Constructing Your Trading Plan

This article was originally released as a followup to “My Super Secret Trading Technique” (which is now “Understanding Leverage“).

In part one of this article, we discussed the importance of money management as part of a good trading plan. We also had a brief discussion of how to adjust your risk exposure in the futures markets. Now, in part two, we will take that knowledge to the next level and discuss position size as it relates to your trading plan

Position size, while it may sound simple, is actually a complex topic. It is no secret that a great deal of the success of the Turtles is attributed to their mastery of money management, and more importantly, their ability to adjust position size appropriately. Even if you are a small account, able to only trade a one lot, you need to consider position size in your money management approach. Otherwise, how will you know when to increase size based on success, or hold off trading until additional capital can be raised.

There is no single right answer as to what the right position size is. Since the audience for this article is broad, we will have to suffice with some general principles. The first is an examination of how much volatility you can stomach. If you don’t like big swings, decrease your risk exposure by applying more capital to the trade.

Traps and Pitfalls

Over-leverage

If your approach is a short term, daytrading approach and you are trading with less that overnight margin, you need to reevaluate your entire plan. Daytrading the E-mini S&P with a $2000 account is sheer madness. A single handle in the contract is a full 2.5% of your account. I know the attraction is the large percentage returns on your account you can take out when you are right. But I have found the best plans make the assumption that you will be wrong a good percentage of the time. Get appropriate risk capital to work with or get out of the casino!

In the last few years, I have seen it become quite popular to daytrade the E-mini S&P and other similar contracts with as little as $500 intraday margin per contract. Think of it this way. In a $2000 account (quite common, unfortunately), that is 4 contracts that can be traded. Each full handle in the E-mini S&P is $200, or 10% of the account. Each tick is 2.5%. In my experience, the most common amount of risk for these people is 2 handles – $400 in our scenario. If you are wrong on your first two trades, you are down 40% and you are probably out of business.

Over-leverage can kill your trading business. Don’t be lured in by the potential for fast money. Have patience with what you are doing and build on a solid foundation.

Arbitrary goals and rules

Another flawed approach that is too common is setting arbitrary rules. In my experience, this has been most common with newer traders. Let’s assume the trader begins with $10,000 in the account. They begin by saying they will trade one contract in one market until they get comfortable and then they will begin to increase size.

Think about that for a second. How do you define “comfortable?” What exact dollar amount is that? Is that dollar amount, if any, an optimal point at which to add risk? Do you see where I’m going with this? You have to be able to quantify your approach. I’m not suggesting that you have to be absolutely systematic with your approach. That’s neither good nor bad. But one thing that systems have over discretionary trading is that it is an absolute that every aspect is quantifiable.

Not only must you be able to quantify your levels of increasing or decreasing position size, you should have a valid and quantifiable reason for doing so.

What you need to know about your method

By now, you should have an idea of how big of an account you are working with. As we have already discussed, account size is going to determine what you can and cannot do with your money management. But you will also need to consider some other factors. These will vary from person to person, but the general concept will be the same. You need to know:

• What markets will be traded?
• Will any markets be traded simultaneously?
• For each market, what is the average drawdown for each trade?
• For each market, what is the maximum drawdown for each trade?
• What is the average profit achieved?
• What is the win/loss ratio?
• What is the average range of the market for the time period being traded?

Market Diversification

If your method will trade multiple markets, you are going to need to analyze appropriate position size for each market individually. This is because the risk and leverage are not going to be consistent across all markets. An arbitrary choice of trading a single contract does not make much sense when the markets traded are Corn and Crude Oil, for example. (If you strategy is creating a portfolio that is not equally weighted, this will not apply.)

Market Volatility

The markets being traded should be analyzed for volatility not only for diversification purposes, but also for stop placement.

Trading Method Statistics

For each market you are trading, you need to have some idea of what type of moves can be expected based on your method. Where are your stops placed? What is the expected win/loss ratio? Considering these two factors, how many losing trades can come in a row? What is the average profit objective? Does that make sense according to the win/loss ratio and average market range?

A Word about Stops

Conventional wisdom says that you do not trade without stops. I tend to agree. Stop placement, just like all other things, cannot be arbitrary. Setting your stops at a set dollar amount because you are comfortable with the risk is not a good approach. You need to consider, as we have stated before, the potential swings in the market. If the dollar amount of that risk is too great for your stomach or your account size, then you need to remove that market from your trading plan.

Once that is determined, you can approach stops as part of your overall money management plan. Essentially, what you are factoring is the amount of the account that will be risked on a given trade. Trend followers tend to use a percentage of the overall account size to determine how much is risked on each trade.

I tend to use that approach in combination with the average market swings. For example, if my plan has rules to risk no more than 2% on any given trade, then the trade has to fit within those parameters. I consider the range of the market in combination with other technical analysis. My stop is placed a percentage outside of that range. If that amount is more than the account percentage my money management rules state, then the trade must be passed on until all parameters fit the rules.

Conclusion

Putting it all together, you should now have an idea of how to approach money management. Combining the statistics of your method of trading with your risk tolerance and appropriate stop placement, you should be able to calculate the optimal number of contracts to be traded at each dollar level of account balance.

As I said in the beginning, in order to cover a wide range of trading methods, we have to generalize in some areas, but the key rules will remain the same no matter what. Taking these rules in conjunction with what you know about your methodology should allow you to adequately construct a money management model that will give you the optimal position size.

Michael Covel, author of the book Trend Following, sums up money management as follows:

Trading correctly is 90% money management, a fact that most people want to avoid or don’t understand. However once you have money management down, your personal psychology will be 100% of your trading success. Once you have the rules, you still need to follow them.

Build a total trading strategy. Do not overlook money management as an integral part of that strategy. Set the rules. Then stick to those rules.

The risk of loss in trading commodity futures and options can be substantial. Before trading, you should carefully consider your financial position to determine if futures trading is appropriate. When trading futures and/or options, it is possible to lose more than the full value of your account. All funds committed should be risk capital. Past performance is not necessarily indicative of future results.

The content of this article is Copyright © 2007 by Chad Butler. No part of this article may be reproduced in whole or in part without express written permission of the author.