The Only Money Management System that Works in Trading

Boris Schlossberg

By now, everyone should be familiar with the Pareto distribution. Named after an Italian economist from the late 19th century it is colloquially known as the “80-20 rule”. In many disciplines in life, 80% of results come from 20% of factors.

Pareto first noticed the phenomenon with respect to land ownership in Italy where 80% of the land was owned by just 20% of the population. The distribution is not always exact but it is a good general approximation for how things work in real life. The Pareto principle shows up in phenomena as diverse as geography (80% of the population lives in 20% of cities in the US) software (80% of all computer errors in Microsoft products was caused by 20% of bugs) to of course income distribution (where roughly 80% of all assets in the US are owned by 20% of the population).

The Pareto principle is part of the larger structure called power laws and love it or hate it is an inextricable part of life that we need to accept if we are to understand how the secret of success.

Nowhere is the Pareto principle more evident than in financial markets which are the very quintessence of power laws in action with most spoils going to the very few. In trading, the universal truth is that 80% of your profits will come from 20% of your trades, or conversely if you choose to trade like an insurance company 80% of your losses (more like 90% in real life) will come from just 10%-20% of your bets.

This is precisely what makes trading so challenging for most people. It is psychologically impossible to accept losing 8 out of 10 times only to make everything back on just 2 big bets. It’s especially so because after losing 3 or 4 times in a row most traders pass up on a setup -- which inevitably turns out to be the one trade that is the winner that pays for all the losers.

Essentially trading is the art of looking for lottery tickets -- just read the history of any of the great traders from Soros to Tudor Jones to even Jesse Livermore and that fact become obvious.

So how do you create a money management system to accommodate the Pareto principle and at the same time make it psychologically palatable? The only way I know how to achieve that goal is with a short exit/long exit structure or as K and I always call it T1/T2. The idea is to always trade with 2 units. The exit on the 1st unit should be slightly less than the stop and in an ideal world allow you to win 60% of those trades. Then you move the stop on the 2nd unit to breakeven and aim for at least two times risk and maybe even three times risk on the second part of the trade.

This week in my coaching webinar we ran test after test of our trading strategy against a variety of major currency pairs looking at the past 100 trades in each. Inevitably the T2 target was hit between 19%-25% of the time, proving the Pareto principle right.

But!

Although on the face of it such payout odds would seem to be a losing system (run 10 trades with 50 pip stops and 100 pip targets and only win 2 out of 10 times) the blended strategy actually proved to be very profitable.

The reason the T1/T2 strategy worked was that the short exit eliminated about 20% of additional losses. As Warren Buffett and Charlie Munger often say the key to their success is not picking winners, but avoiding as many losers are possible.

The T1/T2 structure offers two key benefits. First it skews the math in your favor making the overall results positive or far less negative because it minimizes the number of losses, but more importantly, it creates a much more human-friendly trading environment by increasing the total number of winning trades.

By the way one final note on our tests this week -- only two out of ten currencies we tested produced positive results that were responsible for the vast majority of the overall pip profit, proving that the Pareto principle operates on the portfolio level just as it does on the single trade level.

There is nothing we can do about power laws in nature, but to accept their presence. But we can survive and thrive in the market environment if we start using the T1/T2 money management system to conquer both Mother Nature and our own behavioral biases.

The single most important trading system is – YOU

Boris Schlossberg

Standard economic thinking would have you believe that the bigger the financial incentive the better you will perform. The idea is that if I pay you more money you will exert more effort and will do the task better.

That’s actually partly true. Uri Gneezy, an economist at University of California at San Diego, paid college students $300 instead of the usual $30 to type a sequence of keys on the computer. Accuracy rates went up from 40% to 80%. For mindless rote activity higher incentive produces better results.

However, that assumption fails miserably when the task at hand requires even a modicum of cognitive ability. The same experiment of paying students tenfold to add a series of numbers in matrices showed a massive decline in success rates from 65% to just 40%.

An even more striking example of this dynamic occurred in poor regions of India where Gneezy ran an experiment asking people to pack tools in the most efficient manner. Participants were paid 10 cents, 1 dollar and 10 dollars each (10 dollars represented a month’s worth of wages for that cohort) At $1 per task 25% of participants succeeded in the task. When the payoff went to $10 every single person who took test failed it. That’s a remarkable insight into human psychology and goes a long way towards explaining why when you decide to “size up” on the exact same setup that you’ve been trading for years you suddenly start to bleed money.

The greatest thing about trading, aside from the potential for profit, the intellectual challenge of finance and the emotional engagement of the game is that the markets are probably the purest, biggest psychological laboratory in the world. If you are honest with yourself and step back to examine it you would have to admit that trading has probably revealed more about your true personality than any other activity you’ve ever done. Good or bad, the markets lay you bare in front of the world in ways that few other things in life do.

I was thinking about that a lot this week, after listening to a wonderful System Trader podcast interview with Mandi Pour Rafsendjani who, instead of focusing on yet another mind-numbingly boring quant system talked about what it really takes to be a successful trader. It’s a wonderful episode and I encourage you to listen to it -- but there were a few key points that she made which I thought were amazingly perceptive.

First and foremost if you are anything like me you probably got into trading for the sense of autonomy. You hate being told what to do. You hate working under other people’s rules and you like the sense of freedom that trading brings you, even with all of its crazy risks. But if you are that type of rebellious person, yoa u probably also hate paperwork and bureaucratic processes and record keeping. After all -- you are trader, not a bookkeeper!

Yet Mandi makes a very interesting point that it is precisely the structure of record keeping that is the gateway to the freedom you seek. Because it is only through record keeping that you will be able to improve. Mandi, who has interviewed scores of traders, notes that winners focus on facts and figures while losers focus on feelings.

Still, the record keeping she has in mind is unlike any you’ve ever seen before. Mandi will be the first to tell you that if you don’t have a setup that you can write out on the back of a napkin, you have nothing. In short, you need a clean, clear set of rules that will guide your trading. But keeping score of the winners, the losers, the drawdown, the entry and exit permutations, the instrument selections and all other usual suspects of trading is just the beginning. In fact for us in FX, the act of record keeping can be 99% automated with journaling websites like www.myfxbook.com.

When Mandi talks about record keeping, she has something else in mind entirely. She believes that record keeping of your state of mind is just as important as journaling your trades. Here are just some ideas she shares. Do you have a magic number of trades after which you get sloppy? For example, she notes that after five winning trades she tends to give a lot of her profits back. So now she simply walks away from the screen and works LESS. What about treating same trades in a different way? For example, when a trade initially goes into profit and then into a loss, do you have a hard time taking the stop versus a case of when a trade goes negative right away? (Guilty!) What about fixating on reaching a key dollar figure on your account equity (like say $10,000) which forces you to leave trades open because they haven’t reached your “target”? (Guilty!) What about trading a style that does not fit your personality because everyone tells you that’s what you are supposed to do? (Guilty!)

For me, the two greatest recent realizations have been that I am a serial, not a parallel trader. I do best when I trade one position at a time. (Read my New York subway column from a few weeks back for more details on that) The second most important realization is that I always lose money if I trade without an execution algo. If I am tapping buttons on my MT4 iPhone app as I dart in and out of the subway -- that is always the start of a journey to trading hell. I will ignore my sizing parameters, I will ignore my stops and I will inevitably cover for a loss after needlessly battling the market for days. On the other hand, if I am entering from a preset template off my well worn MT4 EAs, my control is assured. I may win or I may lose, but either way, I will do it properly and will not damage my account unnecessarily.

Using Mandi’s approach of recording your own state of mind as well as your trades has been an eye-opening process. The irony of her approach is that while winners may indeed be preoccupied with facts and figures while losers are obsessed with feelings, the key facts and figures aren’t actually the standard trade blotter, but the emotions you go through as you establish your trade. Losers may focus on feeling, but winners focus on recording and studying those feelings on a continuous basis. What becomes very clear as you listen to the podcast, is that profitability in trading is much less a function of tweaking your system parameters and much more the case of minimizing your tendency to make psychological errors. Walking away from the interview you realize that the single most important trading system is -- YOU.

Let Plato Design The Perfect Trading System for You

Boris Schlossberg

Plato’s cave is one of the greatest philosophical fictions ever invented. The idea that we don’t truly see the real world but only the mere shadows of things, that our perception of reality is limited by our own flawed senses is such a powerful concept that it remains a topic of debate and discussion 2500 years later, just as Plato’s work, the Republic continues to be the foundation of the Western intellectual canon.

In writing about Plato, Robephiles notes that “Plato was distrustful of the senses when it came to the ability to perceive knowledge. Plato knew that our senses could be fooled and he placed an emphasis on our abilities to think and reason rather than the knowledge gained from the study of the physical world.

This leads us to another famous metaphysical idea, The Theory of the Forms. Plato was fascinated by the problems of universals. An example would be as if I told you I had a dog. If I told you this you might picture a poodle or you might picture a mastiff or a chow or a border collie. These are all dogs yet each one is so different in its particulars. What makes a dog have its essential ‘dogness’? “

In an age of data science, Monte Carlo simulations and million backtests per second, the empirical model -- so successful in the physical sciences -- now completely dominates our world of social science of which finance and trading are a part.

But what if I were to say to you that maybe we have it all wrong? What if I were to argue that the endless data mining we all do -- the search for the perfect indicator, the perfect Fib level, the perfect volatility envelope are all just a giant waste of time. Ironically enough, empiricism would prove me right. Almost every trading system ever invented fails miserably under real-life conditions despite often showing perfect statistical accuracy often to the 99% confidence level. The irony of trading is that we put all our faith in an empirical model that empirically fail us.

But what if we set aside all of our modern tools of computation and started thinking like a 2500-year-old philosopher? What if we applied Plato’s Theory of Forms to the very pedestrian idea of a trend? Granted, trend can come in many shapes and sizes. It could be jagged and rambling with massive choppiness within it. It could be steady and smooth with hardly a retrace in the move. Or it could be something in between.

However, the “trendiness” of trend just like the essential “dogness” of dog is marked by some general characteristics that make it identifiable. In case of trend the best “class” of trend is one marked by higher highs in an uptrend and lower lows in a downtrend.

Thinking about this “Platonic ideal of trend” has really helped me refine my latest trading system. It made me eliminate any element that is extraneous to the setup -- and because it forced me to create much stricter rules for entry, I make much fewer trades. On the face of it that may sound like a negative to a daytrader like me, but in reality, it made my trades much more accurate than before. And it gave me clarity of analysis that I’ve rarely had before.

In the modern world, so full of experimentation and empiricism, we are conditioned to stay away from deductive reasoning. But perhaps the truth is just the opposite. Perhaps instead of running endless backtests to torture the price data, we should just imagine the ideal version of our setup. Perhaps in trading what we need is a lot less data science and a lot more Platonic philosophy.

4 Simple Ways to Determine if Your Trading System is Truly Viable

Boris Schlossberg

One of the best trading resources that I recently discovered is Andrew Swanscott’s podcast called Better System Trader. Even if you are not interested in systematic research and just want to trade discretionarily, the trading insights from the interviews are worth a listen.

One episode I found very valuable is an interview with Art Collins who is long time systematic trader in US stock and bond futures. Art wrote a book, called Beating the Financial Futures Markets which I have yet to read, but his analysis of what makes for a viable trading system really impressed me so I thought this week I would share his ideas with you.

Before all else, Art makes a point that I’ve heard over and over again from many different traders. The single most important aspect of the system is that it be in sync with your personality. If you are like me and like constant action then trading 100 times per day on a 1-minute chart is perfectly fine, as long as you adjust the system to the reality you’ve chosen. If you are like Kathy and think that such an approach is utterly ridiculous and prefer to make 2-3 well-chosen trades per day using the four-hour chart -- that fine too. (I would rather get a root canal without anesthesia, but to each is own.)

That being said, Art has four key metrics to judge a system.

One.
Does it make sense? Do you understand the underlying drivers? If you do not understand what the system is doing you will abandon it at the first sign of trouble. Generally, as I’ve noted many times before there are only two types of trading systems -- continuity and mean reversion. Systems will naturally underperform in adverse market regimes, but If you have a favorable market environment (trending) and your continuity system is not performing you need to quickly assess what’s wrong and to do that you need to know how the trades work.

Two.
Don’t Optimize. Don’t Tweak. Don’t try to avoid the pain. Accept the drawdown because if you don’t it will only get worse. So if you are looking at a series of parameters make sure that if you chose a slightly different one the results will not be much different from all the other parameters. If they are that means your parameter is less than worthless because it only works on a particular set of data in the past.

Three.
At very minimum, the system must work on related markets. For Art that means that if the system is designed for S&P it must also work on Nasdaq and Russell. For us, in FX we need to make sure that the trade idea works on several related pairs, not just one. Earlier this week I had a system that looked very promising but when I analyzed the underlying data I realized that GBPUSD was responsible for 62% of the profit but it comprised just 16% of the trades. My new version was much better balanced with no pair accounting for more than 25% of the profit while comprising 16% of the portfolio. That’s the kind of distribution you want because that means you are capturing repeatable price behavior rather than one-off action.

Four.
And this is perhaps the most important and overlooked aspect of system analysis. Make sure that the bulk of your profits does not come from a very narrow time interval because then it’s a function of luck rather than skill. Since I day trade around the clock with fixed stops and losses, I avoid that problem by creating as much uniformity in my trades as possible. But if you trade on longer time frames with variable profits and losses you should study your results very carefully to make sure that they are not skewed by one or two lucky big trades.

Lastly, Art says that one of the best ways to analyze the robustness of a system is to divide the total profit by maximum drawdown -- something I’ve intuitively done for years and prefer much more than the traditional Sharpe or Sortino ratio measures. But even here you need to be careful. If your system has massively large stops it could provide you with a very unrealistic picture of its robustness. For example one of the best traders in my room had a “return on account” (that’s what this ratio is called) of more than 10. She was up 22% on equity with a drawdown of only 2%. But that’s because the system was trading with massive negative skew (the risk-reward was 1:5) so the losses were rare and provided a false sense of security. Fortunately, she wasn’t fooled by the data and traded at very low leverage to prepare for any large losses that could come like an avalanche. Generally, the return on account of 2:1 or better is a sign that you are doing things well and a much better way to assess the risk of the strategy than the simple risk/reward ratio of any given trade.

I’ll be in Madrid next week at the annual Forex Day show, so no column next week, but come say hi if you are there, it would be great to meet everyone at the show.

There is no Such Thing as a Winning System

Boris Schlossberg

I’ve often made the argument that there are only two types of trades. Continuation or Reversal. Flow or anti-Flow. Trend or Fade. Call it whatever you want, but whenever anyone places a trade they are always implicitly making a bet that prices will extend in the prior direction or will reverse.

That’s why there is no such thing as a winning strategy. All strategic success depends on a market regime. In trending markets momentum strategies perform great. In choppy markets reversal strategies bank pips. You can do all sorts of things to finesse returns around the edges by using fancy money management techniques, but ultimately if you are caught in the wrong market environment you will get stopped out and sometimes even slaughtered.

They key is not to make things worse. And as traders we often do. That’s because we are obsessed with the idea of a “winning system”. That’s probably the single biggest lie ever told in the trading business. The only guy in the history of the markets who had a “winning system” was Bernie Madoff. For decades he fooled investors that he had the magic formula. And we all know how that turned out.

Indeed the key to winning in trading lies much more in NOT TRADING when the regime is against you than in forcing your system on the market that will chew it up alive. No doubt that’s hard to do with any degree of accuracy ahead of time and that’s why you have to accept the fact your great money making system will lose. Sometimes for days, weeks, even months on end. It does not mean it is not working. It just means it is not working NOW.

These days, I spend 90% of my time trying to figure out the most probable cases of when my set up will fail. Then, I try to studiously avoid making trades during those times. Again that’s not easy and answers change because market conditions change, but even if I can avoid three negative days per month, that could be the difference between winning big or just getting by.

Understanding that there is no such thing as a winning system should also help you to understand that there is no such thing as a winning trade. There is just the set-up and at any given time it can go either way. That’s why great traders trade positions not opinions. Opinions should be made before each trade. In fact, each trade is nothing more than an opinion. Once it’s in the market however, it becomes a position and that position either resolves to profit or a loss.

Most of us, however, develop opinions once the trade is in the market, which means that at that point we are no longer trading but practicing religion by relying on hope and faith. Hope and faith are very powerful human drives but they have nothing to do with trading.

Yet even the most atheist of us have prayed when a trade turned against us, especially if we changed its initial parameters with a post entry “opinion”. In fact the more we’ve changed the initial position the more intense our prayers become.

Tell me -- how’s that worked out for you in the past?
I thought so. The market can be crueler than the meanest of the Greek gods.

That’s why it all starts with understanding that there is no such thing as a winning system. Once you can come to terms with that you can start trading positions not opinions and save your prayers for when they can help.

You Will Never Make Money With a Trading System …

Boris Schlossberg

Let’s start with the basic fact of trading. No system -- no matter how good you think it is -- will ever make you money otherwise every EA buyer in the world would be a millionaire. And yet… hard as I look I can’t seem to find any EA millionaires in FX. There are plenty of demo millionaires. There plenty of ads that promise an EAs will make you a million for only $9.99 plus a tub of tupperware, but … There. Are. No. Actual. EA. Millionaires. Like unicorns they seem to be creatures only of our imagination.

Ok. Let me set my snark aside and tell you right up front that I actually LOVE trading systems and I use EA’s for every single trade I make. Yet I am not foolish enough to believe that this is the source of my profit. A system like a scalpel is simply a tool. In the hands of a gifted surgeon it can do marvels. In the hands of klutz it will just cut you badly and make you bleed out.

One of the greatest joys of my trading life this year was to create a live trading room that allows me to observe on a daily basis the variety of ways that the same system can be used by many traders. In our Slack room we now have more than 400 traders from across the world all trading essentially the same old fashioned market making method that I adopted for retail trading We all use the same EA, look at the same currency pairs and follow similar risk management rules. Yet while someone like me may only lay down out 3-5 trades per day another trader in our room will do as many 40 trade cycles in a 24 hour period.

Here is the kicker. We both make money, we both follow the rules and we both trade the same system -- but you would never know it if you just looked at the P/L runs of our accounts. The reason is that no matter how mechanical we want to be -- we are all human, all different in temperament, style and philosophy.

I trade essentially like someone with PTSD -- firmly believing that old Andy Grove observation that just because you are paranoid it doesn’t mean they are not out to get you. I view the market as field full of landmines and try cross it as quickly possible avoiding a misstep at any cost. That means that I often pass up many profitable trades or get out too early, but I live to trade another day.

The 40 trade per day trader on the other hand operates with the stoicism of Marcus Aurelius. He trades every set up to its full conclusion -- good, bad or ugly. And he does it with a sense of serenity that I can never hope to achieve. He makes 1%-2% per day like clockwork- but when he gets clipped -- he can lose 4% of his capital in the blink of an eye.

Here is the thing though. Instead lamenting our particular foibles we should embrace them. It is after all our individuality that makes us unique and valuable. Instead forcing ourselves to adjust to the system which is what so many traders try to do, we should adapt the system to our own personality.

Here is a discount to team trade with us

That’s why no system can make you money until you make it your own. So no, all those EAs sitting in your Experts folder aren’t going to “make it rain”. Not until you begin to understand not only the science, but the art behind their algorithm.