Archive for Money Management
Day Trading Income Potential For Index Traders
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"How much money will I make trading emini S&P?" is one of those questions often asked by people interested in learning to trade. It is not a simple figure that I can just toss out because it depends on many factors. However, I can provide a good overview here on the income potential why trading emini S&P is better than most regular jobs.
I wrote about the account requirement on trading the emini S&P quite some time ago. That information is crucial because it limits who has a better chance to make it in trading emini S&P. So if you have not read that please do so later so that you have a better understanding of the context of this article.
The development in CFD (Contract for Difference) markets has somehow changed the barrier to entrance for people interested in trading the index markets. CFD on worldwide stock market indices is not something new. In fact people in Europe and Asia has been trading that for well more than 15 years. I will discuss about that in a separate article in the future.
A Typical Emini S&P Day Trader
A typical beginner who day trades emini S&P may average around 3 trades a day, 65% winning rate, winners taking 2 points while losers dropping 2 points. That is someone who paid the dues in learning to trade already and have mastered one basic trading setup. For those articulate minds, please forget about commission or slippage for now. The details of his performance actually does not matter because that varies from person to person. What matters is the expectancy.
The expectancy for the example given is that this trader can net 0.6 point profit a day per contract. It is not much consider each emini S&P point is $50. So he is expected to make just $30 a day on average. So yearly he is expected to make 126 points (0.6 points over 210 trading days) or $6,300.
$6,300 a year may not sound like a lot comparing to a low paying day job. To those with a closed mind or brainwashed by MSM beliefs, they would take this as the reason why one should not think of trading and do a dead-end job instead. They are totally wrong because regular jobs are not scalable. Bluntly, I may also add that many dead-end jobs are exploited so badly by the employers and the management, it is hazardous to one’s health.
Now let’s look at the power of scalability. Given that the trader does not touch the money from the account and increase the trade size by one (1) contract on increase of $10,000 capital at the end of each year. Following table shows the yearly income changes.
| Year | Contracts Per Trade | Yearly Income +0.6 pts / contract / day |
| 1 | 1 | $6,300 |
| 2 | 1 | $6,300 |
| 3 | 2 | $12,600 |
| 4 | 3 | $18,900 |
| 5 | 5 | $31,500 |
So for someone who never improves his skills beyond the one single trading method he knows, and that the trading setup only produces positive expectancy of 0.6 point. This trader will still be looking at more than $30,000 a year income from trading after 5 years. As long as this trader continues to do exactly what he knows that work, his yearly performance will continue to grow. This is the power of scalability.
You cannot say the same thing when you are doing a dead-end job with minimal chance of career advancement.
What I am trying to show here is that even if your performance is just marginally positive with daytrading, you will come out ahead, way ahead, of a dead-end job. Of course, it will take hard work and persistency at your end. But if you do have these qualities why waste them on a dead-end job that will not reward you for your effort?
A Better Trader
Let’s look at a better trader. One who can produce positive expectancy of 1.5 points per contract on average. You will be surprised how big a difference it is.
| Year | Contracts Per Trade | Yearly Income +1.5 pts / contract / day |
| 1 | 1 | $15,750 |
| 2 | 2 | $31,500 |
| 3 | 5 | $78,750 |
| 4 | 13 | $204,750 |
| 5 | 34 | $535,500 |
Notice that I am not talking about a star trader who can pocket 3 points (or more) per contract. I am taking this straight from the mechanical/discretionary hybrid methods commonly used by firm traders in engaging the emini market.
It is true that trading a single lot in the beginning does not produce a lot of money in the first 2 years. But once the trader has enough money to go 5 lots or more, you start to see the real power of scalability.
Legendary Traders
There are several well known traders who start out with single lot trading and made over 1 million dollars within a year. Many people mistaken that they made it with big swings and assuming huge risk. That is not true.
What many of these guys did was essentially a turbo charge version of the scenario mentioned above. Instead of increasing size every $10,000, they increased size aggressively with much higher trading frequency than just 3 times a day by having multiple good trading setups. Hence the per contract risk taken stays the same.
As mentioned in Essense of Trading: Trading Is Easier Than Most People Think, it takes time for people to adjust their minds to trade size. For these legendary traders, their personalities also play a huge role in their accomplishments. Not everyone can adjust their mindsets to handle large equity swings that quickly and efficiently.
I know I am not one of them for sure. I have accepted the fact I am a slower person in this aspect. The important thing to remember is that there is no shame in not being able to handle as many contracts as another trader. The only thing that really matters is that you are pulling in good money from trading.
Aim For The Stars
After spending so much time in warning people to be careful with trading, I guess it is about time to talk about the income potential objectively. I think I am painting a fair picture here on what to expect from trading the emini S&P if you focus on consistency and profitability. Day trading emini S&P is a good career path provided you have what it takes to stay consistent in this highly competitive game.
My advice to young guns has always been the same, "Aim for the stars! You know it is possible because you have seen others doing it. Give it your best shot. Even if you do not rise to the top, reaching half way through you will still be way ahead of other career choices."
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Renaming The Chapter Names Of Defensive Money Management Explained
Posted by: | CommentsRenamed the chapter names from just part 1, part 2, etc. into something more meaningful so readers can have some expectations knowing what they are going to read.
I am finally ready to add more chapters to the series after a long break.
Originally, due to the length of each article for the series was very long, it makes it difficult to edit and release the chapters. My mistake was gunning for completion of a board topic per article. Going forward, I will release several shorter pieces to address a topic so that the project can move on.
You can see the new chapter names on the main page here.
Magic Multiples For Position Sizing
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Many people asked about my strategy of position sizing. I know the standard techniques involve calculating the exact number of contracts based on certain threshold of your trading capital to optimize performance. Since I do not stretch my trading capital for maximum exposure, it is not what I do. My method evolves around 2 magic numbers – multiples of 3 and 4.
I started out trading single lot like everyone else. As I started to add more contracts, I experimented with various position sizing schemes and I can tell you the idea of maximized exposure is definitely the worst experience I have. Over time I settled on this interesting method to scale up and down in various market conditions. It works quite well and it is easy to follow once you understand the reasoning behind.
Following is a table how I scale out of a position in normal situation based on the entry size. The last few lines show 2 ways to split the remaining position on the 3rd and 4th exit.
| Size | 1st | 2nd | 3rd | 4th |
| 1 | ||||
| 3 | 1 | 1 | 1 | |
| 5 | 2 | 2 | 1 | |
| 6 | 2 | 2 | 2 | |
| 10 | 4 | 3 | 3 | |
| 12 | 4 | 4 | 4 | |
| 18 | 6 | 6 | 6 / 3 | - / 3 |
| 24 | 8 | 8 | 8 / 4 | - / 4 |
| 36 | 12 | 12 | 12 / 6 | - / 6 |
| 60 | 20 | 20 | 20 / 10 | - / 10 |
| 108 | 36 | 36 | 36 / 18 | - / 18 |
There are 2 goals to my scaling method:
1. To be able to split the initial position into half or 1/3
2. To be able to do that again on the remaining position one or two more times
The concept itself automatically drives the initial position size to be a multiple of 3 and 4. Hence I seldom do round number lots like 20 or 50. 30 works ok and 60 is probably the only round number that works with my scheme for position size under 100.
Logic Behind The Magic Multiples
The reason for splitting the position into 3 parts is that most of the trading setups I take can be traded mechanically with 3 types of targets.
One is a high probability target (70%+) that is very likely to happen.
Another one is good probability target (60%+) that will likely happen if the first target is tagged and breached.
Last one is a trailing stop based method with exhaustion exit.
As I put on the position it is the same as putting on 3 positions separately. Hence the need to manage them separately.
The reason for the ability to split the position into half is my contingency plan.
When the market does not unfold as expected, the probability of tagging my further out targets will be greatly reduced, so it is just foolish to hold onto the complete 2nd and 3rd part of the position upon tagging the first target. Taking half out instead of my regular 1/3 is to reduce exposure on the 2nd and 3rd part of the position at the same time I close out the 1st part. It is just more convenient to do so.
Sometimes I take out 2/3 upon tagging the first target if the trailing stop based portion has signal me with an exhaustion exit. It happens from time to time when I am trading on the wrong side of the market.
A Conservative Approach
Notice the scaling of size jump by 6 contracts. What it means is that to increase or decrease position size I usually round them down to multiple of 6 and if possible multiple of 12. The idea is to make sure I allocate even size for each of my 3 parts in a position.
That also means I have to wait for my trading account to grow enough money to cover 6 more contracts before I would increase my maximum position size. I do not increase my maximum position size within a year. That is done only once at the beginning of the year.
Time To Slack Off
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Over the weekend I reviewed my performance so far this year. I know I have reached my own base line trading goal for the year since September. At the end of October, I hit my ambitious goal as well. Whenever that happens, I reduce position size and trading setups that I will use until the end of the year. I will also allocate more time to do my research. It is a good practice and something you should put into your own trading plans too.
When your trading goal for the year (or whatever period you choose) is reached early, it can be the result of more outlier winners (in terms of amount) than usual. It can also be the result of more winners than usual. It can also be both. Experience and my research on trading methods told me that such improvement usually would not last.
By reducing the overall position size I am going to take until the end of the year, I am reducing the impact of losing trades significantly. I am not talking about a cutback of just 10 to 15 percent in size. I am reducing my position size by half. Should these last two months of the year I am doing fine, I have nothing to worry about. On the other hand, if I am facing significant setbacks, I will stand to keep more of my money I made so far.
Those who read my writings know that I am someone who advocate tracking each trading setup one uses separately. This tracking of your own performance based on each separate trading setups can help you identify which one has been doing exceptionally well. In my case, it is the counter-trend setups that have been doing so good I know they are likely going to fail more going forward. So until the end of this year I will be limiting my counter-trend trades significantly.
Some of my trading buddies prefer outright stop trading after their goals for the trading year is reached. Quite a few would take a long vacation or work on a hobby project until after New Year. That is the other way to avoid losing money back to the market.
Spending the hard earned money on yourself and family surely beats giving it back.
How Much Money Is Needed For Trading Emini S&P
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I have received this question so many times I guess I should post the answers here.
Answers? Yes. Not one answer but answers.
Learning To Trade Discretionarily
If you have no proper daytrading experience before, given the current overnight margin on 1 Emini S&P contract is about $4000 USD (it various among the brokerages), you probably need to burn through multiple $20,000 USD accounts before you will be able to trade profitably. By proper daytrading experience, I mean you have been trading other future contracts and have been reasonably profitable for some time already.
Remember the amount stated is on a per contract basis. That means if you are aggressive and like to trade 2 contracts at a time to start your trading career, then be prepared to burn through multiple $40,000 USD accounts instead.
Already Profitable Daytrading Some Other Markets
If you have some proper daytrading experience and is expanding into trading the Emini S&P, then you probably need to burn through one to two $20,000 USD accounts only.
Already Making Good Living Daytrading Some Other Markets
Then do not switch to trade Emini S&P. Especially if you are used to trade instruments with good follow-thru price actions (e.g. crude oil). Emini S&P will wreck your mind and mess up your trading on the other market as well. Be prepared to trade conservatively and expect to burn through at least one $20,000 account before you get used to the way Emini S&P behaves.
Have Swing Trading Experience In Other Markets
I’m sorry that does not count at all. Daytrading Emini S&P is a completely different ball game.
Account Size Minimum
Some brokerages have an account size minimum that once breached, you can no longer trade. If this threshold is higher than the margin requirement, you need to add the difference to the amount of money needed.
For example, a brokerage may have a $5,000 minimum balance policy. Even though their Emini S&P margin is just $4K, you still need $1K extra to hold just 1 contract. In this situation it is better to have $21K seed capital instead of $20K to start.
Daytrading Margin
Some brokerages offer daytrading margin rate to their clients. The margin can go as low as $300.
I strongly advice new traders to have enough money to cover the full margin as oppose to having just enough margin.
For example, having only $17000 vs. the recommended $20000 when daytrading margin is $1000 only with your brokerage should work fine in normal market conditions. However, when the market goes wild, brokerages who offer daytrading margin rate may choose to stop offering that suddenly and catch you off-guard and put you in a very bad situation. This has happened before during the financial crisis and it can happen again.
Think about the situation where your balance is down to $3.5K and you are long 1 contract with their $500 margin rate. Then the brokerage suddenly choose to raise their margin back to the normal rate of $4K. You are then immediately under margin and the brokerage can liquidate your position.
Starting With Smaller Amount
The question I hear most often right after I replied to the title question is, "Can I start with a smaller sum of money?" or "Would $5000 do?".
You get what I mean – you wanted to know if it is possible to learn trading emini S&P discretionarily with a budget of $5000.
The soul destroying answer is no.
I have seen countless number of posts in trading forums claiming that someone did it and it is so easy.
Well, can someone trade Emini S&P with just $5000 to cover both margin and buffer for losses and make a lot of money from it? Of course it is possible.
The real issue here is that those who can are either traders with a lot of experience already and/or pretty good at trading Emini S&P, or, they are at least borderline mechanical trader with a well defined trading model that is known to perform. Only rarely an inexperienced trader can survive the learning curve with a very small size trading account unless they get a lucky home run or a very lucky streak.
In normal situation, the chance of surviving the learning curve for an absolute beginner goes straight down to almost nothing with such small amount of seed trading capital.
My advice is to switch to some other markets that offer a better chance of survival comparing to Emini S&P.
Or, wait until you have save up enough money before you try your hands on it.
Expect To Burn Through Multiple Accounts
Notice that I said burning through multiple $20K accounts. The reason why losing $20K at a time is better than stuffing, say, $60K right from the beginning, is that each round of blowing out an account should have taught you something and in turn increases your chance of survival when you are trading the next $20K account.
If you put up $60K right from the beginning to learn trading, you may lose it all while learning just the first lesson that should have cost you only $20K.
Every time after you blow up a $20K account, you need to reflect on the reasons of your failure. Do not blame it on others. Do not associate the failure with pessimistic judgement either. Be objective.
Lessons like trading discipline learnt from blowing through an account is 10 times more likely to stick with you than reading a book on proper money management.
Trading Mechanically
Given that you have a stable trading model on hand and you know the historical backtesting results, the amount of money needed is,
Margin + 2 x Max Drawdown + Worst Loss
The interesting thing is that if your trading model is a good one, you would need a lot less amount of money to trade successfully comparing to those who try to trade discretionarily.
We Have Not Talked About The Details Yet
If you are new to trading and want an answer to the title question, please do yourself a favour and read my ebook Know Your Odds Before You Trade. It is free. It covers more than the answers I have listed here because trading is not just about the capital you need to open a trading account. For example, have you thought of the amount of money you need to survive for prolonged period of time while you are learning the skill?
Do yourself a favour by learning about all the issues you have to face first. I am not trying to discourage people from trying their hands on trading here. In fact I encourage people to learn the skill because of the way the world is heading is going to be very unforgiving to those who want do an honest job to just make a living.
So instead of going gung-ho cheerleading you into trading, I want you making informed decisions. Just face the challenge as it is with a prepared mind.
Written by Lawrence Chan. All rights reserved.
Note: Feel free to email me with your feedback lawrence@daytradingbias.com
To illustrate the importance of deleveraging overtime on any particular trading model that depends on trading edge based on entry signals, here is a case study of an interesting trading model.
Let’s examine the following chart first.
The red line above shows the net profit of a day trading model on emini S&P. It trades only 20 to 30 times a year. Profitability is very consistent over the years and its winning percentage swings around 50% until 2008.
It is a short only signal. Surprising, isn’t it?
Most of you must be very curious about the exact trading model. Don’t worry I will talk about that in details a bit later.
The Winning Years
As you can see, the model works all the way since 1990s. A slightly more sophisticated version of the model works since late 1980s.
If you have been trading this model as late as 2004, you will still get a great run from the model.
If you run a hedge fund, there is no reason why you should not bet your farm on this. Well, hedgies may throw out terms like Kelly formula, optimal f, etc. but we all know it is just finding an excuse in applying maximum leverage (that should not blow the fund up based on historical performance) and hope for the best. Thus the performance of your fund would be exponential better than the one I’ve shown here which stick to a single contract.
The Crash and Burn Years
During year 2008 and 2009, the winning percentage of the model dropped to less than 30%. That, coupled with extremely wide range during the time period, totally destroyed the system.
If you started out trading the model during 2007, your expectation of the model is high and you will be wiped out for sure no matter how defensive you are, unless you have applied the concept of absolute equity stop on the model.
If you started out trading the model with at least a few good years beforehand, as long as you deleverage (i.e. reducing the use of margin in trading the model over time), or, having absolute equity stop (i.e. 20% of equity committed behind the model), you will be able to survive this crushing period.
From the chart above, it is clear at least 50% of the total accumulated profit is wiped out if you simply let the model do what it does.
How many traders and funds are prepared in handling a disastrous scenario this way? Not many.
I am disclosing this model here to show everyone, and especially those who focus a lot on discovery of trading edge thru entry signals, that successful trading models can fail and it can happen very quickly.
The Recovery
Since 2010 the model has returned to its normal 50% winning rate and recovered somewhat.
Can it recover fully? I have no idea as the edge it depends on could be gone already.
My disclosure of the model here, if words spread around, will likely accelerate the discount process of the edge.
That we have to wait and see.
The Model
Using RTH only Emini S&P data, excluding the last 15 minutes after 4 pm, you get a data series of daily bars.
When 3 period simple moving average on close crosses below the 7 period simple moving average on close, short the next trading day from open and close the trade by 4 pm.
No more rules. It is that simple.
You can improve the model in so many different ways, allowing you to extract more money from the market using this entry as the foundation. But such variations will not save you from the crash and burn period. The more optimized these models are to capture more profit, the more likely they would amplify the losses during the crash and burn period.
The reason for this simple concept to work so well is that many funds and traders use moving average based trading models. Thus the pattern emerges from their aggregated actions while they participated in the market. It is not a system trying to outsmart the other participants. Instead, it jumps in on those days most other players would do the same. The logic behind is simple, but most people do not recognize that many great trading signals work that way. This is what I mean by trading edge based on entry.
The same reason for the success of this model is also the reason why it was crushed so bad in 2008 and 2009. Well known market force PPT knows very well what most market participants do and during that 2 years, they choose to intervene the markets at times where they can get the impact maximized. Hence, massive short squeezes were coordinated on trading days that had every technical and fundamental reasons to go lower.
End Notes
This raw signal was in use by at least 2 large funds I know of, both of which have retired the signal since 2009.
And to those who tried to guard this signal as a secret – bite me.
- end of part 6 -
If you think silver margin hikes was bad, see this.
Posted by: | CommentsIrish bond margin requirement is now 65%, increased from 55%.
Notice is given 1 day in advance only.
http://www.lchclearnet.com/risk_management/ltd/margin_rate_circulars/repoclear/2011-05-25.asp
Saw this from zerohedge here.
Defensive Money Management Explained: The Death Trap Of Averaging Losers
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Written by Lawrence Chan. All rights reserved.
Note: Feel free to email me with your feedback lawrence@daytradingbias.com
Averaging into a Losing Position
One of the most cursed bad trading habits that terminates many beginner trading accounts is averaging into a losing position (a.k.a. average down). To many traders who never really average into a losing trade, it is hard to explain why it is so addictive and sexy. For many traders who have lost a lot of money using average down, every time they are cornered by the market and lost their shirts because of averaging into a losing position, they would promise themselves not to repeat this mistake ever again, yet they keep repeating this same mistake all over again sooner or later.
Let’s take a look at how it all started for many traders to get addicted to averaging down. Surprisingly, many of these traders were profitable at least for a period of time.
One Miracle Turnaround Day
A trader who has a consistent trading setup of { 60/40, $150/$100, 1000 } is a decent producer of profits. But, one day, a bad trade hit the trader hard with a loss way bigger than $100, say $200. Many things can cause the bad trade to happen – not enough time to place the stop loss order, internet outage taking out your client side stop loss order, brokerage side failure that cancelled your stop loss order, or, you like to use mental stop and you could not pull the trigger to cut your loss at the predetermined level ($100 in this case). At this point in time, the trader sees another potential setup again. Isn’t it stupid to cut the position now as the setup is happening at the moment? Remember that the trader is not thinking straight at this point in time. A haste decision would drive this trader to add to the position.
And now, the magical moment, the market reverse its course and started to move in favour of the trader. The trader flat out the total position at the normal profit taking target for the second entry. $100 is made. It came from a loss of $50 from the first set of contracts traded and a profit of $150 from the second set of contracts traded.
Logical Handling of the Accident (or Mistake)
The trader is likely to ask the following questions,
- Isn’t that a great discover?
- Isn’t averaging down the greatest trading secret of all time?
Well, the answer is no to both questions, for this particular trader.
If this person is thinking logically, then the following calculations should be carried out.
1. Expected profit = (60% x $150 – 40% x $100) x 1000 = $50,000 a year
2. Cost of stupid mistakes, disaster events, and failure to cut losses on time
= % of losing trades x expected # of losing trades x absolute disaster stop amount
For 10% of losing trades having these problems, and that the trader is willing to accept the loss of $250 as the absolute stop point in his trading plan, then the extra losses (or cost of the trading business)
= 10% x (40% x 1000) x $250 = 40 trades x $250 = $10,000 a year
3. Net expected profit taking disaster events into account = $50,000 – $10,000 = $40,000 a year
Thus a logical person should add the concept of disaster scenario into their trade plans and having a predetermined resolution to handle such situation since that was not considered in the first place. Well, most retail traders teach themselves how to trade, it is understandable that the concept of disaster handling was not there in the beginning.
It is never too late to add it to any trading strategies. Then the trader should be able to continue trading profitable without averaging down.
Emotions Triumph Common Sense Most of the Time
But humans are emotional. Most of the time, the trader who just recovered from a bad day in trading using average down cannot see the potential complexities and pitfalls of the concept. More likely, the trader is exhausted from the day and can hardly think at all. The emotional sense of beating the odds and coming out ahead for the day overwhelm the person’s ability to reason. Averaging down becomes the lifesaver to the trader – an emotional anchor that gives the trader the potential feelings of getting high. It works very much like the addictive substances.
Thus the logical thinking scenario is not likely going to happen for an average retail trader. Instead, after a few episodes of such events, normal human will think that they must incorporate the great discovery of averaging down into their trading methods. That is the moment this trader throwing away the consistent profitable trading method he or she might have already discovered and steps into the world of averaging – a world not that friendly for those who are not prepared.
For those traders who do not have a consistent trading setup to start with, or, do not have an account that allows for averaging down multiple times, they will be cleaned out easily anyway with or without the use of the method. So the impact of averaging down for these individuals are significant but we will focus on those who originally having a reasonable performance.
Rosy Results Masking Out the Risk Involved
For those traders who do have a consistent trading setup to start with and that the account allows for averaging down many times, they are the ones who are most likely addicted to average down for life.
Not all trading setups allow for easy backtesting, thus many traders who have decided to incorporate average down into their trading styles may not be able to backtest the idea properly and see the potential impact in doing so. Not all traders are programming savvy either, that leaves them the only choice of manual backtesting to see the effect of average down which is something not many people are willing to do because manual backtesting is a very tedious task.
Here is a summary of the effects of average down on a reasonably performing trading setup,
1. The immediate impact of average down multiple times on a reasonably profitable trading setup is that the winning percentage will increase significantly. We are not talking about 60% going up to 75%. I am talking about 60% going up to 90%.
2. The amount of money made would increase several folds because there is almost no down day due to the high percentage of winning trades. Misunderstanding of such high winning percentage as skill improvements will burn deeply into the person’s mind that average down is the right way.
Luck is not a Dependable Factor
The problem, however, is that the trader is slipping unconsciously into overleveraging. In the second chapter, I explained that to increase the survival rate one must increase the capital behind each unit that you risk trading. For example, if the margin requirement is $5,000, and that the trader has $25,000 in the trading account, then as long as this trader is trading the profitable trading setup we are talking about in this chapter, it is very likely healthy profit is made after a year of trading.
However, if the trader chooses to average down on losing trades, then the margin requirement increases to a total of $10,000 when average down just once and that the real amount of money behind each unit traded is $25,000 / 2 = $12,500.
When the trader adds onto the position one more time, the total margin requirement increases to $15,000 and the real amount of money behind each unit traded would be $25,000 / 3 = aprox. $8,333. That leaves only $3,333 between the trader and a margin call.
As averaging down just once is not enough, the trader may choose to average down a few more times. Of course, a wild run of profit is likely because the original trading setup has its merits. But, the trader is stretching thin the amount of money put behind each unit added to the losing positions.
Remember that there is no sure thing in trading? As more units are added to a losing position, the trader is effectively betting all the hard earned winning over many trades behind a single trade. Probability will eventually catch up and all profits made from the wild runs will vanish in a trade or two.
Alternative Strategy Taking Advantage of Probability
The main reason for an average retail trader to fail at using average down is that they are averaging into the losing position without a plan. Proper engagement rules are not defined. For example, when is the right time to average down? How many times of averaging down is allowed based on the account size and capital requirements?
Two logical views in dealing with the questions above,
- The use of average down is the acceptance of your initial entry based on your trading setup is not necessary the best price level to enter the trade and that you know why that is the case. If you used to trade with a view of precise entries , then average down techniques are not compatible with your overall trading style.
- You are getting ready to participate in market making activities in the financial markets. Thus if you choose to engage in average down, you must be properly capitalized. For most retail traders, that is not possible.
The reason for averaging down into a losing position is that you are expecting the reversal is coming soon, but you have no control over when your original trading setup is going to show up, and you have no control over how much the market is going to go against you before your trading setup will show up. We are talking about two unknown factors, or, in statistical terms, two new (almost) independent variables, meaning that you know absolutely nothing about them. If you have no idea what I just talked about in this paragraph, then it is not a good idea for you to incorporate what I am going to show you in the next section.
If you can accept the fact that you have to treat the occasional bigger losses from uncontrollable disasters as part of your cost in running your trading business, you have the right mindset to review the original trading setup again. Your willingness to let probability to work in your favour even though you have to accept the extra losses as part of the cost in running your trading business means that you should be able to utilize the following concept properly.
Lesson 4: Consistencies in Winning Percentage Combined with High Winner to Loser Ratio is Gold
You know that the winning percentage is 60% and to be conservative (as repeatedly pointed out in previous chapters) we should think of the winning percentage as 50% only. Then you know the following is true,
| # of Consecutive Losers | Probability based on 50/50 | Probability based on 60/40 |
| 1 | 50.00% | 40.00% |
| 2 | 25.00% | 16.00% |
| 3 | 12.50% | 6.40% |
| 4 | 6.25% | 2.56% |
The odds of 3 consecutive losers is 12.5% if your trading setup is performing at 50/50. If it is performing at 60/40 it will be lower.
If you increase your risk size after 2 consecutive losing trades, you would be able to profit from the statistical bias. Using our example trading setup, if you double the risk size,
the expected return = (60% x $150 – 40% x 100) x 2 = $100
Do not underestimate this minor change of bet sizing rule. Let’s take a look at the expected net performance for the year
Expected extra gain if trading setup performs at 60% winning
= $50 x 16% X 1000 = $8,000
Expected extra gain if trading setup performs at 50% winning
= $25 x 25% X 1000 = $6,250
In short, if your trading model is performing at 50/50 or better, as long as your winner to loser amount gives you an edge by itself, you can choose to increase your risk (not double down – that is completely different) to improve your trading performance. For example, if you are trading conservatively using the 1% risk over 20% risk capital method mentioned in Chapter 3, then raising that to 2% will still be sensible risk taking.
When your winner to loser amount is 1 to 1, say, $100 to $100, or worse like $100 to $250, however, then do not think of double down. Your trading style does not give you the right combinations to take advantage of this hybrid average down strategy at all, even if your strategy has a very high winning % overall. The reason is that your potential return from using average down strategy will not be able to compensate for the potential losses you would have racked up against you already.
- end of part 5 -
Defensive Money Management Explained: How To Ruin Your Winning Strategy
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Written by Lawrence Chan. All rights reserved.
Note: Feel free to email me with your feedback lawrence@daytradingbias.com
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.
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 -
What’s Next For Apple Inc.
Posted by: Lawrence Chan | Comments (0)My last piece on Apple was posted several months ago here.
Several projections materialized after it was published:
1. For a potential false breakout, Apple will be capped by approx. 5% above the May high. Apple was capped there for a month before the news driven extra rush to $700.
2. Green support trend line break on the chart will indicate the bull party is over. Apple broken that trend line at $625 and dropped $100 since.
Here is the updated chart of Apple.
What should we expect next?
a. If Apple can move above the 570-580 area, it will move back up to 600-610 zone. i.e. the midpoint of the range marked by the purple horizontal lines.
b. On weekly and higher timeframes, Apple has a classic blow off top in place where it dropped 20% straight down. That implies the price of Apple will not be able to retest its all time high for a long time. How long? The pattern seldom results in any retest of the all time high within 5 years.
c. A long term decline is likely on its way. Best case scenario for bulls is a stair step drop with Apple bounces back up to $600 and above, then topping below $650, and continue to decline slowly and erratically.
d. Short term support for the price was the $525 to $530 area (lowest blue line). A retest of the zone from above that failed to hold the price on weekly closing basis will indicate further decline with target below $450.