What a coincidence (do coincidences actually exist???) that just as I've been thinking more about money management Worden has had a run of users writing in about money management. Here are some of those letters which were published in the Worden Report (emphasis & links added by yours truly):

We Dub Thee Sir Pareto

Sir Pareto has drawn upon the "Pareto Principle" in building a highly practical approach to trading. He says that he believes money management is the real Holy Grail of trading. So I suggest the many of you looking for help on money management get busy and read this. We welcome Sir Pareto to the Roundtable of Knights Who Think for Themselves. A cool bottle of Veuve Clicquot Ponsardin has been retrieved from the moat. -DW

Hi Don,

I have been trading for over 14 years as a professional options market maker, futures local, and stock market maker on the exchange floors. For the past few years I have been an off floor trader trading a variety of different instruments and with all my experience I believe that money management is the real Holy Grail of trading. Let me explain what I mean.

I have come to realize that Pareto's Principle comes into play with trading and investing. For those not familiar with Pareto's Principle it is the famous 80-20 rule where 80 percent of your success comes fro 20 percent of your resources. I have found that this holds true with trading and investing, 80% of my profits come from 20% of my trades. So out of every 10 trades or investments, 2 of them will be very profitable and the rest are breakeven or minor losses.

Because I do not know which 2 out of 10 trades will be profitable, I use specific money management techniques that most people do not focus on. I like to get trades to pay for themselves as fast as possible, in that way I can let part of my position to work for me for a long time and maximize the gains. I also ensure that most of my other trades are stopped out for breakeven or even minor gains. Here is how I accomplish this strategy. I look for entry techniques where the trade will give me a quick initial pop in the direction I am trading. When I get the quick initial pop, I reduce my position significantly and use the profits from the quick profit to finance my stop loss. An example helps explain this strategy.

For example, I purchased 1000 shares of SNDK on the breakout above the previous swing high at 59.86. I got filled at 59.94 and put my initial stop at 59.48 for a risk of 46 cents on 1000 share or $460. I know from my trading experience that this kind of breakout, if it could get above the $60 mark, would run for $.50 to $1.00 before consolidating so I put in 2 sell orders. I placed one order at $60.49 for 300 shares and the other at $60.99 for 300 shares. Both were triggered and I banked $165 + $315= $480. After I locked in the profits, I moved my stop on the remaining 400 shares to 58.69, which is below the low of the breakaway gap day. So now my risk on the position is (59.94-58.69) x400=$500. However, I already banked $480 so my actual risk is only $20. I then placed orders at $62.99 for 100 shares and at $64.49 for 100 shares in case we got continuing follow through. By doing this, I am scaling out of my position, but I am keeping 200 shares for a core position. Both orders were filled on April 6th and I banked $305+$455=$760. I am leaving my original stop in the same place for the remaining 200 shares.

At this point, even if I get stopped out on the original shares, I have made money on this trade. I am leaving my stop at the original location because it makes sense. Always make sure that your stop location is in a location that makes sense to you, meaning that if the price got back to that level, you wouldn't want to be in the position anymore. Don't just place a stop in a location based upon a monetary value, your stop may get hit and you may still like the trade. That is why I use profits from exiting some of my position to finance my stops. That way, I am not worried about losing money on the trade while being able to leave my stop in a great location.

Now that I have my core position of 200 shares at this point, I don't mind if the trade pulls back, because I can always trade around my core position, meaning that I could add some shares back on a pull back. However, I still don't know which of my trades will be the most profitable so I just let my remaining shares work for me. Eventually, if SNDK keeps moving up, I will move my stop to lock in a profit but I will only do that when I can find a logical place to put my stop. Sometimes, I hang onto the remaining shares for a few weeks or months. The trade has been paid for and I let my winners run.

To sum up my money management and trading rules, I look for situations where the trade follow-through will finance the remaining position. I enter a larger position so that I can quickly unwind part of the position at a profit, which I then use to finance my stop loss. That way, if my stop loss is hit, I will get close to breaking even. The whole key is to not get greedy and to look for situations where the trade will trigger follow-through. If I get in a trade and I do not get any follow-through in a short period of time, I will exit the trade and preserve my capital.

I keep detailed records on my trading and I have found that on 10 trades I have this distribution of winners vs. losers.

Trade distribution
2 losing trades, Average loss = $463
6 breakeven trades, Average gain = $24
2 winning trades, Average gain = $976

So out of 10 trades, I am generally making about $1170. The key is finding trades that will pay for themselves since I don't know, out of the 10 trades, which ones will be the 2 big winners. Usually, the trades that turn into the big winners surprise me. I have found that the trades that I am expecting to be big winners actually break even most of the time and some of the trades that I am lukewarm about turn into the most profitable trades. Such is the nature of investing and trading. Don't try to predict, just get in to the right trades and let the market pay for your position. At that point, you shouldn't care what happens, some will work, some won't and some will break even.

Thanks for producing a great product.

Mike

Squire Loss-Limiter does an excellent job here of showing how a "money handling" technique known as "position sizing" has increased the consistency of his profits and his confidence as a trader. He fell short of knighthood (though he can get a seat at the table with an additional submission) because he fell short of explaining the most important aspect of "position sizing," which is to suppress the risk (and potential profit) of volatile stocks. I don't see how this could be done systematically without a consistent and systematic method of determining loss-cut points, based upon volatility. Secondly, in his enthusiasm for an approach which is making him money, he refers to it as "the most profit-generating system he's seen." Actually, the system provides "consistency," not greater profits, (except indirectly when the approach increases confidence with better judgment following - clearly what it does for him). Also, he states that profits must average twice as much as losses. But profits and losses are after the fact. A method of determining risk/reward ratios before opening the trade is not addressed. The first knight to introduce "position sizing" to our Users was Sir Rhino on May 6, 2003 (see the next letter). His article is a natural companion to this one. -DW

Hello Don:

I read with interest "Sir Pareto" and his Holy Grail. My Holy Grail deals with money management, but in a different manner. My trading has been revolutionized by giving me consistent profits, no large losses and a confidence to trade without fear. Nothing has changed in my techniques of stock selection. I still use breakouts to enter and to exit, if necessary, when the stock violates support.

My Holy Grail is called "position sizing", a technique that is fairly new to the investment community. And, it's rarely used although it's the most profit generating system I've seen.

Here is how it works: Let's say I have a $100,000.00 trading account. The most loss I will accept is .05% (one-half of 1%). This equates to $500.00 per trade.

Let's say I want to buy a stock at a breakout point of $50 and exit if it breaks $49.10 on the downside, a .90 loss. Divide the .90 into the maximum loss of $500 and I buy 555 shares. If it goes against me, my loss is limited to $500, exclusive of slippage and commissions.

On a breakout of $21.01 with a stop at $20.64, will give a loss of .37. Divide this .37 into $500 and purchase 1351 shares. Again, the loss is limited to $500, less slippage and commissions.

To exit on profitable positions, use the same techniques you are using now. However, to effectively use position sizing properly, the profit should be at least 2:1 to the loss. If the loss is .37, profit should be at least .74. My percent of winning trades is 57% and using 2:1 makes a nice profit.

Think of the profits for those of you who have 65-70% winners. I'm not smart enough to figure out the percent of winners necessary to be profitable, but using the guidelines outlined, I imagine it would be 35-40%. Remember, position sizing changes nothing you are currently doing. It only affects the amount of shares traded.

Thank you for your fine service,

Keith

The aforementioned submission from Sir Rhino:

What I find unique about Sir Rhino's approach is that it is a combination of money handling and trading technique, not one or the other as is usual. It aims squarely at what should be every traders most important focus: RISK CONTROL. The underlying principle of this approach may at first seem subtle -- almost allusive. Sir Rhinos risk control is implemented in one stock at a time as you open the positions. But the strategy can only be understood in the context of the entire portfolio or of total trading capital, rather than just one individual stock at a time. We welcome Sir Rhino to the Roundtable of Knights Who Think for Themselves, and hereby christen him with a bottle of Veuve Clicquot Ponsardin. -DW

Dear Mr. Worden,

I wrote this in response to your comments of Friday night concerning the inherent problems of handling breakouts.

I have a rather straightforward way of dealing with the runaway stocks that were the subject of Friday's Worden Report. In short, I treat them pretty much like any other stock. That means that if I determine that price action is bullish and I want to be long, I find a natural stop loss point to give me a frame of reference for how much risk is involved in the trade. I then use position sizing to control such risk. Position sizing is the real key to being able to board one of those soaring stocks that would otherwise be relegated to the 'buy on dips' category. As you pointed out many times, with this kind of stock, there is either no opportunity to buy on a dip, or, if there is a dip, you later wish you hadn't bought it.

One way to really understand how to trade one of these high fliers is to view the trade as a function of volatility and number of shares owned rather than looking at a dangerously steep rise, or a big gap up on a chart. Let's start with this simple observation. When we trade in the markets, our goal is to capture as much upside (or downside in the case of a short position) volatility as possible while eliminating as much risk to principle as we can. Different trading vehicles demand different tactics to reach this end. Dull trading stocks that do not move much demand larger size trades, and big breakout moves or large daily point swings in a stock allow a smaller number of shares to do the job. If you apply this simple concept to any stock that you are considering buying, you will see that it provides the answer to the question of how to buy a 'hot stock' without exposing your capital to undue risk.

Here is an example. Hypothetically, let's say you never risk more than $1000 of capital on any stock trade. Let's also say that you have spotted a stock that you wish to be long, but it has gapped past your targeted entry price of $20. It is all the way up to $23. The nearest natural support is at $18. Whereas you initially were prepared to risk a decline of about 10% in the stock price, you now must risk a decline of about 22% before you know whether you are right or wrong on the trade. This being the case, you would need to determine if there is enough upside potential to the position to warrant taking a position at all (just like with any other stock). I usually use 2 to 1 as a rule of thumb for reward/risk. That means this particular stock would need to have a price objective of about $33 or better to be viable given that we must risk 5 points on the trade. Note that the price objective is dynamic because our underlying assumption for this type of trade is that sharp or persistent upside movement creates a higher likelihood of continued longer term upward movement. In other words, in this situation you might have been looking to trade the stock from $20 to $25 originally, but the breakout to $23 has put it in a position to move up to the mid thirties where the next resistance lies. Assuming that the overall reward/risk criteria are met and given that the stock has just given confirmations of our bullish suspicions, it is time to take a position. Very simply, we will size the trade such that no more than $1000 (the same amount you would risk on any other trade) is at risk. Since there are 5 points between the entry ($23) and the stop ($18), some very simple math indicates that we should buy no more than 200 shares. We are now on board the train, and should the stellar performance continue, we will make money. Should the stock fail and go below $18 . . . well, it is just another trade.

The true beauty of this methodology is that it allows the trader to take a position, control risk, and still have options as price action unfolds. If the stock continues upward, the position can be increased as more support levels develop and the stop is moved up. If the stock bases or declines a bit, then firms up, again the position can be increased. And if the stock continues to rocket upward and we never get a chance to add to it, that is OK too. Win, Win, Win.

Many times the notion that we can control our risk with position size, in spite of the volatility or the extended price chart of the trading vehicle, is overlooked as we struggle with the false dichotomy of buy or don't buy. We have many more choices than that. We can buy small size, we can buy larger size with a tight stop, we can substitute call options for a long stock position to control risk (depending on volatility premiums in the option), etc. It is not always black and white, right or wrong. Sometimes we can finesse our way to profits that would otherwise be left on the table.

As always, thanks for a great product. Happy trading!

Regards, Jake, aka Rhino

And in response to Sir Workaplan came this:

Dear Don- Regarding Sir Workaplan's contribution last night, there is a classic formula that combines win probability with profit edge per trade. I call it 'Profit Factor.' (aka expectancy) There are other variants of this, and others use that phrase to describe other formulas. But this is the best description and best formula I have found to describe what's going on. PF=(pW*avgP)-(pL&avgL) where pW is the probability of winning trades pL is the probability of losing trades avgP is the average profit of all trades avgL is the average loss of all trades. The probability of winning and losing trades is derived by dividing the count of all winning trades by the total number of all trades, and, similarly dividing the count of all losing trades by the number of all trades. Applying Paul's numbers into the formula, you come up with PF=(0.57*5.4)-(0.43*4.5)=1.143 That is, you make $1.14 every time you bet a dollar on a stock, or whatever. Do it every other week for a year, and your $10,000 becomes $320,000. Not bad for a year's work, eh? All the best, 'Copernicus' (John)

And finally, the almighty Kelly Criterion:

Sir Gambler on the Kelly Criterion

This is a bit of a repetition of a post I offered many, many years ago -- But it's Sir Copernicus's fault!

His post last night caught my eye right away. In it he recapitulated a formula beloved of serious gamblers, called the Kelly Criterion, after John Kelly, of Bell Labs, who invented it about 50 years ago. The purpose of the formula is to estimate what is the optimum fraction of one's bankroll to hazard in a given proposition. (For Kelly, it was to calculate the optimum transmission rate of data over the noisy lines of the day).

It turns out that if you habitually hazard more than your expectation on your gambles (or, ahem trades), you will, sooner or later, go broke. In other words, even if you have a winning system, if you risk too much, in time normal variance (bad luck) will get you. On the other hand, if you hazard too little, your bankroll will not compound as quickly as it could.

To get an objective measure of one's expectation, it turns out that the formula that Sir Copernicus describes exactly fills the bill. It does require a good sized sample, but once one has the data, knowing what is the maximum amount to risk on a trade gives a trader a great deal of comfort.

One quibble with Sir Copernicus's calculations. He confuses the numbers of Sir Workaplan's results with those of Squire Loss-Limiter, on whose offering, the former was commenting. Sir Copernicus's calculations showed an expectation of 1.143% per trade. But using the win percentage of Sir Workaplan (.55 vs .57 for Squire Loss-Limiter) the results give an expectation of 0.945%, almost 20% less. Assuming Sir Workaplan's sample is reasonably large, if he consistently risks the larger number, in time he will certainly end up broke.

A more conservative formula that most gamblers use to avoid the pitfalls of insufficient data, is to only hazard some fraction of their expectation, say 75% or even 50%.

As an example, let's say one's bankroll is $100,000 and one's Kelly number is 1% (after subtracting a safety margin from a formula result of 1.25%). That means that on any given proposition we can hazard $1,000. If we are looking at a $20 stock with a natural stop loss point (a support line, for instance) at $19, we can not buy more than 1,000 shares, and we must be disciplined enough to know that we will never, never, never let ourselves lose more than that much.

After each trade we plug the new number into our spreadsheet and re-calculate our expectation. The immediate purpose of all our decisions is not to make money, nor is it to be right, or impress people with our sagacity: it is to raise that Kelly number. We must keep that goal in mind at all times, for that is the real key to success. It has often been called "The Holy Grail" of money management.

(By the way, you will note that if our expectation goes below 0.0% we must stop gambling or find a new game where we have a better expectation.)

On the trading system I'm currently working on, my expectation is 2.6%, with about 40% winners and an average hold of somewhat more than one week, but I'm doing some very interesting work on reading candlesticks with a neural net which I hope will jack up that number a little in the near future. If it works, I'll let you all know -- unless it works too well, in which case I'll have to restrict myself to just teasing you a little.

--Bob (Gambler)