Defensive Money Management Explained: How To Ruin Your Winning Strategy

By Lawrence

Written by Lawrence Chan. All rights reserved.

Note: Feel free to email me with your feedback

Index Page

When You Have More Than One Trading Setup

Many traders, when successfully mastered a trading setup with pretty consistent results, they would consider adding more markets and/or adding more trading setups.

Each new combination of an instrument and a trading setup (or price pattern, trading method, model, etc.) will produce a completely new set of expectations and performance statistics. How you manage such additions to your trading will heavily impact your overall performance.

Single Setup Performance in the Eyes of a Trader

Given a basic trading setup of { 60/40, +150/-100 } (60% winner, 40% loser, average winner $150, average loser $100) that trades 1000 times a year with $10,000 initial capital, you get the following equity probability graph.


A pretty impressive performance isn’t it?

In the eyes of the trader who trades this method, however, it is more realistic to look at the potential daily profit/loss results.

# of Trades Expected P/L Worst Case Best Case
0 0 0 0
1 +50 -100 +150
2 +100 -200 +300
3 +150 -300 +450
4 +200 -400 +600
5 +250 -500 +750
6 +300 -600 +900
7 +350 -700 +1050

As the trading setup usually generate 1000 trades a year and that a normal instrument only trade 5 days a week, we can expect that some day there will be no trade (rare cases), and most of the time there will be 4 to 5 trades a day. It is less likely that there will be 6 to 7 trades a day.

On a day with a single trade, you never get the expected profit of +50 ever. All you will get is either +150 or -100. The amount of +50 is just the statistics.

On a day with 2 trades, you may get one of 3 possible outcomes, -200, +100, or +300.

Most of the time, when trading this trading setup, the trader will see positive results at the end of a trading day.

A Second Trading Setup with Different Characteristics

Now, let’s look at a completely different trading setup with its performance profile of { 50/50, +300/-200 } and that it only happens 300 times a year.

image A very impressive model as well but the potential daily profit/loss results is quite different from the first one.

# of Trades Expected P/L Worst Case Best Case
0 0 0 0
1 +100 -200 +300
2 +200 -400 +600
3 +300 -600 +900

For this trading setup, due to its nature of fewer trades per year, it is rare to see 3 or more trades within a day. That also makes someone who trade this setup more like to have a few days of losses in a row comparing to the first trading setup.

Mixing 2 Trading Setups of Different Characteristics

The profile of the first trading setup is a typical good scalp/n-min swing setup.

The profile of the second trading setup is a typical production breakout model.

When the 2 trading setups are mixed together, the daily performance turns into something quite different.

Trades from 1st Setup Expected P/L P/L of 1 Trade from 2nd Setup Net P/L
4 +200 -200 0
4 +200 +300 +500
5 +250 -200 +50
5 +250 +300 +550

For a trader who trades the second trading setup originally, adding the first trading setup would likely be a welcome addition because of the expanded number of trading opportunities and potential profits. The most likely complain would be too much work for relatively mild increase in profitability.

However, for a trader who trades the first trading setup originally, adding the second trading setup can be very uncomfortable because the consistent daily profitability is gone. Equity swings become more wild. And most obvious of all, hard earned profit are easily wiped out by taking just 1 trade from the second setup.

Do not underestimate this uneasy feeling with the daily performance. It can stress out a good trader and turn a profitable trader into a losing one if the trader tries to refine his trading style madly for “better performance”.

Understand the Impact of Your Trading Setups on Your Daily Trading Results

Many beginners pick up daytrading (and trading in general) by reading books and tracking charts for a short period of time. Thus they are taking on trades from all kinds of trading setups. Such non-organized effort may produce some random spikes in profitability but performance will be mediocre over the long term.

Different people have different personality traits that fit well with some types of trading setups and it is very counter productive for someone who feel uncomfortable with some other types of trading setups to actually trade them.

By looking into your own trading records, and properly identify the reasons why you took each trade. It will surprise you with insights of what really drives the profits in your trading. Better yet, you will find out what kind of trading setups you do not handle very well. By dumping the type of trades that you do not handle very well, you can boost your trading performance very quickly.

Lesson 3: Minimize Risk Exposure When Trading a New Trading Setup

For those who have successfully mastered trading one and only one trading setup already, as confirmed by the test of repeated performance that I suggested in last chapter, it is best to hold off adding new trading setups until after you have increased your trading size on your primary setup.

The reason is that adding new trading setups to your trading routine could cause huge impact onto your daily performance as illustrated in this chapter already, thus it is best to trade the smallest possible size on the new trading setup until after you have worked out issues that come with changes to your trading routines.

Smallest possible size is a relative concept. When you are trading your existing trading setups at a size that eclipses the impact coming from trading the new trading setup, you will be able to evaluate and eventually integrate the new trading setup comfortably without going through the unnecessary emotional swings.

The Mental Block Aspect in Adding Different Style of Trading

Many traders who trade discretionarily with certain degree of success in scalping are the ones who have the biggest difficulty in moving into other trading styles.

The reason is that they have learned very well to trade by watching price actions and reading the tape. They have fully adapted into the fast pace trading environment. All these great habits like cutting loses fast and locking in profits are part of the reason why the trader has been trading profitably.

But all these habits and almost second nature in trading instincts will interfere with the better judgment of the trader when it comes to taking trades that has a different profitability characteristics. Every minor swings that does not matter in the context of the new trading setup will trigger the trader to have an urge to take profit or flat out the position.

At the end of a trading day, the trader who is not prepared mentally to take on trades of different behaviour would have battled himself continuously within his mind and will become exhausted easily.

All that is unnecessary if the trader is aware of the difference and is prepared mentally to accept the possible outcomes from the trades taken based on the nature (performance characteristics) of the trading setups involved. That being said, it will still take a long time for the trader to adapt to the change because humans are habitual creatures and habits are very hard to break.

– end of part 4 –

  • Han777 December 12, 2014 at 8:37 am

    Speaking of scalpers your third paragraph from the last, “But all these habits…will interfere….” rings in my boxed ears, “Too true!” This scalper’s psychological impulses scream against holding a longer-term daytrade, both during pullbacks and when price action overextends in the profitable direction. Every trained nerve is too-ready 1) to jump out of the way at the first signs — when the horse ears lay down and a hind foot is unweighted and ready to kick; or conversely, 2) to jump off the horse when it suddenly leaps toward my destination, fearing it will suddenly stumble and fall, and me with it. Wikipedia reports of Nassim Taleb, “His preferred strategy is to be both hyper-conservative and hyper-aggressive at the same time.” Is there no way to use a scalper’s tape reading skills to improve on longer term daytrading positions, for reckoning both when to enter and when to exit before reaching the target? I am slow to abandon that hybrid marriage, yet painfully slow to tame hyper-aggressive reflexes in order to accommodate my allegorical bride’s conservative need for stability through patience. Doesn’t Nassim Taleb also teach that watching price action distorts reality over time as small, accumulated emotional responses unite to induce stronger emotional impulses to react prematurely? How can a trader gain the best of both worlds, and when should he stop trying?

    • Lawrence December 12, 2014 at 8:04 pm

      About Nassim: that implies Nassim is bleeding chips buying OTM options for larger than normal returns. =)

      #1 I do that all the time using my good old tape reading / chart reading skill on sub-minute charts to jump in a tad earlier than the normal single timeframe confirmed entries. You have to decide first if you are playing long and deep or quick and dirty before you engage.

      My usual rule of thumb is that in a trending market, for my counter-trend plays I act like a scared bunny. Be as cautious as possible.

      For my major reversal plays and trend plays, I go bold for the 2nd target or nothing.

      #2 Nassim got that right. Only way to avoid the pitfall is having a balanced mind entering the arena each day, and debelief yourself after the day so that you have a clean slate for the next day.

      #3 I will post a few reviews of trading psychology course soon. Some are good, some are average but useful in certain areas. Give them a try as they have freebies. The goal is to learn certain “mind tricks” to retrain your mind. It can help a lot if your obstacle is not your trading skills but your mental blocks.

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