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Money Management

The subject of money management is a broad area with many options, but its use is necessary to survive in trading today’s volatile financial markets.

If used properly, money management techniques can stabilize or dramatically enhance the performance of a trading system.  On the other hand, if money management is used improperly, it can adversely affect the results of a trading system.

 

In this article, I am going to discuss the general rules for employing money management orders and demonstrate how to write a basic money management strategy that works.

What is Money Management?

Money management is the act of managing open positions in a trading system based on current profitability, relative performance to other market positions or statistical behavior computed from historical testing.

The principle behind money management is very simple – if profits can be taken before they vanish and losses reduced before they grow in size, a trading system should, in theory, make more money and be easier to trade.

There are 3 basic types of money management rules

1.   Stop Loss
2.   Trailing Stop

3.   Profit Target 

Stop Loss

Stop Loss is the concept of closing out a position when some predefined level of loss is reached.  The predefined level could be a fixed amount of money or a fixed number of points from the entry price point.  There are many ways to define the stop loss level. 

Trailing Stop

Trailing Stop is the concept of protecting the profits of an open position.  Usually, a trigger level has to be reached before the trailing stop orders are placed.  The trigger level can be a fixed amount of profit or a fixed number of points from the entry price.  Once the trigger level is reached, the trailing stop order is placed to protect a certain part of the current profit.  

Profit Target

Profit Target is the concept of taking a profit while it is to your advantage.  A predefined level of profit is set and when that level is reached, the system exits the position immediately.  Predefined level can be anything from a fixed amount of profit, a fixed number of points from the entry price, to a particular price level like the previous month’s high or previous trading day high. Usually, profit target rules are implemented through the use of limit orders.

General Tips in Applying Money Management Rules

1. Apply money management code only after the system shows some form of consistent profitability.

2. Avoid using money management orders whenever possible.

3. It is a known fact that the further you place your stop loss orders away from the price, the higher your percentage of winning positions combined with an increase in drawdown size.

4. It is a known fact that profit target rules can boost profitability significantly.  Profit targeting may not work going forward, unless your targeting rule takes into consideration adapting to current market conditions.

5. By using optimization on money management rules, it is possible to turn most non-performing trading systems into profitable systems.  Such results are not sustainable going forward because it is curve fitting the system against the historical data.

Static Value versus Volatility Adjusted Value

Most beginning traders design trading systems with static values in their money management rules. You cannot blame them because most trading software provides canned money management options so everyone can optimize their systems to show some form of profitability.

A more appropriate approach is to use adaptive values that change based on market conditions, not a fixed value chosen arbitrarily by the user or optimizer.

For example, if you designed a trading system that has a fixed 3-point profit target, it may work at current price levels, but it may not work when the price level has changed to double the current price.

Modifying an Existing System

Another issue encountered when adding money management code to an existing system is that you have to properly modify the system so that its entries do not change.  Otherwise, you will fall into the trap of developing a new and different trading system without realizing it.

For example, if your system takes an oscillator signal when the indicator reverses from overbought and oversold conditions, you could have multiple buy signals without a corresponding sell signal.  If your money management rules take you out of a current position, should your system take consecutive signals in the same direction that follow?  In most cases, it is best that you do not let your system re-enter a position in the original direction unless and until the original position has been offset.

An Example

In this article, we will use a basic moving average system that works consistently as a daytrading system, but less so when positions are held overnight.

Can money management techniques help improve the results?

Notice we are dealing with e-mini S&P data over so many years.  The price ranges from 800 to 1500, which is a huge variation for any static money management rules to work properly.  We need something that is more robust to consistently describe our rules.

The technique used is a volatility based method using average daily range.  The reason is obvious, since we keep positions overnight.  We need to be able to work with the volatility of the daily changes in the e-mini S&P.  All stop loss, trailing stop and profit target are described indirectly as a fraction of the average daily range.