Money Management Part 3.
In the huge currency markets there are only a handful of high stake players. Ironically, although these traders sometimes take positions measured in billions of dollars, yes billions, they are virtually unknown to most of the financial community, let alone the public Bill Lipschutz, is one of these traders. This is Jack Schwager’s introduction of Bill Lipschutz, in his book The New Market Wizards.
In his early years of trading Bill Lipschutz managed to wipe out an account in two days that had taken him four years to build. When asked how the sudden demise of his personal account changed him as a trader the following discussion ensued.
Bill: I probably became more risk control oriented. I was never particularly risk averse.
Jack: what you mean by risk control?
Bill: There are a lot of elements to risk control: Always know exactly where you stand. Don’t concentrate too much of your money on one trade or group of highly correlated trades. Always understand the risk reward of the trade as it now stands not as it existed when you put the position on. Some people say, “I was only playing with the markets money” that is the most ridiculous thing I ever heard. I am not saying that all these concepts crystallised in one day but I think that the experience with my own account set me off on the track of considering these aspects seriously.
Jack: On the subject of risk control, how do you handle a losing streak?
Bill: When you are in a losing streak your ability to properly assimilate and analyse information starts to become distorted because of the impairment of the confidence factor, which is a by-product of a losing streak. You have to work very hard to restore that confidence and cutting back trading size helps to achieve that goal.
Randy McKay a veteran trader of more than 20 years has consistently earned much more than $1 million a year for 18 of those 20 years.
Here is what Randy had to say when asked about what advice would have with other traders:
The most important advice is to never let a loser get out of hand. You want to be sure that you can be wrong 20 or 30 times in a row and still have money in your account. When I trade, I’ll risk perhaps 5 to 10% of the money in my account. If I lose on that trade, no matter how strongly I feel, on my next trade I’ll risk no more than 4% of my account. If I lose a game, I’ll drop the trading size down to about 2%. I’ll keep on reducing my trading size as long as I am losing. I’ve gone from trading as many as 3000 contracts per trade to as few as 10 when I was cold, and then back again. He felt that this dramatic variation is trading size was a key element to his long-term success. His reasoning was as follows: when you are trading well, you have a better mental attitude. When you are trading poorly, you start wishing and hoping. Instead of getting into trades you think will work, you end up getting into trades that you hope will work.
He wanted to wait until he got back into the proper frame of mind, but the only way he felt he could do that was by winning and he didn’t want to take large positions until he had regained his confidence.
Victor Sperandeo: another fine example of long-term success. Victor managed to string together 18 consecutive winning years before registering his first loss in 1990. Over this period his average annual gain was 72% with results ranging from a single loss of 35% in 1995 years of triple digit gains.
In discussing risk, Victor stated that these losses are always predetermined so he could measure is risk you would know exactly where he would get out for he ever entered the trade. When asked losses had much of an emotional impact on him, he replied. None taking a loss never affects me, but they don’t take big losses. Jack asked him if he had ever deviated from his risk control guidelines. He recalled one instance when he did so, which ended up costing him over $1 million.
I’m going to tell you a little about that trade as aside from the numbers it sounds a familiar experience to most traders I have spoken to. I quote “when the market went down for four days in a row, I knew I was wrong. I wanted to be out. The market just kept on falling. On the sixth straight day down, I got out. If I had sold after the fourth down day, my loss would have been only half as large.
Jack: I thought you had a rule about getting out?
I did. My rule would have taken me out day.
Jack: So you violated your rule?
Yes, the reason that I didn’t get out was the decline seemed extremely overdone. My plan was still to liquidate, but to wait for the first day the market rally.
Victor stated that to be a successful trader, you have to be able to admit mistakes. Unlike nearly every other profession, the person who can easily admit to being wrong is the one who walks away a winner.
In trading, you can’t hide your failures. Your equity provides a daily reflection of your performance. The trader who tries to blame his losses on external events will never learn from his mistakes. For a trader, rationalisation is a guaranteed road to ultimate failure.
In the first part of the series on money management, we looked at drawdown and why it’s so important to keep it within reason. We showed that the percentage to recover from a drawdown increased at a geometric rate as the drawdown increases. For instance, a 60% loss of capital requires a 150% return on the remaining capital just to get back to breakeven; a 70% loss requires a return of 233%, and so forth.
In the second part of the series we looked at 17 general guidelines that should help to protect capital and ensure profits as a trader. These included risk control techniques such as use of stops, keeping drawdowns within reason, portfolio correlation, judging risk-to-reward, volatility of markets, understanding the instrument being traded (i.e., derivatives), percent per trade risk and overall portfolio risk.
We looked at techniques to help ensure long-term survival and capturing profits such as being adequately capitalized, 2-for-1 money management and taking windfall profits. And finally, we touched upon the psychological impact of losses.
In Parts 3 and 4 of the series we looked at interviews with professional traders and money managers. Although their approaches to the markets varied greatly, they all had the utmost respect for risk and clear and practical methods to control it.