Defensive Money Management Explained (Part 7) – The Money Management Edge Part 1

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Most of the time traders looking for profitable trading setups do not think about the maximum risk first. Jargons like high probability setups and low risk entries often dominate the reading materials a trader can find. Those are entry methods with possibly an edge or a bias that the trader can lean on. But could that be just an illusion the trader identified incorrectly from a complex set of rules? I am going to explain what money management edge is and the importance of recognizing how much that can contribute to your success in finding and building winning strategies.

The Science of Handling Noise In The Data

If your focus is trading a particular timeframe (e.g. daily), all higher resolution timeframes (e.g. hourly) to you are extra information. Knowing something about those timeframes may assist you in making your final decision in engaging a trade or not, but ultimately your maximum risk exposure in the trade you are taking is dictated by the volatility of the timeframe you have chosen. By choosing a proper initial disaster stop to protect your capital, you ensure yourself that in long run you would not be losing money due to market noise – normal fluctuation of price movements that can be considered as random or unimportant to your timeframe.

Specific market combined with the timeframe you have chosen to trade would have its own unique volatility. For example, if you trade the ETF for S&P500 (SPY) on daily basis, its volatility would be quite different from day trading its intraday swings. The daily SPY volatility is also different from, say, the ETF for Nasdaq 100 (QQQ). Each forex pair has its own unique volatility behaviour thus you have to deal them separately.

In general, you need to collect basic volatility statistics on the combination you are going to trade. You will also need to keep track of the changes to the volatility regularly so that you are aware of potential negative effects on your trading setups.

One way to measure volatility is to track the average range of each bars within the timeframe you are trading. There are other more complicated methods that can produce better results. For now, however, average range is sufficient for our purpose.

Here is a table of average range on British Pound over different timeframes as of August 24, 2013

Volatility tends to correlate well with the volatility for the next trading day. That means, most of the time, you can use the volatility measure you have to project the price movement of the next trading day with certain degree of accuracy.

The Initial Stop Loss

The initial stop loss based on volatility measure should be the nearest price level that is not likely (i.e. low probability) to trade at. Depending on your risk appetite and the kind of trading setups you are expecting to trade (e.g. trend continuation, counter-trend, breakout), you can choose to accept a lower probability like 65% (that the price will not be touched) in exchange for a smaller absolute risk. For example, by setting your initial stop loss at 2 times the average range of your timeframe, given that the market you are going to trade has shown normal distribution like behaviour from your entry points, the expectation could be the case that only 20% of the time the market is going to tag your stop loss within a short period of time. If you reduces the stop loss to 1.5 times the average range, the probability of the market going to tag your stop loss may increases to 35% or more. Understand the reason and make a choice that you are comfortable with.

This initial stop loss value should always be greater than or equal to the stop loss as suggested by your trading methodology or trading setup. If your trading model turns out requiring a stop loss value not correlate with the volatility measure, it is likely you will have great difficulties in trading the model as the risk is no longer bounded. In another words, you do not have scientific evidence to support the way how your stop loss is placed. When you encounter a profitable model with huge stop loss that cannot be expressed in fixed multiples of the expected volatility, it is difficult to tell if the model is a result of curve fitting, or if it is driven by some edge that you do not understand. Either case, extra precaution is necessary before trading such model.

Profitable Trading Models Using Only Money Management Edge

Coupling the initial stop loss with a small profit target, anyone can easily produce whole range of marginally profitable trading models. Throwing in slightly more complicated money management rules, you can even turn a coin-flip model into a stable performer. The trick lies in the fact that the initial stop loss was chosen because it is not likely going to happen. Thus given enough time and price swings, the price target automatically have the advantage to be tagged first before the stop loss is hit.

Do not misunderstand that money management driven models are not legit. In fact, for most consistently profitable retail traders, money management edge drives a significant portion of their profits, even though they may not realize the truth. The reason is that trading edge coming from entries can and will fail or discounted over time. When your particular trading setup no longer produces the expected outcome from the market, the only reason you can still coming out without major losses is prudent money management.

This is where a lot of confusion happens as prudent money management can have two very different meaning. On one spectrum, it can be the use of tight stops and rigid rules to protect profits. On the other spectrum, it can have very relaxed stop loss rules when the positions are taken with very low leverage such that the position size are already part of the money management consideration.

Using a slightly different point of view, we can say money management edge is the ability to take advantage of market noises and inherited volatility independent from the entry advantage (if there is any).

Summary

Over time, traders refine, modify and adapt their trading methods to the market environment in the hope of extracting more profit. But it is those who understand the importance of staying rigid with money management rules would survive while those who don’t are penalized. It makes sense to adjust your trading strategies to handle the current trading environment better but it is never a good idea to deviate from the original money management edge your strategy was designed to depend on.

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