

Joined Mar 2003
re: my journal 2

Quote:
 Originally Posted by Adamus by the way, i totally respect waht you say here. Carpe diem.
I respect your respect, and I see why you would agree with me that getting things done imperfectly is better than trying to do things perfectly and not getting them done, since you named your thread "Deadline June".

__________________
Read: E.P. Chan, Cogneau - Hubner, Sewell, Tverberg. Search: expected shortfall, Monte Carlo VaR, extreme value theory. Trade.

Apr 12, 2010, 7:48am   #669

Joined Mar 2003
still struggling with money management

Let us first of all define risk and money management.

I would simply say this, as funny as it may sound:

1) risk management is the management of risk (i.e.: worrying about not blowing out your account).

2) money management is the management of money with a focus on how to increase it as fast as possible.

Now, if we accept my concepts above, my problem is with money management right now, because I took care of risk management until yesterday, and now I am done with that part.

The problem specifically is money management with futures.

You see, it's hard to deal with this, not just because I suck at formulae, but also because futures do not mean investing money on something, but using margin.

And there's the other usual problems at stake, all intertwined with this central problem of margin.

Brainstorming:

1) A...

I'll continue from the office, in a few hours.

Ok, back.

In the meanwhile I've sent myself this book:
[eBook Trading] Balsara, Nauzer J. - Money Management Strategies for Futures Traders.pdf

I had read it before, and I don't remember finding any precise solution to my problems, but maybe when I read it I didn't see the problems I see now. So, I'll try to read it again with my new problems in mind.

Getting back to my brainstorming:

- I have established which systems work best, through accurate and reliable formulas.

- I have limited the risk of ruin by monitoring a value obtained by biggest losses and drawdown.

- I have to find out what is the fastest way to increase my capital.

No, I've got it all wrong.

I am still worried about drawdown and possibility of blowing out my account and that's what makes this so hard.

I am not just looking for a combination that will increase my capital as fast as possible: I am looking for a combination that will increase my capital as fast as possible while decreasing my chances of blowing out my account as fast as possible and I have to do all this on 40 systems at once.

This is why it's being so complicated. AND because I suck at formulas.

I can tell I won't get out of this unless I speak to some mathematician, so I'll just quit until I meet one.

I will just recapitulate my present risk/money management (because the two things are clearly intertwined and almost inseparable) until here, because I believe it's pretty good (it works), but neither univocal nor clear nor simple, all of which are no good. I would like to meet a mathematician to come up with just 1 formula to deal with all these problems (the ones in red above).

I guess that mathematician could be Balsara himself and I could read his book again. We'll see. Maybe I should just read between pages 130 and 140, all these sections:

Quote:
 ALLOCATION WITHIN THE CONTEXT OF A MULTI-COMMODITY PORTFOLIO
Quote:
 USING THE OPTIMAL f AS A BASIS FOR ALLOCATION
Quote:
 LINKAGE BETWEEN RISK CAPITAL AND AVAILABLE CAPITAL
Quote:
 DETERMINING THE NUMBER OF CONTRACTS TO BE TRADED
Anyway, the present situation is this, in a simplified description, and a comparison to "car pedals" of it:

1) Risk management (yes, I keep them separate, and that's the problem maybe), the brake pedal.

For each system I get a value which is derived from drawdown and biggest loss, and use that as a risk parameter: I can't invest on a system more money than what will cause me a max loss of over 5% of capital. This is just a very quick explanation. This is therefore a risk measurement, and a LIMIT to my investment in each system, but does not tell me which systems are more convenient. It just keeps me from investing so much in a system that will make me risk blowing out my account.

2) Money management, accelerator or "gas pedal"

For each system, I used Return On Account, Profit Factor, Average Profit / Average Deviation to measure performance and rated it on a scale from 0% to 100%. Then I allocate capital according to this scale, and multiplying by how much I want to allocate to the best system, which will score 100% (the others are ranked accordingly).

This money management of mine continues this way: I then divide the allocated money (and up to here everything seems reasonable) by the margin (intraday or overnight) required to trade 1 contract with a given system. This is where I see some contradictions and problems.

But even before this, who says how much I should diversify and how much I should privilege the best systems?

In terms of absolute return indeed it would be more convenient to invest all money on the best system. But then again, it won't trade all the time, so I can also invest on the other systems... so ultimately it would make sense to invest all money available in all systems trading at that time...

You see, it's quite complex.

If we then look at drawdown and Return On Account values, we can find a solution which might help us, or not.

The CL alone has a drawdown of 5k. But if we trade it together with the other systems, the overall drawdown might stay at 5k or even decrease. So does this mean I should invest in all systems at once?

I don't know. I just have endless questions due to my lack of math and statistical knowledge.

I certainly would make more money, and apparently the drawdown stays the same or even decreases.

But maybe only because I got lucky. Indeed, by trading all systems together, I could get unlucky and they could lose all at the same time, and then my choice would not have been so good.

But how likely is it that all systems will lose at once? Am I more likely to blow out my account by trading just one system on 100% or trading 40 systems each on 100% of capital? What if I decrease that %? By how much?

And what about this other question: if I play it very safely, say by allocating 1% of capital to each system and keeping 90% of my capital not used, how likely am I to reach my goal by the time I die?

Also, if I don't use all the systems at once and play it safely, how likely are they to last long enough to make it worth it? Or maybe am I just wasting a good moment to use them, since they won't work in a few years?

I have no answers to these questions above and many more that I am not writing.

The best approximation to answering these questions is looking at my equity curve for the past 9 months, tweak the contract numbers on it, also monitoring how much margin I'd need and how good the systems being traded are (that much I do know). Then I look at how high the equity curve rises and how deep its valleys are, and I get a pretty good idea of how much I should have allocated to maximize returns and minimize risk (minimize fear, which would happen if I incur a big drawdown). But that's the past: is that a guarantee that because I can make that curve look smooth in the past, it will also look smooth in the future? Probably better than if I get that curve to look bumpy even for the past.

Some things I can just guess, without the help of formulas.

1) The more systems the better.
2) The more markets traded by the systems the better.
3) The combination of contracts that makes the curve look the smoothier and with the least drawdown, should guarantee less drawdown in the future

I am positive about the first two. The third is a "probably".

Now I'll print those 10 pages of Balsara, to see if they enlighten me.
__________________
Read: E.P. Chan, Cogneau - Hubner, Sewell, Tverberg. Search: expected shortfall, Monte Carlo VaR, extreme value theory. Trade.

Last edited by travis; Apr 12, 2010 at 12:19pm.

 Apr 12, 2010, 12:53pm #670 Joined Mar 2003 eureka about money management I was brushing my teeth and I just went "eureka" so to speak. I need to find a way to monitor, for any given capital all used as margin, average daily profit / average daily deviation (simplified sharpe ratio) for different combinations of contracts allowed and then come up with best value. __________________ Read: E.P. Chan, Cogneau - Hubner, Sewell, Tverberg. Search: expected shortfall, Monte Carlo VaR, extreme value theory. Trade.