09-Sep-2005

>Money Management-I

(i can assure you, only the best traders would be able to read to end or understand this post completely :-)) )

The description of blog has the words risk and money management.
Its time we had a look at it, after all EagleEye has a focused brain behind the sharp eyes. ;-)

You see, if we’re flipping a coin, heads has a 50 % chance of turning up on each flip of the coin and so does tails. But, each flip is independent of the last. The last coin toss has nothing to do with the one before it, each flip is a random event. This means it’s possible to get a hundred heads in a row if you do it long enough.

Trading is the same. A percentage of your trades will not work out. A certain percentage will not go in your favoured direction, and the next trade has nothing to do with the last one. Even if you have the world’s most accurate method, over time you will go broke if you don’t practice good money management.

Money management rules include defining

  • your trading float
  • setting your maximum loss
  • calculating your stop loss
  • and most importantly learning how to choose your position size.

Once these rules are in place

  • it’s important to stay with them.
  • They will keep you from making snap decisions, and playing the odds longer than you should.
  • This is why money management rules are a critical part of any effective trading system.
O.K. I have heard this shit many times over? any details? yes....>

what & why money management?
  • The mathematical process of increasing and decreasing the number of contracts/shares/options..
  • The purpose of utilizing money management should be to increase the profitability during positive turns and protect those profits during darw downs of any trading system or method.
  • oh.. i see... sounds good.. but what the big deal...duhhh..!!
an example please? why not...>
Take a coin, toss it in the air 100 times.
The ratio of heads to tails landing up should be very close to 50/50.

If you were to win Rs. 2.00 every time the coin landed heads up and lose $1 every time heads landed face down, you should have won approximately Rs. 50 by the end of 100 tosses.
This is a positive expectation situation. The odds of you winning are heavily in your favor.
Further say you have Rs. 100 to bet with.

The question is, what percentage of your money should you risk on each flip of the coin?
What would you say is the best percentage to reinvest on each flip? 10% 25% 40% of 51%?
This means that if you begin with Rs. 100 and choose to risk 10% of your capital on each flip, you begin by risking $10 on the first flip. If the coin lands heads up, you win $20. You would then risk $12 of the new $120 total on the next flip of the coin. If you lose, you lose $12 and if you win, you win $24 and so forth the game goes. Would it make a difference which % you used? If so, how much? Remember, you make twice as much when you win than when you lose. The odds of you winning are 50% every time.

The answer may surprise you.

By risking 10% of your money on each of the 100 flips (a Rs.10 bet on the first flip) you will turn your Rs. 100 into Rs. 4,700! Money management increases your return from 50% to a 4700% return!

Reinvesting 25% of your money would have turned Rs. 100 into Rs. 36,100! An increase of just 15% per toss increases your total return from 4700% to 36,100%.

It looks like it gets better the more you invest. ??But wait. ..

Increasing your risk another 15% every flip to a total of 40% being risked on each flip would turn your $100 into $4700. This time by increasing your risk, your return dropped drastically.

What if 51% of your money is invested? With this scenario, you actually lose money even though the odds are statistically in your favor. Your $100 decreases to $36. A loss of 64%.

The point? USING THE RIGHT OR WRONG MONEY MANAGEMENT CAN MAKE OR BREAK YOU!

Notes:
  1. In the example above, it would not matter in what order heads or tails were achieved.
  2. The great thing about money management is the fact that money management is purely a function of math. A hundred years ago, two + two = four. Today, that same equation yields the same answer. Therefore, money management IS predictable unlike trading strategies or systems.
  3. Money management is more powerful than any trading system that it can be implemented to.
  4. It is more logical to implement proper money management to a trading system than to trade that system without it. Money management will take you farther with less.
  5. The wrong money management applied to your trading could actually hurt the end result.

a little thinking on a different question....
=> suppose you have 55,000 rs in your account.
one contract of nifty takes 20,000 rs and one contract of sbi takes 50,000 rs.
(assume nifty and sbi are same in every other imaginable way, only difference is in amount to buy one contract)
what would you trade? Nifty or SBI and why? (assume you are a godly trader and you never loose)

If you use Nifty you can buy only 2 contracts and 15,000 would be idle.
If you use SBI you can buy 1 contract and only 5,000 would be idle.

Now think what would you trade?
I would trade Nifty, since its more granular. I can rapidly increase the number of contracts I trade while its more difficult to do so in SBI.
To trade one more lot of SBI, I would need 50000 more Rs every time.. while for Nifty I need only 20000. So profits can re reinvested more easily trading Nifty than with SBI..
Thus I would be trading a more fuller part of my portfolio with Nifty then with SBI and over time Nifty trading would grow my portfolio faster than SBI trading...!!! (startled?? ) (incase its not clear leave a comment).
Dont forget the above point.. This is one thing which would give one trader a sustained-competitive advantage over another.

Some say money management is simply a matter of preference and that it is going to be different for every trader (risk apetite.. ehhh). To some degree, this is true.

But if you take the same account size with the same risk tolerance and the same profit goals, there is only one "best" money management application for that set of circumstances. In geometry, the definition of a line is the shortest distance between two points. There are other ways to get from point A to point B, but there is only one way that is most efficient to achieve the same results. That is the same way with money management.
It is a matter of mathematics(class 10th). Keep in mind.

need to read on risk management?? click me.
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leave ur comments.. praises and slaps.. :-)

2 comments:

Prashanth said...

Wrong Example, Buying a Contract of Nifty may leave you with 15K, but you are essentially putting up 70% of your Portfolio into a single Trade.

A Good Portfolio shoulnt have more than 10% of the Total Portfolio in any Indivdual Stock (5% for Risk Averse) and Max Losses that should be taken (Stop Loss) shouldnt be more than 1% of the Total Portflio.

Another thing you have taken for Granted in the examples is the Risk : Reward ratio, the compounding 4700% holds good if Risk:Reward is 1:2, what if it changes. This will adversely affect the whole system.

What is your say?

Cheers

Prashanth
prash454@rediffmail.com

CK said...

Nice article Rajeev. Could you elaborate more on position sizing and pymariding strategies. My personal experience has been that pyramiding has the power to dramatically increase returns when you have made the right call.