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Tortoise Trades Money Management
Every trading system will produce losses and the key to staying with any system is to plan for the inevitable. You do not want the losses to cause you to quit trading before you have given the system a fair chance to make a profit. I will show you a mathematical system for deciding how much of your total trading capital to risk on each trade. Our goal in using money management is to stay in the market for as long as we want to trade.
There are two important factors to consider. The obvious one that almost all money management methods focus on is the dollar risk per trade. The other factor that will be considered is the dollar volatility. Because of the way the Tortoise Trades system enters the market the dollar risk can be small but the volatility can be high and vise a versa. This added consideration will be more important as your account increases in size. It will help “normalize” all trades and their effect on the account’s funds.
The management systems I have always read about were complicated. They were designed by mathematicians that used Greek letters. Some one sent me a management system based on Ralph Vince's optimal ƒ money management theory. The formulas were confusing and a person who does not have a math background would not be able to understand them. My money management method will keep it simple and if I can explain it, you can understand it.
I will explain this method in general terms and then we will decide on specific percentages to use. At the end of this explanation will we deal with small accounts and what alternative you can do until your account becomes large enough to trade every market.
PROBABILITY
The first thing in constructing a money management system is to consider the number of times the system is right. If the system generated trades that were always profitable it would have a probability rating of 100%. And if you had this system to trade, you would bet all your money on each trade. Why not! Every trade wins, so use 100% of your money on each trade. Now this is not reality and most good systems are profitable between 50% and 90% of the time. So the first aspect of our management system we want to develop is based on the probability of the system's trades making a profit. The higher the probability of winning trades the more we can risk. The lower the probability of winning trades the less we can risk.
Okay, let us first create an imaginary system. The trades with this system are profitable 50% of the time. Now if we make 100 trades we can ask, “How many times can we get one trade in a row that will lose money?” The answer is 50. The answer is obvious but we are going to use an equation that will take us in the direction we want to go. The total number of possible losing trades of a 50% probability system is 50 out of 100. We are going to come up with the same answer only using a simple equation. You divide the total trades by total negative trades and you get 2. You take 2 to the power of one (1 trade in a row) which is 2 and divide that into 100 trades. As we develop these numbers you will see what this formula does.
Now let's go to the next level. How many times can we get 2 trades in a row that will lose money? You now take 2 (100 trades/50 losses) to the power of 2 (2 trades in a row) which is 4 and divide that into 100 trades. The answer is 25. 25 is the correct answer to this problem. So far our equation looks like it works, but something happens when we go to 3 in a row. We again ask our question, "How many times can we get 3 trades in a row that will lose money?" If you do this out mechanically you will get 16. But using our trick formula you take 2 (100 trades/50 losses) to the power of 3 (3 trades in a row) which is 8 and divide that into 100 trades. The answer is 12.5. Now it is time to use the power of a spreadsheet. When we set this up we will be able to change our values to help define a method of money management. Let’s create a table using this method.
| No. of Losses in a Row |
100 Trades |
1000 Trades |
| 1 |
50 |
500 |
| 2 |
25 |
250 |
| 3 |
12.5 |
125 |
| 4 |
6.25 |
62.5 |
| 5 |
3.125 |
31.25 |
| 6 |
1.5625 |
15.625 |
| 7 |
0.78125 |
7.8125 |
| 8 |
0.390625 |
3.90625 |
| 9 |
0.1953125 |
1.953125 |
| 10 |
0.09765625 |
0.9765625 |
| 11 |
0.048828125 |
0.48828125 |
Now we have a base to build a money management system. We have labeled our first column as "No. of Losses in a Row". Remember our very first example? One lost in a row can happen 50 times in 100 trades. Looking at our columns we see 2 losses in a row can happen 25 times. 3 is 12.5. Now what number does the number of losses in a row become impossible? In other words, when does the number of losses in a row become less than one. In the 100 Trades column the answer is 7. So our conclusion is if we have a system that has a 50% probability of being profitable this chart says there will never be 7 trades in a row that are losers, because 7 losses in a row is less than one, and in effect that is zero. You can not make a .78125 trade.
Even if this conclusion is not true and even if the laws of probability are not applied correctly here, we have a desired outcome. This is important. When you download the spreadsheet at the bottom of this page you will see when the values are changed the numbers change in the direction we want them to change. What do I mean by this? The logic is in trading a system, the lower the percentage of being right, the less money we want to risk per trade. The higher the accuracy of a system the more we want to risk per trade. We also get another piece of information from this table. The more trades we make the greater the chances are that we will get x "No. of Losses in a Row" and the higher the "No. of Losses in a Row" can be. Compare the values for 1000 trades. When do we hit our magic less than one value?
Let's take our next step in managing our money. You may not agree with this logic but the important point here is this next step moves us toward a desired direction in managing our money. Take the time to think this through. With this imaginary trading system we want to determine when do we call it quits. How much of my capital do we have to lose to abandon this system? Let’s choose 50% of our capital as our cut off point. We now have a number that produces less than one which is 7. We don’t want to lose 50% of our capital so we take 50% and divide that by 7 and get 7.14 or roughly 7%. We can now have a system that tells us to never risk 7% of our capital in a system that makes 50% profitable trades in 100 trades. Again let me emphasize that if you change the values in a spreadsheet of this system the numbers will change in the direction common sense will tell you to change. If we don't want a drawdown of more than 40% you will risk less per trade.
This money management also adjusts with the number of trades. If we have more trades, wouldn't you agree that the odds are higher that we could get 7 losses in a row. Let me show you what I mean. Let's take a more active trading system. For the sake of clarity I created a column with 1000 trades and 7 losses in a row is no longer under one. Our magic number under one is now 10. We may have a system that trades 1000 per year, very active, or let's say we may want to trade for many years. With our imaginary system we find it makes 50 trades a year, so it will take 20 years to trade 1000 trades. What percent of your capital would you risk with this scenario? 50% (max drawdown) divided by 10 trades is 5%. Our goal of staying with a system for a longer time will cause us to risk less capital on each trade. Would you like to trade for the next 20 years?
We are now at a point in our money management that if you know the probability of profitable trades, how much capital we are willing to lose, and how many trades the system makes in a year and therefore in your trading career, then we can determine how much capital to risk with each trade so we can stay in the game a long time.
VOLATILITY
Now we are going to consider fine tuning our money management system. What if all the losing trades were in high volatile trades like in heating oil and all your winning trades were in low volatile trades like sugar or corn. Maybe unlikely but you know Murphy’s Law will have a play in this. So we need to do something that “normalizes” all trades. We do not want a lot of profitable trades in low volatile markets and then have one loss in a high volatile market. This could potentially upset our losing trades in a row concept and decrease our account too quickly with just a few trades.
This idea is important when considering systems that use market points to determine the risk on a trade rather than a set dollar amount. An example may be a system that puts a stop at a weekly low. This stop could be small or large in a heating oil trade depending on current price movement. The same system could have a large weekly stop in sugar. Both trades may not have correlating profit objectives.
We determine volatility using an average of the true range and express that in dollars amounts. You will have to know the dollars per point of each contract traded to determine the dollar volatility. Let’s call this DV to save key strokes on my keyboard. I like to use a 10 day average of the true range to determine the volatility. Times this by the point value and you have the DV of the average true range.
Next we determine the average DV of the system we are trading. In our imaginary system let’s say it is $600. When a trade develops the DV will help us fine tune the loss probability. An example might be as follows. The current trade’s DV is $1,200. Divide the average DV by the current DV and you get 50%. Now take you maximum percent of your total capital for each trade in the above 1000 trade example, which was 5% and times that by 50%. You now have adjusted your risk on this trade to 2.5% of your capital.
Let’s do another trade. The current DV is $400 and that divided into the average DV is 1.5%. Now the risk can be 7.5% of our trading capital.
This now gives us a precise method in controlling our trading capital. When a trade develops, the stop is determined by the system giving us the dollar risk and a DV amount can be determined using the last 10 day’s data. Using the DV to adjust the percent of your risk capital for this trade you now divide that by the current trade's risk and you have the number of contracts that you should trade. The adjustment of the risk amount in this way helps “normalize” each trade and will produce a smoother equity curve.
With the Tortoise Trades system each trade has its own risk that is determined by how the trade develops. Trades with a low DV can have a higher dollar risk than trades with a high DV. I have tested my track record using several ideas and the one that I have describe above works the best.
I have set up an Excel spreadsheet to calculate this method that I just explained. At the bottom of this page you can download a free Excel calculator. Try it on another system you have. If you subscribe to Tortoise Trades, each trade alert will have the current DV and dollar risk so you can use this money management system to trade.
FINAL THOUGHT
Let me make one more observation on money management. It is not a good idea to always increase your capital size with your profits right after each winning trade. If you have a large profit on one trade and therefore consider the new funds as your trading capital where you take a percentage of for your next trade, you are setting yourself up for a larger drawdown. There is problem with a large drawdown. The larger the loss, the higher the return has to be to make up that loss. Dropping 20% will require 25% increase to get back to break even and dropping 50% of your capital will require 100% increase!
You can come up with your own strategy but I like adjusting my capital every 6 months using only half of my gain. Don’t let happen to you what happened to some one in the news I read about when we had the high tech stocks bubble in the 90’s. On Dec 31st the government wants you to pay taxes on market to market value of your profits. This person made $100,000’s on high tech options only to lose it all with the first quarter of the New Year. He had a very large tax bill on April 15th that he could not pay. If you keep playing with your money until April 15th you may not have enough to pay your taxes on your profits from the previous year. Don’t laugh; it happened to me one time.
SMALL ACCOUNTS
Now I would like to add some thoughts and deal briefly with the limited funded account. First let’s define a small account to be between $5,000 and $15,000. Most systems will have a hard time being successful with this amount of capital. We obviously want to preserve capital, but in order to have any participation in the game you have to be willing to increase your maximum percent drawdown. Losing $2,000 or 3,000 is very easy to do in futures with just a few trades.
A critical element to successful trading is a commitment to a system. Trading with limited funds is like trying to get out beyond the surf on a surf board. You paddle and paddle and the breaking waves keep pushing you back but, sooner or later there is a break in the wave motion and you make it beyond the “breakers”. Trading a system is like getting beyond the “breakers”. Once your capital grows to the point of withstanding any losing trade you are on your way. This may require a lot of effort on your part on funding your account. Try to put yourself in a position to keep the account going even if you have a large drawdown. Saving up another $4,000 over the next year should be a doable goal. If it is not, I would strongly reconsider if trading futures is for you.
If you are trading with a small account, the money management system described above will keep you out of trades. It will take the decision process out of your emotional based judgment into a well thought out plan. Staying with a trading system is very difficult because of the human greed and fear factor. Money management as well as a trading system is critical to your success.
Now with this money management system your goal should be to stay with the plan. Take your focus off the profits. Treat the money management system as part of your trading system. Do not make a trade unless you have first check with the "management".
In another page under training I have talked about using options to control risk. Some Tortoise Trades will be too high risk for smaller funded accounts. Using options is not that hard and if you are not familiar with futures options take the time to look at this page. It is a very good alternative to controlling your risk on certain trades. Still use the money management system to know what your risk can be and then trade an option with that amount in mind.
One last word - Use money management!
Download "T.T. Money Management"
(Excel spreadsheet)
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