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.

In Trading Losing is a Feature not a Bug

Boris Schlossberg Uncategorized

One of the best things a trader can do is run the strategy tester function in MT4 on any 1-minute chart. Ideally, you’d like the test result to be positive in the end, not because it will show you how to make money, but because of what it will teach you about the nature of trading.

The one minute chart, as I’ve said many times in the past, is an amazing hack that allows you to look at hundreds of trades over just a few weeks of data. So run the strategy in MT4 and watch the graph dynamically build itself in real time as each trade gets added.

One thing you will never see is a straight 45-degree line running from left to right. There are no regular paychecks in trading, What you will see instead is the equity curve rising 10% in an uninterrupted fashion only to drop back to zero and then below it. You may see that a few times during the lifespan of the strategy and every time that happens more than 90% of you will stop trading the system. Yet in the end, after a few months or a year or even a few, the system could end up being incredibly profitable.

All of us come to trading with an absolutely wrong model of how things work. Sure, we can imagine, one, two maybe even three losses in a row. But after careful study, hard work and discipline we imagine that we can eliminate those mistakes and embark on smooth consistently profitable money making adventure.

Wrong.

To borrow a line from the software business -- losing is a feature, not a bug. In fact, almost all great investors lose or underperform for long stretches of time. Warren Buffett underperformed the market by a whopping 54% in the late 1990s and has had several drawdowns of 40% in his career. Almost no one who tried to copy his trades would have stayed with him through the losing times and yet his long term record is one the best ever.

That’s why the single greatest lesson any trader can learn is not risk management, or strategy selection or market analysis. All of those are crucial to long term success but will be utterly useless unless the trader accepts the fact that stomach-churning losses will never stop.

Here, the Oracle of Omaha can be a useful guide. You can’t make losses disappear, but you can do your best to survive them. To that end Buffet offers two great pieces of advice -- don’t do stupid things and don’t overlever your trades.

Both Buffett and his investing partner Charlie Munger have always claimed that their success came not from making smart choices but mostly from avoiding the dumb ones. If you are running a system and a given instrument is only producing mediocre results -- continuing to trade that instrument on that system is sheer idiocy. There is no guarantee that any of the well-performing instruments will maintain their edge, but there is almost complete certainty that a poorly performing instrument in the past will cause you losses in the future. Sure, there are exceptions to the rule but that’s precisely the point. Strategies are about rules, not exceptions.

Still, the single best advice from Buffett is not to over-leverage. Leverage is the single biggest reason why most retail traders blow up their account. You can survive a lot of adverse market regimes on low leverage but you can’t survive even one mistake on high leverage. That’s why it’s worth it to always start trading with no gearing whatsoever by trading one times equity per trade. The natural leverage of multiple positions will be more than enough to keep you on your toes.

You’ll Never Understand Trading Unless You Read This

Boris Schlossberg

If you’ve run hundreds of backtests over the past few days like I did you come to a startling conclusion.

There are no winning trading systems.

There are only systems that drawdown a little less than they run up.

EVERY SINGLE system you trade will lose money if you trade it long enough and sometimes it will lose a lot.

I call this the Law of Paying the Pip Piper. Basically, the absolute best that you can hope for is that your drawdowns are slightly less or equal to run-ups. So that a system that just made you 300 pips over the past few months will -- as surely as day follows night -- now proceed to lose you 150 to 250 pips over the next few weeks.

Why does this happen? Because market regimes change and every single system is optimized for one or the other set of conditions -- continuity or mean reversion -- or to put in more colloquial terms -- trend or tread. In continuity (trending) markets systems that bet on continuation will thrive. In markets that tread the exact opposite bet pays out. There is only one letter difference between trend and tread but that tiny change is all you need to make a lot of pips or lose them.

Trading is the closest thing we have in the modern world to the natural state of volatility. Our hunter-gatherer ancestors fully appreciated the idea that tomorrow will not at all be like today and more importantly that pleasant comfortable weather will inevitably turn into a miserable multi-week storm or rain and destruction. But the very goal of civilization is to completely annihilate the volatility of everyday life. We built massive furnaces up North which allow us to live in comfortable 65F weather in Sweden and we build massive air conditioning complexes in the south allowing us to do the very same in Las Vegas. We smooth out our income streams through the magic of “salaries” and smooth out our food supply chain through some of the most complex logistics ever imaginable so that it becomes as natural to eat a peach in December as in June regardless of whether it comes from Chile or Georgia. So little wonder that our modern mind, so carefully protected from the vagaries of nature is, so coddled by the myriad of tools of civilization is so ill-equipped to handle trading.

That’s why backtests are so useful. Not because they will provide you with the one answer to true riches. No, they’ll never do that. But they will show us the narrative of the trade. Like time-lapse photography, they will compress thousands of hours of market action into just a couple of minutes of results so that we clearly see how and why we will fail and how and why we will succeed. In short, the backtest will “uncivilize” our minds and open us up to the true nature of the task.

Now lest you think that these principles matter only to us lowly system traders and don’t apply to stock pickers, allow me to tell you about an exchange I had with the great Eddy Elfenbein this year. Eddy runs a great newsletter called Crossing Wall Street and you probably have seen him many times on CNBC’s Trading Nation. He is truly a great stock picker and his newsletter has beaten the S&P many years running. One time Eddy tweeted out about LUV (Southwest Airlines)

“Here’s a long-term chart of Southwest. Note the log y-axis to see how amazing the stock has been. Up 26,600% since 1980. RIP Herb Kelleher.”

I took look at that chart more closely and realized something and responded back to him,

“And yet Eddie it lost 75% of value between 2001-2010 -- that required real belief to hold on.” (This btw was way before its current troubles with Boeing’s 737).
To his credit, Eddy fully acknowledged that point.

So the point is -- if you trade you always have to Pay the Pip Piper -- even if you don’t trade FX.

Weekly Forex Trading Calendar for March 25, 2019

Weekly Calendar Calls

We have just posted our weekly news trading calendar for the week of March 25, 2019. You can download the pdf and excel file by clicking on the Read More Link. These are soft biases on economic data and not trades that we directly trade or track like BK Swing and News.

Excel version of calendar032519

PDF version of calendar032519

What Flip or Flop Taught Me About FX Trading

Boris Schlossberg

I have never owned a house. In fact, in more than half a century of being alive I have never held a deed to anything more valuable than a couple of rusted out 1990 Honda Civics. My life has resembled nothing so much than the classic 30 Rock episode where Alec Baldwin’s Jack Donaghy, interrogates Tina Fey’s character.

“Lemon, where do you put your money?”
“The bank.”
“What?! What are you -- an immigrant?”
(Guilty as charged)

So it’s no small irony that my one big weakness for TV is HGTV. I haven’t had cable for more than a decade, but when I am on the road, there is nothing I like more than binge-watching home renovation shows. I like the Scott brothers, the ever-chipper Chip and Joanna Gaines and Nicole Harris’s rehab, but I love Tarek and Christina el Moussa the most. (And yes I was heartbroken when they divorced).

There is no greater voyeuristic pleasure than watching Flip or Flop episodes as they go through the struggles of buying dilapidated property and then restoring it to its utmost beauty and value. Each show is a mini-drama that happily kept me glued to the TV screen in many hotel stays.

So I was instantly intrigued when a CNBC clip of Tarek popped up my Twitter feed this week, and like the fanboy that I am, I instantly clicked to watch it. What surprised me however was that in his two and half minute appearance Tarek laid down more trading wisdom than I’ve heard in years from seasoned market pros. Here are some of his pointers.

1. It’s not the exits, it’s the entries.

As Tarek says, “You make your money when you buy the house.” What he means, of course, is that every investment (or trade) is only as good as the price you pay for it. This made me step back and re-examine my own trading systems. The default move of my strategy is to go market when the signal sets up. What if, I wondered, I just laid out limit orders 3 pips under the market for day trades, and 10 pips under the market for swing trades? Would the price run away from me? Turns out that no. In fact, I pick up as much as five extra winning trades per week and for a guy who does more than 100 trades each month, that is a massive, massive edge that I intend to explore.

2. Less positions, more money.

When asked about how many flips he had going at one time Tarek noted that at his peak he was running as many as 74 properties which stressed him to no end. Currently, he runs less than half that amount but his profitability is actually higher.

This is a problem I struggle with all the time. Like everyone else in the FX market, I want -- More! More! More! And yet when I look at my P/L at the end of the week I realize that more strategies actually means more risk.

Did you know that finance academics determined that you can achieve 95% of the benefits of diversification with just 15 stocks? That’s why trading the 30 Dow stocks over the long run pretty much produces the same return as trading 500 stocks in the S&P.

When I look at my basket of algos I realize that just a few medium term swing strategies produce the vast bulk of profits. The rest just keep me glued to the screen and torture me with their seesaw swings in equity.

3. Trading is timing in more ways than one.

As Tarek says, instead of ultra-high-cost projects that could tie up his capital for months or years, he likes the “turn and burn projects” in the 300K-700K range. The risk of the market “shifting” in a long term project is really high and the prospect dead money could be detrimental to your “trading” capital. Much like him I find that the 4 hour chart is the perfect “turn and burn” sweet spot for my algos. The risk is very clearly defined so the drawdowns are bearable, and while the rewards are modest they truly add up as you flip those trades.

Here is the full interview -- hope you enjoy it.