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I was reading a journal by an obviously extremely talented trader here who isn't maximising his potential anywhere near to the kind of money he could and actually should be printing.
The problem very obviously is not his trading method which is very successful, putting it mildly.
No.
The reason why he is nowhere even close to where by all rights he should be is due to a different reason altogether.
It's a lack of proper position sizing combined with a lack of compounding vs the excellent expectancy of his method.
That's why I decided to pen this, market volume having dried up as it is anyway what with Christmas round the corner and everybody closing their books.
So here goes.
Provided you have a method or system with a positive expectancy then the single most important determinant of your overall success will be position sizing and compounding, two of the most overlooked sizes in most peoples neverending quest for a holy grail of perfect entries and exits.
Let's quickly go through the success relevant factors driving your P&L:
Expectancy of your system quite simply consists of the following ingredients:
I: Divide average size of your winners vs average size of your losers = Win / Loss Ratio
II: Percentage of your trades that end up > breakeven = Win Probability
III: Transaction costs = Commissions + Slippage
IV: Trading opportunities = how many signals per month, week, day, hour, etc your system generates.
You can play around with some of those parameters here and see how your expectancy stacks up:
Random Equity Curve Simulator of a trading system. Learn it before you trade
A positive expectancy is obviously a prerequisite, no positive expectancy, no net profitability.
But provided we have a system with net profitability - and don't forget that that is achievable with a system that on average has 33% winners, and a risk / reward ratio of 1 / 3 - then the next step will be position sizing and compounding.
This alone will determine the extent of your success.
Keeping in mind that risk and reward are correlated, that the slope of your equity making new highs will have corresponding drawdowns, it's down to you and your pain threshold to determine the amount of money you will be printing from now on, where you will be in the next year or in ten years.
Of course everything has an optimum, and many will miscalculate what they are willing to endure.
Backtesting something on paper and seeing that if you are willing to risk X % per trade that that will generate XYZ in returns one year down the road, but also means you will have to endure a 50% drawdown, is ONE thing in theory, and a totally different matter in practise, depending on what you can or, more likely, cannot handle.
Another thing that needs to be kept in mind is that outlier events are not a question of IF, but only of WHEN.
You WILL have losing streaks you would never have believed possible if you survive long enough in this game to experience them, if you haven't blown up or given up before.
Risk of ruin isn't just a theory, it's a very real threat.
Cliché, but true, there are old traders, there are bold traders, but no old AND bold traders...
Enough about the risks then, lets move on to the position sizing options themselves.
The key factor behind the money you will make isn't an eternal search for fail proof entries or woulda-coulda-shoulda exits that took you out at the top hehe, it's simply how big you trade and if you can keep compounding your position size in an anti-martingale style - ie where you get bigger as your equity grows, and smaller when it shrinks - with every new position you put on.
The mechanics behind fixed fractional position sizing are straightforward enough:
First you determine where you want to enter.
Then you determine where you will be stopped out with a loss if the market goes against you.
And the distance between your entry price and your stop loss will then always equal a position size that constitutes the exact same percentage amount of your account.
Meaning that if your trade gets stopped out with a loss that will then always equal (excluding slippage or gaps during adverse or fast market conditions) whatever % of your equity you are willing to lose per trade, 0.25%, 0,5%, 1%, 2%, 3%, or whatever seems justifiable per your systems expectancy and your ability to handle drawdowns.
In absolute terms total amounts of money won or lost will obviously vary along with growing or shrinking equity levels in your account as you go through losing or winning streaks, but the percentage amount which is really all that counts until eventual liquidity issues will force you to start trading smaller and smaller percentage wise will always be exactly the same (adverse market conditions apart as mentioned).
The inherent beauty and amazing power of this method of fixed fractional position sizing is that it adapts perfectly to your current situation, when things are going your way you get bigger and bigger with every single trade, harnessing the magic of compounding to the hilt, whilst when things are going against you, you are reducing your position size with every trade thereby ensuring your survival - your most important objective in trading - and that you will be around to capitalize on better market conditions for your method when they arise.
Market Wizard Ed Seykota of the hundreds of thousands percent returns has a great piece about money management here:
Risk
Not a great fan of this guy who basically leeched off of others he never had any connection with but his summary here is good nevertheless:
Money Management | TurtleTrader
And this guy who trades for a living goes into great depth:
Mechanical Trading Systems - Money Management
Once you have a method with a positive expectancy then position sizing and compounding combined are the only real Holy Grail, the only real Keys to the Magid Kingdom !
The problem very obviously is not his trading method which is very successful, putting it mildly.
No.
The reason why he is nowhere even close to where by all rights he should be is due to a different reason altogether.
It's a lack of proper position sizing combined with a lack of compounding vs the excellent expectancy of his method.
That's why I decided to pen this, market volume having dried up as it is anyway what with Christmas round the corner and everybody closing their books.
So here goes.
Provided you have a method or system with a positive expectancy then the single most important determinant of your overall success will be position sizing and compounding, two of the most overlooked sizes in most peoples neverending quest for a holy grail of perfect entries and exits.
Let's quickly go through the success relevant factors driving your P&L:
Expectancy of your system quite simply consists of the following ingredients:
I: Divide average size of your winners vs average size of your losers = Win / Loss Ratio
II: Percentage of your trades that end up > breakeven = Win Probability
III: Transaction costs = Commissions + Slippage
IV: Trading opportunities = how many signals per month, week, day, hour, etc your system generates.
You can play around with some of those parameters here and see how your expectancy stacks up:
Random Equity Curve Simulator of a trading system. Learn it before you trade
A positive expectancy is obviously a prerequisite, no positive expectancy, no net profitability.
But provided we have a system with net profitability - and don't forget that that is achievable with a system that on average has 33% winners, and a risk / reward ratio of 1 / 3 - then the next step will be position sizing and compounding.
This alone will determine the extent of your success.
Keeping in mind that risk and reward are correlated, that the slope of your equity making new highs will have corresponding drawdowns, it's down to you and your pain threshold to determine the amount of money you will be printing from now on, where you will be in the next year or in ten years.
Of course everything has an optimum, and many will miscalculate what they are willing to endure.
Backtesting something on paper and seeing that if you are willing to risk X % per trade that that will generate XYZ in returns one year down the road, but also means you will have to endure a 50% drawdown, is ONE thing in theory, and a totally different matter in practise, depending on what you can or, more likely, cannot handle.
Another thing that needs to be kept in mind is that outlier events are not a question of IF, but only of WHEN.
You WILL have losing streaks you would never have believed possible if you survive long enough in this game to experience them, if you haven't blown up or given up before.
Risk of ruin isn't just a theory, it's a very real threat.
Cliché, but true, there are old traders, there are bold traders, but no old AND bold traders...
Enough about the risks then, lets move on to the position sizing options themselves.
The key factor behind the money you will make isn't an eternal search for fail proof entries or woulda-coulda-shoulda exits that took you out at the top hehe, it's simply how big you trade and if you can keep compounding your position size in an anti-martingale style - ie where you get bigger as your equity grows, and smaller when it shrinks - with every new position you put on.
The mechanics behind fixed fractional position sizing are straightforward enough:
First you determine where you want to enter.
Then you determine where you will be stopped out with a loss if the market goes against you.
And the distance between your entry price and your stop loss will then always equal a position size that constitutes the exact same percentage amount of your account.
Meaning that if your trade gets stopped out with a loss that will then always equal (excluding slippage or gaps during adverse or fast market conditions) whatever % of your equity you are willing to lose per trade, 0.25%, 0,5%, 1%, 2%, 3%, or whatever seems justifiable per your systems expectancy and your ability to handle drawdowns.
In absolute terms total amounts of money won or lost will obviously vary along with growing or shrinking equity levels in your account as you go through losing or winning streaks, but the percentage amount which is really all that counts until eventual liquidity issues will force you to start trading smaller and smaller percentage wise will always be exactly the same (adverse market conditions apart as mentioned).
The inherent beauty and amazing power of this method of fixed fractional position sizing is that it adapts perfectly to your current situation, when things are going your way you get bigger and bigger with every single trade, harnessing the magic of compounding to the hilt, whilst when things are going against you, you are reducing your position size with every trade thereby ensuring your survival - your most important objective in trading - and that you will be around to capitalize on better market conditions for your method when they arise.
Market Wizard Ed Seykota of the hundreds of thousands percent returns has a great piece about money management here:
Risk
Not a great fan of this guy who basically leeched off of others he never had any connection with but his summary here is good nevertheless:
Money Management | TurtleTrader
And this guy who trades for a living goes into great depth:
Mechanical Trading Systems - Money Management
Once you have a method with a positive expectancy then position sizing and compounding combined are the only real Holy Grail, the only real Keys to the Magid Kingdom !
