Paper Trading and Money Management

I must tell you all, this is an extremely long post, even for me. : If you have the time give it a read and let me know what you think (good or bad). Only by discussing different concepts will we learn.

PAPER TRADING:
“So, when you paper trade, make it real, make it count, make it like the REAL thing. Don’t cheat on your entry or stops. Start with a margin account that would represent what you could open an actual trading account with. Practice giving your order to your broker.” Common Sense Commodities by David Duty

MONEY MANAGEMENT:
“Let me start out by saying that if you don’t have a good plan for managing your money, you will go broke. Read that again!” Common Sense Commodities by David Duty

“I know that many people just love to trade for the stake of trading. They like the excitement the markets offer. They like the upside potential that’s always there. They seem to have to trade something, just anything, in order to feel like they are ‘in’ the markets. This, my friend, is the formula for failure.” Common Sense Commodities by David Duty.

Take two traders. Give them the same starting capital, the same trading platform, the same market, and the same trading system with precise rules for entry and exit. Come back a month later and what will you find? One trader will be up 20%. The other will be down 40%. It’s fascinating, isn’t it, how two people can have the same opportunities in life, and yet get very different results. In the following essay I hope to explore why this happens.

Trading is a game of probabilities. Imagine we’re flipping a coin. Heads I win one dollar – tails you win one dollar. Simple. Heads and tails will each come up half the time, and we’ll both neither win nor lose. However, unknown to me, you have a loaded coin. For every 100 throws, heads comes up 49 times, and tails comes up 51 times. You now have a license to print money. Let’s call it the ‘Tails Trading System’. All you have to do is sit back and bet on tails forever. Eventually, you’d win all my money (and anyone else’s who took you on). All any trading system gives you is an ‘edge’. A favorable bias. Something that is more likely to happen than not. Whatever trading system you use…

For example… pattern breakouts, trend-following, Fibonacci, moving average, channel following, oscillator signals, Bollinger bands, swing trading, opening gaps… you are relying on a positive bias. Essentially, the trading system is saying ‘when x happens… y usually follows’.

Sometimes it doesn’t. Most of the time it does. And all your trading system does is help you identify high probability trades, enter then correctly, and protect yourself while allowing your profits to grow.

Now some trading systems are better than others. But don’t get caught up on the search for the perfect system… You know, the trader’s Nirvana… the elusive ‘Holy Grail’… the system that delivers profits on demand and never, ever gets it wrong. Find a trading system that you like. One you feel comfortable with. One you understand. Then stick with it. Be consistent. A cool, disciplined, trader will take an average system and make money with it. A nervous, arbitrary trader will take a brilliant system and wreck it.

All traders have ‘good days and bad days’. Some days you’ll make small profits. Other days you’ll make small losses. And once or twice a month, on average, you’ll make big profits. That’s how you make money as a trader. It’s not 9 till 5.

Problem is, you never know when the big trades are due to arrive. Like our ‘Tails Trading System’ above, the one time you don’t take the trade is exactly the time the market takes off and never looks back.

You must see the big picture. Realize that the current trade is only one of many. On that basis, the current trade hardly matters. It’s like a piece of plankton in a very large ocean. Trading is all about managing risk and then surrendering yourself to the oldest law in the Universe. The ancient law of probability.

This is why you will see me use many different option strategies with the main first objective of making the position into a ‘Free Trade’ ASAP. The second objective is to have, as many ‘Free Trades’ is many different markets as possible. This way you are increasing the probability of a large winning position and controlling your risk to zero. Remember, a ‘Free Trade’ (option trading or Future trading) should include commissions and fees to be truly free. How would you like to have 10 possible free trades in 10 different markets? What this last question is asking you is, how would you like to have 10 possible profitable trades while at the same time holding the risk to your capital account to zero.

“The best investment you make is the investment in yourself” by David Jenyns.

Money management is simply a set of rules and guidelines that keep your risk at a level at which you’re comfortable with. These rules and guidelines need to be determined before you even enter a trade. The make-up of a ‘Trader’s Ingredients’ are 10% system, 60% Psychology and 30% Money Management

“Study and research into the state-of-the-art in money management will pay enormous dividends.” By Richard Dennis

DEFINE YOUR TRADING FLOAT:

First define your trading float, by trading float I mean the amount of capital that you have to trade with. It’s important to understand that you realize that when you first begin trading you’re going to have to pay your share of tuition. There is a learning curve involved in learning the markets. Don’t try and skip this, just make sure you’re prepared for it in advance. The solution is to simply treat your trading as a business. Any business including trading requires start-up capital. Don’t fail because you are undercapitalized.

“Rule number one of investing is never lose money. Rule number two is never forget rule number 1.” By Warren Buffet

SETTING A MAXIMUM LOSS:

The maximum loss is quite simply the maximum amount of capital that you are happy to lose on any one trade. By defining this upfront before we even open a trading position is to make sure that you can stick to one of the cardinal rules of trading and that is to keep our losses small. We want to make sure that we set what our maximum loss is and make sure that’s a small percentage of our trading float so it won’t have a detrimental affect when we have a string of losses. If 95% of traders end up losing money, the primary reason for this is because they haven’t applied good money management.

“Never risk more than 1% of your total equity in any one trade. By risking 1% am indifferent to any individual trade. Keeping your risk small and constant is absolutely critical.” By Larry Hite

SETTING STOP LOSSES:

The stop loss is simply the predefined point at which we exit a trade. This exit point is determined before we even enter the trade. Effectively, it’s like drawing a line in the sand, if prices cross the line we exit. Psychologically humans are hard wired into believing that they must be right, since there is always two sides to every trade we all can’t be right, the stop loss is a easy way to control this poor but strong trading emotion.

“You’re protective stop is like a red light. You can go through it, but doing do is not very wise!” by Richard Harding

CALCULATING TRADE SIZE:

When we talk about position sizing, we’re asking the question, ‘How much are we going to put into any one trade?’ Use a percentage strategy that decreases the size of your losses during losing streaks. When experiencing a winning streak, your position sizes will actually grow. By simply changing the amount of capital we’re wishing to risk, we’re going to change the characteristics to our risk to reward ratio. Many people believe though, they’re doing an adequate job of position sizing by simply having a stop loss in place. Sure, this will tell us when to get out and by setting our maximum loss, we’ll also know how much capital we’re risking, however, it doesn’t answer the question of how much or how many contracts we can trade. Since, we have already calculated our maximum loss and our stop loss, we can simply take these values, plug them into a formula and calculate how many contracts we trade without ever exceeding our maximum loss.

“If you have an approach that makes money, then money management can make the difference between success and failure… … I try to be conservative in my risk management. I want to make sure I’ll be around to play tomorrow. Risk control is essential.” By Monroe Trout

TRAILING STOP LOSSES:

Traditionally what an inexperienced trader will do is once they see a little bit of a profit in their trading account, they want to crystallize that profit straight away. The psychological reason for this is because they don’t like to lose, and they falsely believe that those profits are their profits, and they don’t want to give them back to the market. The reason this strategy is doomed to failure is the fact that you’re not adhering to one of the cardinal rules of trading and that is to let your profits run. The astute person may have realized that we’re starting to implement rules that adhere to these cardinal rules of trading. By setting our initial stop loss, we’re cutting our losses short, and now we need to introduce a rule that allows us to let our profits run. By simply setting these rules, we’re going to be able to control two important variables – whether or not we make a profit, and how much profit we’re actually going to make.

“You’ve got to know when to hold ‘em; know when to fold’em; know when to walk away; and know when to run.” By Kenny Rogers

TARGETS:

It would be unreasonable to assume prices will keep running forever in your trade direction. Though trailing stops let your profits run, target (stops) placed at strong resistance/support areas will let you take profits before prices bounce off of the resistance/support area and possible hit your trailing stop. This will help you maximize your profit. You could always re-enter the market either off of the bounce or the break of the resistance/support area.

“Targets are profit-taking opportunities. When you make a trade, you must know what your profit target is before you place your order (to enter). If you don’t know what it is, how can you figure your reward/risk ratio?” Common Sense Commodities by David Duty

THE WORST TRADING STRATEGY:

There is one trading technique that I’d like to warn you about. It’s quite possibly the worst trading strategy I’ve ever seen. You may be wondering why would I want to learn about the worst trading strategy around. Here’s why – because once you know the worst possible strategy, one that is destined to maximize your losses over the long run, then you can reverse those ideas to craft a strategy which does the exact opposite. That is to create a strategy that’s designed to produce some tremendous long-term gains.

The worse strategy I’m referring to is known as averaging down. I hear about this strategy mostly when talking about option trading but there have been a few times where this strategy was talked about involving future contracts. This is the process of buying more contracts that you previously acquired. Now, the price has dropped and you buy more. The motivation behind this type of strategy is people believe that they can reduce their initial entry price by continuing to buy more as the price fall away. Only bad investors average down buying contracts of a sinking market to decrease their average price per contract. This strategy is like throwing good money after bad. It’s hardly ever effective. In addition, you’ll magnify your losses if the price keeps going down. The hope is that prices will turn and when they do you will have many contracts at low average entry. (Just reverse the general idea if you are selling a market).

“I’m more concerned about controlling the downside. Learn to take the losses. The most important thing about making money is not to let your losses get out of hand.” By Marty Schwartz

PAPER TRADING - BACK TESTING:

Back testing your methodology involves applying the rules and conditions of a trading system to historical data. This is not to be confused with paper trading real time, which I’ll talk about later. To back test it’s only possible if you’re trading a system that is entirely mechanical and does not require any discretion to trade. How can you know whether or not your system is completely mechanical? I’ll ask you this question. Could you write down your trading plan, your set of rules and guidelines that you follow, and can you hand that over to someone and they could trade the same system and receive the same results if they follow the system? If the answer is yes, you have a mechanical system. If the answer is no, I would recommend that you look at implementing a completely mechanical system. Back testing does not give you 100% accuracy as to the profitability of the system once you start trading it. The reason for this is price movements are never going to be exactly the same. That said, price is driven by supply and demand. Supply and demand is a direct result of decisions made by humans. For this reason, you can assume that price movements in the history although not exactly the same as the past may mimic and have similar attributes over time.

With this in mind, back testing a system can give you confidence in your system. Perhaps one of the hardest parts in trading any system is to have the confidence to stick with your system (plan). In fact, a mechanical system almost forces you to make decisions that are in direct conflict with what your gut feeling might tell you what to do. Remember, our gut feeling tells us we should hold on to losing trades to wait until they get to break even, and our gut feeling would tell us to exit as soon as we’re a little in profit. Back testing is a good way to see how mechanical our system is.

“If you haven’t back tested your system… You might as well trade with your eyes closed.” By Unknown

PAPER TRADING – REAL TIME:

Why paper trading real time? First, let’s compare real time to historical (back testing) paper trading. With historical paper trading we can move price (with Tn’T software) at what ever time interval we wish, by time interval I mean, we can make the price per day move faster or slower. In a matter of 30 minutes we could move prices through the entire life of a contract. The question this brings to mind, are we really paper (practicing) trading by testing our method for 30 minutes of time that would normally take a year?

We are testing our mechanical system but are we testing our psychological restraints by historical testing but not real time testing? There is a big difference between waiting 1 second to see if you are right and waiting 16 to 18 hours. There is a big difference between second-guessing your decisions for 10 minutes and thinking about it overnight.

This is why I recommend, after you have found your self a mechanical system which involve money management rules and guidelines that you can profit with, that you paper trade (with a broker) real time to test your psychological restraints and your ability to follow you mechanical system. Start with a realistic account size and once you have doubled it paper-trading real time without a brokers help then try it with brokers help. Ask him to include slippage and types of orders. Ask him/her what difference would it have made if I used different orders or entry/exit techniques. If nothing else by paper trading real time with your broker you both develop an understanding of what is required of each of you.

“To be a money master, you must first be a self-master.” By J.P. Morgan

I know this is a long post and by now most people have stopped reading to go on with their busy lives, but for the few who have taken the time to read this rather large post I thank you.

I am sure to hit a few sore spots with a couple of my comments above. My only wish is to have people comment on this forum about what they agree or disagree with as far as this post goes. If you disagree, yet say nothing, how do we learn if not by questioning?

Then again maybe it’s Just Me.

Justme Another C$C Student

 

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