The Finance Book Club

Chapter 6 - Entry strategies and Position Size

1. Both strategies require the market to move in the anticipated direction before the trade is entered. (and there’s your secret sauce right there, ladies and gentlemen. Momentum, not fibs, time fibs, stochastics, waves or anything else. Just plain old momentum.)

Trailing One-Bar Entry and Stop

1. The trailing one-bar-high (or low) entry (Tr-1BH/L) “is very simple and logical”
2. Enters a trade with a close stop
3. Once setup conditions are in place, trail the buystop or sellstop to enter one tick above the high or below the low of the last completed bar.
4. Stops placed one tick above or below the swing high or low

1. “There is probably no better trending market than forex” (curious statement, at least these days)

Entry strategy 2: swing entry and stop

1. Much like the preceding strategy but this one requires the market to take out a swing high or low in the direction of the anticipated trend.
2. Capital exposure is usually greater because the entry price is further away from the initial protective stop
   1. so may not be suitable for a smaller futures account
   2. Great for an unleveraged SPY index/mutual fund position

   
   

3. Should have a higher rate of success
4. Not to be confused with swing trading

Position Size

1. Successful traders always have a relatively close stop.
2. It is absolutely critical to minimize losses and preserve capital
3. The best professional traders rarely have a greater than 50% win record
4. Most amateur traders simply don’t accept this reality, which is why they are not ruthless about limiting the potential loss on any one trade.
5. “Listen up, reader. If you have better than a 50% winning trade percentage over time, you are among the trader elite. If you get good at trading, you will have around a 30 to 40% win percentage. That is why it is absolutely, positively, unquestionably critical that the losses on losing trades are relatively small and profits on winning trades are relatively large. There is no other way to trading success.” (seems closed-minded to me, however I can certainly understand sticking with what you know)
6. There are many complicated methods to determine position size but the simplest is the best
7. Gann said never risk more than 10% of account capital on a position
   1. Miner says over the years he’s learned 10% is too much

   
   

8. “Three percent maximum capital exposure on any one trade and
9. 6% maximum exposure on all open trades is the accepted standard, and it is a good one.”
10. “The maximum exposure should be a percentage of the account equity available. If your available equity is $20,000, the maximum capital exposure on a trade should be $600 ($20,000 × 3 percent). The maximum capital exposure on all open trades should be $1,200 ($20,000 × 6 percent). It’s that simple. If you go over these limits, you are stacking the odds of success against you and you are not conducting your business of trading in a responsible manner.”
11. Also have a max loss per month; when reached, stop trading for that month
    1. No more than 10%

    
    

12. Maximum position size is a function of maximum initial capital exposure per trade unit.
    1. First, calculate the maximum trade capital exposure of 3% of available account balance
    2. Then calculate the capital exposure per unit based on the objective entry price and initial protective stop. The unit could be a futures contract or per share.
    3. Finally, divide the maximum account capital exposure by the trade unit capital exposure to arrive at the maximum position size for the trade.

    
    

“The trade capital exposure per contract is 6.5 points (1441.75 – 1435.25) or $325
(6.5 × $50). If you have a $20,000 account, what is the maximum position size?

Three percent of $20,000 equals $600.
Dividing $600 by $325, and rounding up, your answer is two contracts.

You can have a maximum of two contracts for this trade. If you were to put in a buy-stop order to enter a long trade for more than two contracts, you have no business with a trading account. You don’t understand one of the most important principles of the business of trading: capital preservation”

1. Sadly, Miner’s website seems to be out of commission (since 2017) so the spreadsheet he uses cannot be downloaded. I cannot find the link to it on the archived copy of his site either. However you likely won't find a simpler money management system (besides running on instinct) so a spreadsheet isn't really necessary.
2. Solid advice, for the most part. I think max trade risk really depends a lot on the chosen strategy, and if your strategy is mostly random, as is Miner’s (by his own admission) you are well advised to minimize exposure.

To his credit, Miner has a chapter on exit strategies which many books of this type do not, but it is characteristically at the end of the book, because people care least about what they should care most about. I don't know about you but I am glad this is the last (real) chapter!

Chapter 7 - Exit Strategies and Trade Management

1. Maximum return you can gain is dependent on the market (true)
2. You can’t control the market but you can control how long you stay with a trend
3. There is an old market axiom, “You can’t go wrong taking a profit.” It is absolute nonsense. (is it though?)
4. It encourages taking a profit quickly and possibly missing out on the larger time frame trend. Taking a profit too quickly on a full position can greatly limit your potential return. Yes, but you can't go broke taking a profit. You can go broke riding a trend the wrong way to oblivion.

Multiple-unit trading

1. Every position has at least two units - it can be composed of however many subunits you want
2. If the trade entry is successful, exit one unit quickly, and let the other run
3. “Jaime Johnson, who is the chief technical analyst for our DT Daily Reports for futures, stock/ETF, and Forex has done several tutorials over the years about how to be dead wrong on the market position, but still end up with a profit by using a two-unit trading strategy.”
4. I call this ‘the double-tap’ as it’s the same concept used by tactical shooters. You shoot twice in rapid succession as you maximize your chance of hitting the target before you have to re-align.

Risk/Reward Ratios

1. Miner seems to dismiss these and says the better term for risk is ‘initial capital exposure’
2. He claims the reward portion of any potential trade is always just a guess
   1. The potential reward is never known
   2. Can be based on any number of factors
   3. “Market structure such as typical E-wave price targets, prior support or resistance, the probability of a market exceeding a swing high or low, and price percentage change

3. Reward estimate should be based on the same factors used to make a trade decision (agreed - which is why it should be fairly accurately known, therefore it’s not much of a guess at all though it may be variable)
4. 100% alternate price projection or the distance to a new extreme beyond the high or low of a swing are logical targets
5. “Most professional traders don’t pay much attention to a risk/reward ratio. They focus on identifying optimal trade setups, good trade execution, and good trade management through the trade exit. If the focus is on these positive factors, closed profitable trades will usually be several times the initial capital exposure.”
6. “Forget about it. It’s only a best guess. Focus on positive and logical trade management and the risk/reward will take care of itself. Get hung up on so-called risk/reward ratios before taking a trade and there is a good chance you have caught the dreaded paralysis of analysis disease!”

Exit Strategies

1. Always let the market take you out by moving against the position. Do not exit at a predetermined target (oof)
   1. If you do, you'll miss the big trends (so what, and why aren’t you re-entering if it really is a big trend?)
   2. You should ‘more than make up’ the losses from stop-outs when a market trends right through a target
   3. If you were going on vacation and could not ‘update your data’ you might have a take-profit (or just go on vacation)

2. Exit strategy should be based on the same market conditions that determined conditions to enter in the first place (which is why risk should be calculated with the same factors in mind)
   1. “momentum, pattern, price, and time that are keys to identify a trade entry are the same factors used to identify the exit strategy”

3. The third factor is too vague for me to summarize - do some stuff I guess. I fear I have failed you, dear reader, but if you think it's important - get the book.
4. As the market provides new information the trade management and exit strategy may change
5. There isn’t one rule-based exit strategy that can be used in all markets and all conditions
6. You can never eliminate the decision-making process with rules. This is a bit like the peak-oil arguments that crop up now and again. No matter how green things get we will never be able to completely eliminate our dependence on fossil fuels but that doesn't mean we shouldn't make the attempt.

Trade Management

1. You must have a plan.
2. Miner chooses to demonstrate with examples rather than actually outline a strategy so this is as good a place to stop as any.

The last two chapters are examples of his students taking trades, and talking about the business-side of trading. The business section is interesting but is probably advice you’ll hear everywhere eventually, like, keep a journal, have a routine, elements of a trade plan. Check out the book if you’re curious.

My final thoughts in the next post.

I’m hesitant to be too negative about this book as much of the reason I dislike it is that Miner and I have clashing trading 'styles'. He seems fond of pseudo-science; he makes decisions based on indicators and patterns; he holds for an uncertain target, and he employs some discretion in every trade. I hate all of that. These are methods used by someone who thinks there is some logic to most market movements, and it might be slightly better for a perennially trending-market-trader or a position trader, who trades infrequently, to put in the effort to form an opinion about where price is in a trend. If that’s you, then you might want to check it out in full. You might want to check it out anyway and ignore my opinion. After all, having the ego/confidence/skepticism to ignore other people's opinions is almost certainly a necessary trait of a successful trader.

I suspect it isn’t worth it though.

To me it seems like Miner took all the most popular schools of voodoo technical analysis, put them in a blender and hit ‘chop’. It’s not an entirely new and coordinating thing with a few structural elements, but it’s ALL the elements, each one competing for attention. This violates the principle of simplicity espoused by so many other successful traders, and you’re bound to run afoul of the curse of dimensionality when trying to validate any system with this many moving parts.

I have to wonder if this book was a cynical attempt to try to weld together the main silly schools of TA in order to create a best-selling book, or is it a very sad tale of a logical person who has made a valiant effort to try to make use of the worst (and most popular) of all possible tools by any means necessary, out of pride, bluster, or sheer bloody-minded engineering tenacity?

Since I don’t have a way to test the parts of this that depend on discretion or experience figuring out which fib levels are valid and which waves are the correct waves to count I cannot say whether this will work for anyone or not. I suspect it will likely work, somewhat, if above all you follow the entry rule that requires price to move in your intended direction first. However it will work in spite of the system, not because of the system itself.

It’s not for me though. To me this seems like the exact type of trading method that b-book brokers would teach. It’s complicated enough to be confusing and effortful. It sees trading as something to be ‘mastered’ with technicalities. It sees it as a one-trade, one target, type of hunt rather than the commercial bottom-fishing operation which it really is. If you trade this way, in my opinion you’ll likely go broke slowly, just the way they want. Not recommended.

Up next is Penfold's Universal Principles of Trading. It is a book of a different character, yet again, being neither as narrative as Weatherall, but less system-specific than Miner's. I hope you will find it a refreshing change of pace.

Notes and footnotes

The Universal Principles of Successful Trading by Brent Penfold

Chapter 1 - Reality Check

1. The only real secret is that ‘the best loser is the long-term winner’ (from "Phantom of the Pits") Added to reading stack
2. Losing is what seems to happen most of the time, so to survive you have to be a good loser
3. Using a simple 3 bar stop (Naked Forex!) would likely improve your results
4. If your trading results are depleting your account the problem is your methodology doesn’t work (yes. This x 1M)

1. It’s not what’s in your head that’s holding you back!
2. Psychology can be a challenge, but the real problem is your method (yes, yes yes!)
3. Your method doesn’t have an edge and hasn’t been validated
4. If you had validated your method you would have seen that its expectancy was poor and you would have thrown it out (but that’s hard work!)
5. “Over 90 percent of all traders lose” (the classic stat, never verified by any peer review to my knowledge)
6. Gullibility and laziness (look at how popular the ‘easy trading made super easy’ threads are on FF and how popular that thread is)
7. Most authors are failed traders themselves and don’t know what actually works (it's not hard to believe so far)
8. Greater Fool Theory - the customers are the greater fool
9. To succeed:
   1. Methodology
   2. Money Management
   3. Psychology

   
   

10. (When asked what’s the hardest part of trading) “Interestingly, most people raise their hands at psychology. I’m not surprised by this response because the overriding message from most trading material available is that psychology is the hardest part of trading and the key to success.

The usual message is along the lines of ‘‘the only thing that separates the winners from the losers is psychology, nothing else’’ . . . ‘‘the winners have no special trading skills, no special trading secrets, no secret formulas to win in trading’’ . . . ‘‘what sets winners apart from losers is their psychology’’ . . . ‘‘winners think differently than losers.’’
I disagree with this.” (I love this guy (so far))

1. Common mistakes (year 1)
   1. Penfold claims not to be an expert in trading (refreshingly humble, but does he have enough experience to write a book?)
   2. Methodology
      1. Listening to others; following tips
      2. Reacting to nightly news
      3. Averaging entries
      4. Failing to use stops, have a plan

      
      

   3. Money Management
      1. Lol, wut?

      
      

   4. Psych
      1. Trading for excitement
      2. Trading for revenge

      
      

2. Common Mistakes (year 2)
   1. Methodology
      1. Believing what is read and heard (coat-tailing other traders)
      2. Believing TA is the only answer
      3. Predicting (picking tops & bottoms)
      4. Believing more is best (favouring complexity over simplicity)
      5. Believing paper trading will help
      6. Failing to see the trend
      7. Taking profits too early
      8. No plan, switching methods, gurus, markets, time frames, advisers

      
      

   2. Money Management
      1. Overtrading
      2. Impatience, addiction, unrealistic expectations
      3. Being a ‘rationalist’ (finding rationalizations for the reason their trades lost)

   
   

3. Common Mistakes (year 3)
   1. Traders with some knowledge think the market owes them something
   2. Methodology
      1. Failing to let go of what has been learned
      2. Forgetting it’s all about simple support and resistance (oh no)
      3. Confusing technical analysis with trading and failing to separate trade plans from setups
      4. Failing to develop trade plans that support setups
         1. Penfold makes a big deal of this need to have two plans, an entry plan and a plan to manage the trade. It seems to me this is just part of having a system.

         
         

      5. Failing to understand positive expectancy
      6. Failing to validate methodologies

      
      

   3. Money management
      1. Continuing to overtrade

      
      

   4. Psychology
      1. Focusing on the profits and not the process
      2. Having poor discipline
      3. Believing markets are impossible (having lost consistently for three years, you’ll be ready to give up)
      4. Believing there are trading secrets
      5. Believing the greatest risk is losing money
         1. Tampering with your method is a greater risk, says Penfold

         
         

      6. Believing the hardest thing is psychology

   
   

4. The solution: Joining the 10 percent winner’s circle
   1. Commodity Trading Advisers (CTA)
   2. CTAs, will define boundaries within which you can explore and experience trading. If done properly, you may never trade, and by not trading you won’t lose, which will put you ahead of 90 percent of all traders. (LOL - funny, but true)

   
   

Well, this is off to a rip-roaring start. Can it keep up with our expectations?

Chapter 2 - Process of Trading

1. There are six essential principles of successful trading:
   1. Preparation
   2. Enlightenment
   3. development of a trading style
   4. selecting markets to trade
   5. the three pillars
   6. commencement of trading

   
   

1. Trading prep is so much hard work most are unwilling to do it; instead they jump in and get wrecked

The table above basically does as good a job summarizing this chapter as I could do. But what does the baseball represent? Is it shocked by the amount of work it will have to do? Are baseballs naturally lazy?

Chapter 3 - Preparation

1. maximum adversity
   1. The market will do what it must to disappoint the most traders. (Livermore)
   2. For a minute I got excited and thought he was going to talk about max adverse excursions, but not yet.
   3. “Maximum adversity demands that right now you should determine whether you have the fortitude and stomach to accept the miserable existence of a trader’s life despite the potential financial rewards.” Harsh, but fair; many are called, few are chosen.

2. emotional orientation
   1. Winning and ‘being right’ isn’t important
   2. Manage your capital instead
   3. Wanting more leads to fiddling and destruction; greed is deadly

3. losing game
   1. Trading is a loser’s game (a bit fatalistic, but again, not false)

4. random markets
   1. Markets are essentially random (yes! Your RSI is telling you nothing)

5. best loser wins
   1. Manage your losses; it’s the only tool you have (or is it?)
   2. Never move stops
   3. Ask yourself how to lose faster, without short-changing the setup

6. risk management
   1. Your focus should be survival first (yes! like a classic RPG or for the youths, Dark Souls)

7. trading partner
   1. Prevents you from lying to yourself
   2. Must be ‘at arm’s length’
   3. I’m divided over this one. It might be beneficial to some. However, accepting total responsibility for your trading means you can’t lie to yourself anyway, and it means you should be able to be a lone wolf. The best traders are usually.

8. financial boundaries.
   1. Set a maximum loss you’ll accept as part of your ‘tuition’ and if you exceed it plan to walk away - trading is just not for you

Chapter 4 - Enlightenment
After reading this chapter I'm convinced Penfold is the real deal.

1. Switch perspectives from wanting to succeed to wanting to survive
2. If you can survive, you have succeeded!
3. Survival means
   1. Avoiding Risk of Ruin
      1. The most important concept in trading (but earlier it was ‘how to lose well’; I suppose they are closely related)
      2. Rarely taught
      3. statistical concept that tells traders the probability of them being ruined—This accumulative loss is referred to as the ‘‘point of ruin.’’
         
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      4. I have seen this formula expressed a bit differently, and maybe a little bit less confusingly as [(1-Edge)/(1+Edge)]^U where U is the number of consecutive losing trades to get to the point of ‘stop trading’, calculated using risk per trade, but in this case Penfold uses fixed units, which I think is fine. The confusion is if I think my win rate is ⅔ and my loss rate is ⅓ and I subtract 0.33 from 0.66 I get an edge of only 0.33, but actually my edge is ⅔ or 0.66. So W in this formula is not ‘probability of winning’ but really ‘total historical wins in a sample of history’ and L is ‘total historical losses in a sample of history’ to arrive at the total win rate. Please let me know if you disagree and if there is a better way to explain this.
      5. Traders need to calculate how many trades they can afford to lose before ruination
      6. RoR should be (close to) zero, if not actually zero
      7. A zero percent chance cannot be guaranteed as conditions can change; what that means is that over time, every trader will eventually go bust if they stay in the game long enough
         
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      8. The more losing trades you can absorb, the lower your RoR
         
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      9. Improve the accuracy of your method
         
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      10. 4.6 shows the effects of raising win rate from 56% to 63%
      11. Improve your average win to average loss ratio
          
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      12. Determining risk of ruin does have a number of limitations. You need to understand that the figure:
          1. is only a statistical measure—it doesn’t guarantee you’ll avoid risk of ruin because it’s dependent on its inputs. If they suffer, so will you
          2. is not static and changes from trade to trade
          3. has no practical value for actual trading.
          4. Don’t trade if your RoR is above zero (impossible to get it completely under zero)
             

          
          

      
      

   
   

4. Embracing trading’s Holy Grail - expectancy
   1. The Holy Grail system doesn’t exist
   2. A method that has a positive expectancy across multiple opportunities is a holy grail of sorts
      
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1. Expectancy refers to what you can expect to earn, on average, for every dollar you risk in a trade.
2. To calculate your methodology’s expectancy, you need to know how often you win, how often you lose, and the size of your average winning and average losing trades (see fig. 4.8)
   
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3. The only difference between the traders is the amount of money risked per trade
4. They each achieved 20% return
5. But Tom’s risk of ruin was an acceptable 1% where Sally’s was 9% and Bob’s was 30%.
   
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6. The trendy system is best as its expectancy is highest, and so is its average win, despite its low accuracy.
7. Expectancy trumps average win to loss, and accuracy
8. Opportunities
   1. Expectancy is only half the holy grail
   2. If you rarely have a chance to trade, your payoff will be lower
   3. So, the best systems aim to have optimum expectancy with the highest number of opportunities
      
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9. Expectancy and opportunities > trend lines or indicators or gurus (amen)
10. Pursuing Simplicity
    1. Simplicity is the key to developing methods with robust expectancy
    2. Simplicity of design
       1. Must pass the McDonald’s test
       2. Can a teenager understand and trade your methodology?
       3. Too many variables can introduce errors
       4. “Many people who fail in trading believe the answer must lie in complexity—because surely the market wouldn’t give up its secrets so easily? They start to see the market as a Rubik’s cube that needs to be solved.” (have you noticed this is pure gold?)

       
       

    3. Simplicity of support and resistance levels
       1. “Trading is simply the identification of potential support and resistance levels”
       2. Don’t get caught up in the latest software or intricate market analysis. Never lose sight of the basic objective—to find potential support and resistance levels (Had me til the end. I am no fan of the S&R theory.)

    
    

11. Treading Where Most Fear
    1. Don’t follow the crowd (Are you being ignored on ForexFactory? You might be a good trader.)
    2. If most are looking west, you should look east
    3. Only 10% of traders are in the ‘winner’s circle’ so for your survival you should be in the minority
    4. Areas where most fear to tread:
       1. Being the best loser. Don’t move stops.
       2. Being the best winner. Let trades run.
       3. Being a trend trader. Trends fail ⅔ of the time but trend-trading works. Pride yourself on losing on most of your trades.
       4. Embrace simplicity. Most mistrust obvious and simple solutions (and you can’t sell them)
       5. Being skeptical of charting indicators and commercial systems. (I can confirm that traders fall for the dumbest shit most foolish inanities, as I’ve read the threads, many are still active. Hell, my most popular thread ever is complete crap, one of my first.)
       6. Do the work. Most are lazy.

       
       

12. Validating your expectancy with TEST
    1. TEST = Thirty Emailed Simulated Trades
    2. You must email your ‘complete orders’ to your trading partner, as paper trading doesn’t work (but I’m still not sure why live demo trading wouldn’t count) Penfold compares paper trading to masturbation.
    3. “Overlay” your equity curve on the underlying market if your expectancy is positive
    4. Examining your curve will tell you if your results are dependent on a few ‘lucky’ trades. (This seems logically inconsistent. Penfold believes the market is random, and that trends fail ⅔ of the time. So most of his profits are going to come from a ‘few lucky’ trades. How could they not?!)
    5. The trading partner needs to print a hardcopy of the emailed trades and then return that to you for some reason??
    6. Thirty trades is a ‘statistically valid’ sample size (pfft)
    7. ‘Baring your soul’ to your trading partner is difficult but is as close to real-time trading as you will get. (I don’t get this section at all. Why not just live trade a smaller account then? Seems simpler (to fit with the principle of simplicity) and less busy work.)
    8. Only trade single lots
    9. Back to the drawing board if your expectancy is not positive
    10. Backtesting is cheating, only going forward is what counts
    11. If you’re a discretionary trader but can’t explain your trade in an email it means your system is not defined
    12. If your system has good expectancy you might still have trouble trading it because your subconscious mind doesn’t trust it.
    13. The best way to develop a strong belief system in your methodology is to simulate real-time trading conditions as best you can (but whether this is through TEST or not?)

    
    

Chapter 5 - Trading Style
Selecting an appropriate style requires two decisions concerning:

1. Trading Mode
   1. The type of trading you would like to use
      1. Trend trading
         1. Rarer but big wins
         2. Weeks and months in trade
         3. Low accuracy - less than 15%

         
         

      2. Countertrend trading, usually referred to as ‘swing trading’ (??)
         1. Higher accuracy
         2. Lower average wins
         3. In trade for days or weeks at latest

      
      

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2. Trading Style
   1. Time frames
      1. Choose day, short-term, medium-term or long-term
      2. Daytraders are ‘square’ out of the market by the end of the day
      3. Short-term: up to 1 week
      4. Medium: up to 2 weeks
      5. Long: more than a month

      
      

   2. Most guides tell you to pick a timeframe that fits with your personality
      1. “Although it is well intended, it generally ignores the reality of the markets and trading” (well done, Penfold)
      2. Most of what is written about markets is unsupported by real evidence (where is the evidence for S&R levels?)
      3. What feels ‘comfortable’ in trading generally doesn’t work; if trading was comfortable everyone would do it
      4. When an ideas has reached the masses it is already priced into the trade
      5. If you, like most traders, have limited capital, shorter-term trading horizons are more workable
      6. Long-term trend traders need to monitor and trade between 20 and 30 markets to be successful. (nonsense - most markets move nearly in lockstep anyway)
      7. The famous Turtle Trading system is referenced and the big $750,000 drawdown it suffered in March 2007. Although the system was successful overall, most traders couldn’t endure such a haircut

   
   

3. A good long-term trend-trading methodology should deliver an average win that is at least three times above the average losing trade.
4. Characteristics of long-term trend trading

1. Characteristics of short-term swing trading

1. Taking this all into consideration, shorter-term swing trading is better for smaller private traders

1. “It doesn’t matter how you feel as long as your methodology has a probable positive expectancy of making money. Business comes before feelings. Trading deals with reality, not niceties.” (great stuff)

Chapter 6 - Markets

1. Liquidity
   1. Allows you to enter/exit quickly

2. 24 hour coverage
   1. Basically only forex and
   2. CME electronic futures (23 hour)

3. Zero counterparty risk
   1. Futures are most solid, says Penfold
   2. FX, CFDs or spread betting is less secure
   3. Stocks are the most insecure as a company can go insolvent overnight
   4. No such thing as zero risk, says Clemmo

4. Honest and efficient
   1. Futures and regulated exchanges
   2. Sharemarkets - in 2008 many of them banned short selling
   3. Now we can see some of Penfold’s bias, but he’s not wrong
   4. He is curiously silent about FX on this front, but clearly it’s one of the worst

5. Low transactions costs
   1. Slippage, commissions
   2. Futures costs are far less than shares
   3. And here FX excels, usually except with regards to swaps

6. Volatility
   1. Indices and currencies win

7. Research
   1. Sufficient historical data
   2. But markets are random! What value is there in seeking out historical data? Which is it, Penfold?
   3. For backtesting says Penfold, but he also said backtesting was garbage before

8. Ease of short-selling
   1. FX, futures, options
   2. Shares make it difficult, one reason they mainly go up

9. Specialize
   1. It ‘pays’ to specialize as a private trader, in one market (how?)

10. Opportunities
    1. Liquidity + volatility = opportunities

11. Leverage
    1. Futures, options, warrants, margin FX, CFDs, and spreads all allow access at a fraction of the contract face value

Chapter 7 - The Three pillars

1. money management (in chapter 8)
   1. fixed risk
   2. fixed capital
   3. fixed ratio
   4. fixed units
   5. Williams fixed risk
   6. fixed percentage
   7. fixed volatility.

   
   

2. Methodology (presumably chapter 9)
   1. Setup
      1. Identify future S&R

      
      

   2. Trade plan
      1. Instructions on how to enter, set stops and exit

      
      

   
   

3. Psychology
   1. ‘The glue’ that holds the pillars together
   2. Discussed in chapter 10

   
   

Chapter 8 - Money Management
Consider this whole chapter ‘bolded’ (important).

This chapter (nearly as big as the entire rest of the book) contains GOLDEN information that nearly any trader would do well to review several times if they aren't already familiar with it. It's somewhat math-y, and somewhat tricky if you have no background with it already, but I've never read a clearer and more thorough description of Money Management techniques anywhere else.

From now on ‘money management’ will be abbreviated as ‘MM’.

MM is the key to survival. Penfold trades futures so he’ll use futures terms.

1. MM has two objectives
   1. survival—avoiding risk of ruin
   2. big profits—generating geometric profits.
   3. MM allows you to achieve these objectives if you can trade less (reduce position size) when you lose and trade more (increase position size) when you win

   
   
   

2. MM has two schools (I reacted poorly to this at first as there are much more than two schools but later on you’ll see this is just Penfold’s way of categorizing MM methods. In fact most of the methods he references can be martingale or anti-martingale or neither.)
   1. Martingale
      1. Trade more when you lose
      2. Trade fewer when you win
      3. Follows the theory “there is a higher probability a winning trade will follow a losing trade, and therefore one should take advantage of it by trading more contracts following a loss.” (I also reacted badly to this. This is the Gambler’s Fallacy, not the martingale theory. Mean reversion does not affect sequential probability.)
      4. An invitation to ‘disaster’

      
      
      

   2. anti-Martingale
      1. The ‘correct strategy’
      2. Geometric profits
      3. Suffers from asymmetrical leverage during a series of losses
         1. This means your ability to recover from a loss decreases with each loss
         2. This is true whether you are martingaling/anti-martingaling or not

         
         
         

      4. Just as prone to disaster if you double up on winners and halve losers. The markets are random, remember???

      
      
      

   
   

1. Anti-martingales spend longer underwater (they have a lower ‘recovery factor’)
2. Risk Management
   1. You can’t predict your own performance even with the most robust strategy
   2. You can’t influence how a market will behave
   3. You can control your trade volume
   4. Good MM can change a mediocre strategy into a life-changer but it must first have positive expectancy
   5. Penfold detours with a history of Money Management which he attributes to Larry Williams, with Ralph Vince. Before LW it was only used by pro money managers like Richard Dennis who coached the Turtles, says Penfold.
   6. He references a chapter in Williams’ book “Long Term Secrets to Short Term Trading"
   7. In the chapter Williams claims it’s his most valuable secret and he in turn references Kelly’s famous paper (written with assistance by Claude Shannon) which forms the basis for the Kelly Criterion.
      
      Attached Image

      
   8. The long and entertaining story about William’s success, downward spiral and then success again, I won’t reproduce here, but basically he finds that the flaw in this method is that the largest loss can still be very large. The key is to reduce how much is risked on any trade.
      
      Attached Image

      
   9. This is ‘William’s Fixed Risk’ a famous MM method

   
   
   

3. Anti-martingale strategies
   1. fixed risk
   2. fixed capital
   3. fixed ratio
   4. fixed units
   5. Williams fixed risk
   6. fixed percentage
   7. fixed volatility.

   
   
   

4. To test all these methods, Penfold will use a system called ‘Forex_Trader’ (sadly, never described) and compare each to using a single contract with no MM

1. Results using No MM
   1. The details are many so if you want the full picture buy the book, but the short slightly longer story is
   2. All the following results and figures are in dollars (I assume USD).
   3. Hypothetical result trading one JPY/$ currency future contract per signal with
   4. 50$ deducted for brokerage and slippage
   5. This account begins with $20k
   6. No margin calls
   7. 2.3 % standard deviation between trades
   8. All signals taken regardless of individual risks, volatility or drawdown
   9. Worst dollar drawdown was $13, 638
   10. Worst %age dd was 9%
   11. The single contract provided high net profit to dd ratio making $19 for every $1 lost during the worst dd
   12. The results of the test without MM look like this:

   
   

Can we make higher profits using MM?

1. Results using Fixed Risk MM
   1. Fixed risk limits each trade to a predefined dollar risk
   2. calculated by dividing the starting account by the number of units of money you wish to begin trading with

   
   

1. Start with a $20k account balance
2. Divide that into 40 units of fixed risk of $500
3. Taking only trades that present a dollar risk lower than $500
4. “To calculate the number of contracts you would trade, divide the fixed dollar risk by the individual trade risk (i.e. the dollar amount between the entry and stop price plus brokerage), ensuring you round down to the nearest whole integer. Use the following simple formula:

1. Results:
   1. Seems worse. Fixed risk doesn’t trade fewer contracts when losing or trade more when winning.
   2. When you’ve lost a few times and your account size is smaller, you’re still trading a fixed $500 of risk. When you’re winning you can’t risk more. There is no elasticity. That increases your risk of ruin.
   3. The fixed risk also forces the trader to reject many trades.

   
   

1. Some solutions
   1. increase the fixed dollar risk after 40 trades.
   2. You could subdivide the units further (increase the number of money units)

   
   

2. Benefits of this method
   1. Allows traders with small accounts to get started
   2. With a validated stable expectancy this method is unlikely to hit the point of ruination
   3. It does filter out trades that are too risky, as you have a fixed risk limit (risk ceiling)

   
   

1. Results using Fixed Capital MM
   1. Trades using one contract for a fixed unit of capital, rounding down non-integer units
      
      Attached Image

      
   2. If the unit is $15k and you have $20k in your account balance, you trade one unit
   3. If you have $30k in your account, you trade two units
   4. This method does allow a minimum of one contract if your capital is not greater than the min. Unit. This could be used as a signal to top up your balance.
   5. Attached Image

      
   6. Penfold warns, “your worst drawdowns are always ahead of you” so using Forex_Trader’s worst dd of $13,638 is maybe too optimistic
   7. He increases it to $14,000
   8. Blowtorch risk = how much pain you can bear, or how much of your account balance you are comfortable losing in percentage terms
   9. If your blowtorch risk is 30% (you can stand losing 30% of your account), you would trade one contract for every $46,667 ($14,000 max dd divided by 0.30 bt risk)
   10. When that amount doubles ($93k) you would trade two contracts but not sooner
   11. Fixed capital provides flexibility because you can tailor your risk percent to your aggressiveness
   12. If you were suicidally aggressive, you could set the bt risk to 0.933 and trade one contract for every $15k in your account, and forex_trader system would earn an amazing $18M (the dark line in the chart below)
   13. Very strange example. Remember trading is all about survival

1. As you can see from this chart, fixed-capital produces high geometric profits as it requires less profit for each individual contract at each successively higher contract level.
2. Penfold points out that he limited the contracts maximum to 100 for this example as trading 1200 contracts ‘might not be realistic’ but to expect that trading 100 contracts is any more realistic? I admit I don’t know futures as I do forex.
3. Does fixed cap achieve MM objectives?
   1. Trades fewer contracts when losing? Yes
   2. Trades more when winning? Yes

4. Simple formula to tell how many contracts to trade depending on balance and your capital fixed unit
   1. As you lose, and account balance falls below a certain level you will be required to trade fewer contracts, and vice versa if you win and your account grows

5. Useable for smaller accounts (like fixed risk)
6. Greatest advantage is it allows small accounts to build up quickly
7. Disadvantage is that it does this with increased risk

The markets are fairly dull today. Especially when your trading is automated. But you know what's not boring? Comparing different MM systems!!!
Whoo-hoo!

Results using Fixed Ratio MM

1. Developed by Ryan Jones in his book ‘The Trading Game’ (added to stack)
   1. "My advice? Don’t trade until you’ve spent as much time and effort on money management as you’ve spent on developing your entry and exit rules." —Tom Bierovic, Manager System Trading & Development Education, Omega Research, Inc."
   Attached Image

   
   
   
   
2. Adjusts contracts by a ‘fixed ratio’ called ‘the delta’
3. Delta is the most important variable in the calculation but there’s no ‘hard and fast’ rule for calculating it
4. Aggressiveness is inverse of delta; the larger the delta, the more conservative will be gains and drawdowns
5. “To be conservative you should look to make your delta large enough for a single contract to experience its greatest drawdown while still having enough money for an initial margin to continue trading.”
   1. Delta is then calculated:
      
      Attached Image

      

   
   

6. The examples use a max dd of $14,000 and $4000 required margin
7. Delta is then $18,000
8. “fixed ratio money management says you should not increase to your next contract level until every current contract you’re trading has been able to contribute $18,000 in profit. Once they have, you can trade an extra contract, at which level the previous contracts plus the new contract together must all make another $18,000 each before adding an additional contract.”

1. the key to fixed ratio—you cannot increase your contract size until your existing contracts have each made an additional delta in profits
2. Penfold goes to some length explaining how you could decrease your contract size during times of losing at fractions of delta, basically accelerating the rate at which you decrease your trade size rather than waiting for a whole delta to be lost. However when you start winning you would take longer to recover as “you have to earn a greater percentage gain compared to your percentage loss, but you would have to make the gain on fewer contracts, thereby taking longer to recover.” Discussing these details outside the specifics of a system seems pointless to me; there are too many variables to consider in an abstract case.
3. Does fixed ratio achieve the objectives of MM? Yes, in both cases
4. You can see fixed ratio’s profit is greater than no MM, but less than fixed capital MM
   1. However its profit-to-drawdown ratio was 10:1, gaining $10 for every 1$ of dd pain

5. Suitable for smaller accounts
6. Some flexibility in determining your delta
7. No individual trade risk is considered
8. An example using a smaller delta, produces 60% more profits
   Attached Image (click to enlarge)

   
   

Now Penfold takes a detour to consider which of the systems we've seen is superior. Fixed capital, the one that produced that outrageous $18M profit or fixed ratio that produces only $1.5M in the same time?

Chase 18M or 1.5M?

1. Fixed capital seems the clear choice BUT
2. It is much riskier
3. Let’s see what happens to fixed capital and fixed ratio if the system suffers a ‘catastrophic loss’
4. Examples use $20k accounts; $14k historical dd
5. Catastrophic loss is an arbitrary $10k (70% of the historical dd)
6. This makes it ‘realistic and conservative’
7. Penfold, for some reason chooses to have the loss occur at the seven contract level for both systems even though he admits that fixed capital accumulates contracts faster than fixed ratio, though he says the example is still ‘instructive’

1. The fixed capital trader does much worse - 58% compared to - 13%
   1. Because fixed capital experiences the loss comparatively early as it reaches the seven contract level much sooner; this means the account hasn’t had time to grow as much as fixed ratio has before it experiences the loss; to me this seems to queer the conclusion, but obviously fixed capital losses will always be bigger than fixed ratio.
   2. Penfold emphasizes that fixed ratio requires ‘equal contribution’ of each contact to the profit before increasing, where fixed capital requires an ‘uneven effort’ and can begin trading more contracts with less profit at every step. This uneven effort can create a ‘house of cards’.
   3. Fixed ratio dd is manageable - requiring only 15 percent asymmetrical leverage to recover, and you could continue trading seven contracts while you do so.

   
   

Results using Fixed Units MM

1. An extension of fixed risk
2. Limits each trade to a predefined dollar risk as a function of a predefined number of units
3. Divide the starting account by the number of fixed units of money to trade with

1. The main difference between fixed units and fixed risk is that with fixed units dollar risk per trade increases as the balance increases
2. Dollar risk does not decrease when you are losing and the balance decreases
3. The key variable is the fixed units number
4. Minimum number of units to consider is 20
5. In the fixed risk section we used 40 so, for fixed units, Penfold arbitrarily chooses 30 units
6. Assume $20k starting balance
7. Divide balance by fixed units to get dollar risk per trade - 20k/30 = $667
8. Take only trades with dollar risk <= $667
9. To calculate the number of contracts, divide the fixed dollar risk by the individual trade risk (dollar difference between entry and stop plus fees), rounding down to nearest whole integer

1. Dollar risk grows as account balance grows

1. Less profit is required to be made by each additional contract, allowing quick accumulation and geometric profits
2. Does fixed units meet the objectives of MM?
   1. Increased risk when winning? Yes
   2. Decreased risk when losing? No

3. Impressive profits comparable to fixed capital
4. High net profit-to-drawdown ratio - $16 for every $1 in dd

However like fixed capital it is vulnerable to a catastrophic loss
An aggressive but stable strategy, with the advantage over fixed capital that even in drawdown you can maintain your number of contracts, but this comes with ‘substantial risk’

1. Suitable for smaller accounts
2. Fixed units can be increased to reduce risk
3. Produces large drawdowns, but can recover quickly
4. Distinguishes individual trade risk

Results using Williams Fixed Risk MM

1. As mentioned earlier, it’s by Larry Williams from ‘Long Term Secrets to Short Term Trading’

1. Starts with a $30k balance for this example (The others used $20K and this is explained later)
2. Assume 10 percent max dd tolerance, so $3000 per trade ($30k/0.10) is the dollar risk per trade
3. If largest expected loss is $2563 (where is this number coming from) then you would only be able to trade one contract (3000/2563) = 1.17 and we round down to the nearest integer to be conservative

1. Not suitable for smaller accounts - unless the largest loss is small or the percentage risked is high - which is why Penfold increased the account size
2. Dollar risk per trade is recalculated as account grows
3. Starting at $30k and 10% risk a trader is restricted to one contract while the account is under $51,250.

1. These numbers are very dependent on the largest expected loss figure
2. Geometric profits possible as each additional contract requires less profit to be made
3. Does this meet the objectives of MM?
   1. Trades fewer contracts when losing? Yes
   2. Trades more when winning? Yes

4. $10 to $1 profit to drawdown ratio

1. What about the catastrophic loss scenario?

1. Geometric profits come with risk
2. However this handles the big losses better than fixed capital

Results using Fixed Percentage MM

1. Most commonly used method among pro traders
2. You could do worse than following the winners
3. Requires limiting losses to a fixed percentage of your account balance

1. $30k account, 2% risk
2. If your trade risked $500 you would trade one contract
3. 30,000 x 0.02 / 500 = 1.2 rounded down to 1.0

1. All figures rounded down for conservatism

1. 2% risk is an arbitrary choice
2. At each contract level fixed percentage requires a smaller contribution from each new contract which allows steady accumulation

1. 14:1 profit to drawdown
2. Meets MM Objectives? Yes to both
3. Manages individual trade risks; restricts some trades from being taken
   1. In this example one trade was rejected because the dollar risk was too high for the account

4. Not as good for smaller accounts
   1. A $10k account would find it difficult to find a trade with small enough risk ($200 at 2%)

5. Lowers risk of ruin; pro traders care about how much risk they’re taking, and less with how much they’re making

1. Compare this with fixed risk; the account was divided into a minimum of 20 units to reduce risk of ruin; in other words 20 consecutive losses would ruin the account
2. Fixed percentage using 1% risk allows for 528 (diminishing) losing trades before ruin
3. So obviously the fixed percentage MM is less likely to blow up

Results Using Fixed Volatility MM

1. Also called fixed percentage volatility
2. Looks to limit the market’s volatility to a fixed percentage of your account balance

Volatility is defined by market movement over a defined term

1. 10, 20, 30 day average of the daily range is one measure of volatility
2. Tailor the range to your trading timeframe; these examples use daily ranges
3. Individual trade risks are not considered
4. Used by Richard Dennis in the Turtle Trading strategy

1. Assume a $50k starting balance for this one
2. Assume 2% fixed volatility risk
3. Say ATR was 0.0031 and a whole point value was $125k then the volatility is $388 (125,000x0.0031).
4. $50k x 0.02 = $1000 and 100/388 = 2.6 or 2 contracts, rounding down as always

1. Lower contribution required from each successive contract, allowing for steady accumulation
2. If your system required a 10 day ATR range for a stop then fixed percentage and fixed volatility would produce the same results

1. This chart assumes a $30k starting balance, not $50k (??)
2. Meets MM Objectives: yes
3. Distinguished by its ability to manage account exposure to market volatility
   1. More volume is traded when volatility is lower, when the market is presumably ‘behaving itself’ and vice versa when the market is ‘wild and dangerous’

1. No individualized trade risk management
2. The ATR used, a fixed 10 day value, might not be realistic compared to real conditions
3. However this method handles catastrophic losses well

Ok, we've looked at a bunch of money management methods and have some sense of their strengths and weaknesses.
How the heck do we decide which one to use?!