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WHY? WHAT? WHERE? WHEN? WHO? HOW? - 3 Part

WHY? WHAT? WHERE? WHEN? WHO? HOW?


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ago, a trader was excited about the potential effect of money management

on the outcome of his trading. He called me up and bought

my Performance I money management software program. A year

later, I received a call from the same man. I got on the phone with

him and he said to me, “Ryan, I am ready to use the money management

program now, could you help me get started”? A bit baffled, I

said, “Sure, but why did you wait a year to start using the program?”

He replied that he wanted to make sure that the method he was going

to trade worked first. I said, “Fair enough” and proceeded to help him

out. Toward the end of the conversation, I asked, just out of curiosity,

how much he had made without applying money management. He answered

that he had made about $70,000 based on trading a single

contract! After I got off the floor, I told him that had he used money

management from the beginning, he could have easily produced in

excess of $600,000 instead of $70,000.








When? Now!

WHO?

Even though this answer has been indirectly answered through the

answers to the other questions, let me be direct and to the point. You.

If you are even contemplating trading a leveraged instrument,

whether it be stocks, commodities, options, or whatever other leveraged

market, you must address the money management issue. If you

are already trading, you are running late and behind, but late is better

than never. You need to apply these techniques. It doesn’t matter

where you went to school, your age, sex, color, race, or religion.

Whether you are a mother, father, brother, sister, cousin, nephew,

niece, aunt, or uncle, it matters not. Am I getting the point across?

Numbers have no respect for humans. They just are.

HOW?

This is probably the only question that I cannot automatically assign

the same answer to everyone. How you apply these principles to your

trading is going to be different from how someone else views and applies

them. How you apply these techniques will depend on several

factors including but not limited to how conservative or aggressive

you are, your goals as a trader, and your tolerance for risk.

-

HOW? 9

The basic principles of this book apply to all traders. Whether aggressive

or conservative, every trader applies the same principles and

mathematically proven money management techniques. Questions

such as when and who should be aggressive or conservative are answered

in the following chapters.

I hope this chapter has convinced you to read on. The numbers

alone are convincing enough. If you have never consciously addressed

money management in your trading, you may need to go through this

book a bit slower than those who have. But if you take the necessary

time and stay the course, this will be one of the most beneficial books

you will ever read in your trading career














 


W H Y ( P R O P E R )

M O N E Y M A N A G E M E N T ?

All traders have one thing in common. Whether you are an options

trader, a day trader, a stock trader, or a little bit of everything type of

trader, you are-at least in one way-like every other trader. No matter

what the market or method, every trader must make a money management

decision before entering a trade. Sometimes this is not even a

conscious decision. For these traders, money management never even

crosses the scope of intentional thought. This is an extremely dangerous

way to trade. It is amazing to me how much time traders spend researching

where to get in and where to get out of the markets but then

allocate to each trade with little more than a dart throw. Through my

own experiences and a few illustrations, I hope to convey that proper

money management is the key to success in trading.

In this chapter, I explain why and how I turned my focus to money

management and then present several reasons you, and every other

trader, should focus on how to manage the money in your account, even

before you decide on what system or method to trade.

When I trade, I examine something to a certain degree, make a

judgment call whether it is worth trading, and then do it. Paper trading

can yield only so much information. The true story lies behind

the outcome of actually taking the trades. During one of my early

trading experiences, I had opened an account for $10,000. This was,

at the time, the most I had invested in a new trading venture. I also

had decided to trade straight futures with this account. Until then, I

had traded options, option spreads, covered options, futures spreads,

and had written naked options. I had never traded straight futures

consistently. However, I had just purchased a new trading system

from one of those guys who was retiring from a long life of profitable

trading and had decided to reveal his age-old, proven trading method

to a few honored select traders for $100. I qualified because I had

$100. And, just for the record, I think the manual is still for sale if

you want to get your hands on a copy.





Anyway, I had coupled his method with some of my own analysis

I was doing in the markets. I had noticed something that I thought

would be a very high probability trade-divergences. I decided that if

I saw a divergence setting up, I would use the entry and exit techniques

described in this $100 manual. Soon after opening the account,

I began trading these signals. There were, however, entirely

too few of them to make me happy. So, I started doing some other

things in the account to beef up the activity. Surprisingly (not then

but now), I did very well. At the ripe old age of 21, I took a $10,000

account and turned it into more than $20,000 in just four months.

Because all of my previous trading ventures had been complete failures,

I was absolutely elated at this new-found success. Downright

cocky might be a better phrase for it. I thought I had it made. And, it

wasn’t because of some lucky trade that I had wandered onto. I had

methodically, trading 20 markets, inched the account, trade by trade,

to more than a 300 percent annualized return. At the age of 21, I had

achieved a status that only 10 percent of all traders achieved-positive

results.

That was on Thursday. On Friday, I was taking my wife on a little

weekend getaway. After driving for a few hours, I decided to

stop, call my broker, and find out how my 11 positions were doing.

I was in everything from natural gas to sugar. In several of the

markets, I had two or three contracts. When I called, I was informed

that 9 of the 11 positions had gone against me. Although it

certainly wasn’t devastating, I did not have the margin to carry

all 11 positions through the weekend. Therefore, I liquidated a

few of those, rationalized that the others would make up the slack

on Monday and went on my way. I was a little disappointed and

even a little worried, but far from being devastated. That state was

still to come.

Two weeks later, my $20,000+ account had plummeted to less

than $2,500! Now, I was devastated. My pride had been crushed and

I was right back among the 90 percent of people who lose money trading.

What happened? That was my question. I decided to take some

time off from trading and investigate exactly what had happened to

10



 


WHY (PROPER) MONEY MANAGEMENT? WHY (PROPER) MONEY MANAGEMENT? 13

this account. I was going to figure out what had caused the collapse if

it was the last thing I did. Defeat is only temporary.

After analyzing the trades, I determined that the most reasonable

explanation for the demise was overtrading the account. However,

this was new territory to me. My first account was a $2,500

account where I bought five bond options (or five of one market, I am

not sure whether it was bonds or crude oil). I put the whole amount,

into that market. Two weeks into the trade, I had doubled my money.

The day the market went my way, causing the prices of the options to

spike, I called my broker to get out. However, he convinced me that

the market was going to continue to move in my direction and that I

should definitely not get out yet. So I didn’t. Two weeks after that,

my $5,000 was down to about $300. I concluded that instead of overtrading,

my mistake was not getting out while the getting was good.

A few accounts after the option debacle, I had ventured into trading

option spreads. I had been tracking OEX (Standard & Poor’s 100

Stock Index) option time spreads. You would buy the near month option

and sell a deferred month and profit off the decay of the deferred

month with protection. After tracking these for awhile, I spotted a

tremendous opportunity in the British pound options. I noticed a huge

discrepancy in the price of the near month option against the price of

the deferred month’s option price. After much calculation on how

much I was going to make off this trade, I decided to place 20 spreads

with my $7,500 account. I knew that my risk was limited and that I

would not be charged more than the difference between the two options

for margin. Too bad my broker didn’t know this.








A few days later, the broker called me and left a message stating

that I was considerably undermargined. Thinking that this was a mistake

(and because I was actually making about $100 on each spread), I

didn’t bother calling him back right away. A few days after that, I had

nearly doubled my money with the trade and decided to get out not

wanting to repeat the mistake I had made with the crude oil options.

So, I called the broker and exited the position at the market. I learned

several important lessons that day. First, British pound options are

not very liquid. Second, a September British pound option is based on

the September contract of the British pound. A December British

pound option is based on the December contract of the British pound.

Third, full margin is charged in this situation.

Instead of making $7,500 on the trade, by the time I closed both

ends of the trade, slippage brought me down to actually netting a

negative $500 on the trade. When I added in the slippage and $35 per

round turn-40 of them-1 lost about $2,000 on the position that

supposedly was making me close to $7,500!

Next, I was chewed out for not returning the call regarding the

margin deficit. I was informed that I was being charged full margin

for the short sell of the options because they were on the December

contract and therefore were not offset by the September option purchase.

They were about to liquidate my position with or without my

consent (rightfully so, I might add).

Even though I had placed far too many British pound option

spreads in that account, I did not learn about overtrading the account.

This little lesson eluded me until I analyzed why my straight futures

trading took me to over $20,000 in four months and down to less than

$2,500 in two weeks. Not being absolutely certain of my conclusion, I

did a little research on the subject.

This was a major turning point in my quest to succeed at trading.

I picked up a book called Portfolio Management Formulas, by Ralph

Vince (New York: John Wiley & Sons), and was stunned by one of the

examples in that book. Even though the book is highly technical and

impractical for most traders, it does an excellent job of revealing

the importance of money management. The following example from

that book confirmed my original conclusion that I .had simply overtraded

my account and also illustrates why traders need proper money

management,

Take a coin and flip it in the air 100 times. Each time the coin

lands heads up, you win two dollars. Each time the coin lands tails

up, you lose only one dollar. Provided that the coin lands heads up 50

percent of the time and tails up the other 50 percent of the time and

you only bet one dollar on each flip of the coin, after 100 flips, you

should have won a total of $50.

100 flips

50 flips land heads up. 50 x $2 = $100

50 flips land tails up. 50 x ($1) = ($ 50)

$100 + ($50)= $ 50

(Note: This is a fictitious game. I have had some traders call me

and tell me that this doesn’t simulate real-time trading. My response

is that it is not meant to simulate real trading, only to show the

power and demise of money management.)


 


WHY (PROPER) MONEY MANAGEMENT?

Obviously, this is an ideal betting situation. Since we can spot

the profitable opportunities here (being the astute traders that we

are), we are not going to bet just one dollar on each flip of the coin.

Instead, we have a $100 account to bet in this game. There are many

possible ways to bet the scenario. However, you must choose one of

the following four options:

A. Bet 10% of the total account on each flip of the trade.

B. Bet 25% of the total account on each flip of the trade.

C. Bet 40% of the total account on each flip of the trade.

D. Bet 51% of the total account on each flip of the trade.

These are the four options. If you choose A, you will multiply the

account balance by 10 percent and bet that amount on the next flip of

the coin. You will then take the total amount won or lost plus the

original amount bet with, place them back into the account and multiply

the total by 10 percent again and bet with that amount. Therefore,

starting with $100 and multiplying it by 10 percent gives you

$10 to bet with on the next flip. If that flip is a winner, you win $2

for every $1 you bet with. Since you bet with $10, you win a total of

$20 on the first flip ($10 x $2 = $20). Take the $20 and place it back

into the account and you now have $120. Multiply this by 10 percent

and you will bet $12 on the next flip. If the next flip is a loser, you

will lose only $12 which will bring the account down to $108. You get

the picture. Do the same if you choose B, C, or D.




The results are as follows:

A. After 100 flips, $100 turned into $4,700.

B. After 100 flips, $100 turned into $36,100.

C. After 100 flips, $100 turned into $4,700.

D. After 100 flips, $100 dwindled to only $31.

The whys and hows of this illustration will be dealt with later in

the book. For now, I want to point out two critical facts about money

management. First, it can turn a relatively mediocre trading situation

into a dynamic moneymaker. For a trader who staked a flat $10

on every trade without increasing the size of the bet, the net value

of the account would have only been at $600. However, increasing

and decreasing the amount of each bet increased the return by 683

NEGATIVE VERSUS POSITIVE EXPECTATIONS 15

percent. If a trader would have bet a flat $25 on each flip, the net

value of the account would have ended at $1,350. By increasing the

amount bet as the account grew, the return was increased by 2,788

percent. If the trader were to bet a flat $40 on each flip, after suffering

two losses in a row, the trader would be unable to continue.

Therefore by decreasing the amount risked on each flip, the trader

was able to stay in the game.

Second, risking too much on each trade can also turn a winning

situation into a losing scenario. Even though the trader would never

totally deplete the account (theoretically), the decrease would

amount to a 79 percent loss after 100 flips.

This illustration shows that improper money management can

turn a winning situation into a losing situation. However, no amount

of money management will mathematically turn a losing situation

into a winning situation.



NEGATIVE VERSUS POSITIVE EXPECTATIONS

Even though this book does not get deeply involved in probabilities

and statistics, it touches on the aspects required forthe application of

proper money management. This is where positive and negative expectations

come in.

Put simply, the trader must have a positive expectation to apply

proper money management. In addition, traders must experience a

certain degree of positive return. The definition of a positive expectation

can be reduced to the statement that there exists a mathematically

proven probability that the trader will end up with profits, not

losses. The coin example is a positive expectation scenario based on

the following math:

Probability of winning trades = 50%

Probability of losing trades = 50%

Amount of each win = $2

Amount of each loss = $1

The mathematical equation for a positive expectation is as follows:

[l+(W/L)lxP-1


 


 



WHY? WHAT? WHERE? WHEN? WHO? HOW? - 3 Part

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