From the April 01, 2012 issue of Futures Magazine • Subscribe!

How much trading capital is enough?

Trading deviations

One tenet of money management is to fund your account properly so you can sustain a series of losing trades. Because this discussion is not about trade selection, per se, we have to make some assumptions regarding the trading system we are using. Ours are simple. We’re going to have a goal of a two-to-one profit-to-loss ratio and expect a lot of losing trades.

One problem is knowing the duration of a series of losing trades so that we can know the maximum drawdown. (Drawdown is the dollar amount our account equity falls from its peak before it recovers to set a new high.) If we can’t sustain the losses from a string of losers, then we never will get to the point where we can capitalize on the string of winners when they occur.

A strategy that works uses a set framework for defining trades with realistic stop loss levels and profit objectives. That is one goal of a profitable trade strategy: Defining a realistic profit objective and a realistic stop loss for each trade. “Setting stops” (below) shows a pictorial representation of the strategy. 

image

Shown is the daily closing value for crude oil. Plotted along with price is the 10-day moving average. The next lines above and below the moving average identify one standard deviation from the average. (Standard deviations are range measures defined by statistics that, assuming a normal distribution of price variations, contain a certain percentage of data points over time.) The next two lines out represent two standard deviations above and below the average. 

The chart and the data that compose the chart give the trader a framework to seek out trade opportunities. Statistics tell us that 95% of the time the close will be contained within the outer boundaries of this chart, particularly over the long-term. However, we see that the market consistently moves up and down between these outer limits.

Be careful, however. Don’t get the idea that this chart is magic and provides a foolproof way to forecast price. It does not do that at all. What it does do is create a framework that makes sense for structuring profit objectives of at least two standard deviations and loss levels at no more than one standard deviation. For example, it would allow you to enter the market at any of the pivot points and instantly calculate a realistic profit target and stop loss level.

Consider the continuity in price action. For instance, on July 6, the market traded at minus-two standard deviations and continued to move higher through July 21 to plus-one standard deviation. It then moved down to the moving average on day 20, stopping out the trade with a two-standard-deviation profit. This is fairly typical. Once the market begins to move in one direction, it has a tendency to continue in that direction.

With this strategy and our assumptions in place, we can determine the impact of a string of losses properly.

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