Table of contents
Applying money management techniques is one of the final tasks of building a trading system before you set it free for live trading.
What is money management?
Many people see money management as position sizing and risk management but I treat those separately. Money management is the process of making your system as profitable as it can be without unduly affecting your exposure to risk.
Before we start I must provide a warning about money management as it can be abused. Then we will get into some of the techniques.
As with all optimisation techniques it is possible to create an amazing money management strategy that sends your profitability sky high. This is probably done at the expense of risk management and a small variation would inevitably end your account.
Thankfully we have ways of measuring the risk you are exposed to. This ensures you keep the risk within levels you are comfortable with.
At this point you will have documented your trading journal. As part of the record keeping section you will have noticed a few terms that may not be familiar.
- Maximum Adverse Excursion (MAE)
- This is the maximum number of points that the price goes against you whilst in a trade. This would be the lowest low during a long trade, or the highest high during a short trade.
- Maximum Drawdown
- This is the maximum observed loss from the open to the MAE of a trade. This is specified in your trading currency.
- Maximum Favourable Excursion (MFE)
- This is the maximum number of points that the price goes in your favour whilst in a trade. This would be the highest high during a long trade, or the lowest low during a short trade.
- Maximum Runup
- This is the maximum observed profit from the open to the MFE of a trade. This is specified in your trading currency.
Let show an example to illustrate these 4 terms. I purchase 100 shares of XYZ stock at a price of £10. During the trade the lowest quoted price was £9.50 and the highest quoted price was £12.25. The trade was closed at £12.
The MAE is calculated as Open – Low. This is (10 – 9.50) = 0.25
The maximum drawdown is calculated as MAE * Position Size. This is (£0.25 * 100) = £25
The MFE is calculated as High – Open. This is (12.25 – 10) = 2.25
The maximum runup is calculated as MFE * Position Size. This is (£2.25 * 100) = £225
You should have these 4 values calculated for every trade you make as the data will be vital to enhance your profitability using money management.
We will discuss 4 money management techniques to improve your trading system. They can all be used in parallel although we would recommend trying them one at a time.
The examples below all use the same data set for their calculations and they include both long and short trades. When you come to implement your own money management strategy you should split your data into long and short trades. Applying each technique should result in two values, one for long trades and one for short trades. This is done because your system will behave differently in bullish and bearish markets and your money management should reflect this.
Advanced Stop Losses
Whilst discussing position sizing strategies we mentioned that we would revisit stop losses during money management. Now that we have lots of data from our trading results we can find out if any improvements to our stop loss positioning can be made.
The following table shows the realised profit or loss data from 13 trades:
|Loss making trades||Profit making trades||Max DD||Max RU|
Total trades 13; Winning trades 7; Total profits £1145; Total losses £415; Net profit £730
The following chart plots all loss making trades as red dots and all profitable trades as blue dots. What this chart shows us is the MAE (maximum drawdown) of every trade whilst making a distinction between profit and loss.
We can now visualise where our profits are made. From the chart we can see that all of our profitable trades occur with a drawdown of £100 or less. It therefore seems logical that if we placed our stop loss at £115 we would keep the profitable trades but reduce the losses on the remaining trades.
If we apply this new stop loss to our original 13 trades we get the following outcome.
Total trades 13; Winning trades 7; Total profits £1155; Total losses £395; Net profit £760
We have increased our net profit by £30. Additionally, our stop loss would have been triggered sooner meaning we would be in the market for a shorter duration.
The next money management technique is called runup resistance and uses the MFE data. It uses the same data set as the table within the Advanced Stop losses section above.
The following chart plots all loss making trades as red dots and all profitable trades as blue dots. What this chart shows us is the MFE (maximum runup) of every trade whilst making a distinction between profit and loss.
We can now visualise where our profits are made but this time we are looking at favourable outcomes. From the chart we can see that all of our highly profitable trades occur after we reach a runup of £225. We could therefore use this as a trigger to increase our position size. Using this data we will double our position when the runup reaches £225.
If we apply this technique to our original 13 trades we get the following outcome.
Total trades 15; Winning trades 9; Total profits £1255; Total losses £415; Net profit £840
We have increased our net profit by £110. This was achieved by adding to 2 of the original positions, of which both returned a profit.
The next money management technique is called drawdown support. This technique aims to add to select positions when a defined level of drawdown has been reached.
The following chart plots each trade as a separate bar. Loss making trades are shown as red and yellow bars. Profitable trades are shown as blue and yellow bars. What this chart shows us is the level of drawdown that occurs for all trades whilst making a distinction between profit and loss.
We want to find a level of drawdown at which we can add to our position that does not unduly increase our exposure to risk. We should also consider the Advanced Stop Loss level which we set at £125. The majority of our profitable trades experienced a drawdown of atleast £50 before recovering to produce a profit. We shall therefore double our postion when the drawdown reaches £50.
If we apply this technique to our original 13 trades we get the following outcome.
Total trades 23; Winning trades 12; Total profits £2260; Total losses £575; Net profit £1685
We have increased our net profit by £955. This was achieved by adding to 9 of the original positions, of which 5 returned a profit.
The winning series technique aims to increase your profitability when your system exhibits a successful streak. Whether you can adopt this technique will depend on your style of trading and the data you have collected.
The data required for this technique is quite simple. Whenever your system has a winning streak, count how many trades were in that streak and find the average gain. Then make a note of the loss that occurred in the next trade. Perform this analysis for your complete data set and you should end up with a table that reads as follows:
We can see from this example data set that the system has multiple winning streaks. We could therefore decide to increase our initial position size when we have had at least 1 winning trade. As soon as we experience a loss the initial position size reverts to our standard position sizing strategy.
What the data set does not show is how many losing trades there are. Only when you add in that data can you determine whether this money management technique is appropriate for your trading strategy. You could produce a similar table as above but for losing streaks as that may well uncover facts about your trades that you can use to improve your trading strategy.
Is money management worth the effort?
The above data seems to imply it is. To be sure this is correct we shall calculate the affect of adding an advanced stop loss, with runup resistance and drawdown support simultaneously.
If we apply these three techniques to our original 13 trades we get the following outcome.
- Total trades 25; Winning trades 14;
- Total profits £2360; Total losses £555; Net profit £1805
- The maximum drawdown has fallen from £200 to just £115 thanks to our advanced stop loss.
- The winning percentage has increased from 53.8% to 56%
- The average profit per trade has increased from £57 to £72
- The net profit has increased 143%