The Foundations of Money Management I

I've found such a system. With numerous tests it almost never had under 90% profitable trades. The results of one such a test are given in Table 1 in Omega Research TradeStation format. The code for the system is in Appendix 1; you may copy it to Omega TradeStation or SuperCharts and go along winning (in the sense they usually mean winning, that is, having a profit on most trades). The system's main secret is a pseudo-random number generator (too "pseudo" in TradeStation, but doesn't matter much). Then it all goes as usual: if the position is profitable, close it. If the market goes against us, turn investors. Having enjoyed working and socializing with customers of two brokerages over a couple of years, I can insist that is just what most traders do - except the fact they formally replace the random number generator with analytic forecasts, indicator signals, the neighbor's opinion in the pit or just a momentary impulse. The problem is that winning at an exchange and earning money at an exchange are far from being the same.¡¾½»Ò×֪ʶwww.irich.com.cn § macd.org.cn ÊÕ¼¯ÕûÀí¡¿

Surely, the profit seen in the Table 1 example is casual, a result of a lucky dice roll, whereas it would not be profitable in most cases. But if one changes the system entry parameters to more reasonable levels, i.e. sets mmstp=1, pftlim =4, maxhold =10, this will make the system profitable in most tests.

So exploiting the principal idea of speculation - close losing trades fast and let profits grow - combined with money management allows to earn money even from random trades. Most people act just opposite to this principle; they let losses grow, hoping the market turns and proves how right have they been, and quickly close their profitable positions to prove how right they're at the moment. Most beginners and many self-styled pros, as our experience shows, are sure that the skill of market forecasting equals the ability to earn money at the market. Getting a profit on a given trade for them means proving their prognostic abilities and, consequently, their skill in making money.

A person unfamiliar with trading as a business could be puzzled by the fact that "successful investing and trading have nothing in common with forecasting"*. There is bad news and good news. The bad news is: markets cannot be prognosed. The good news is: one doesn't need to do that to have profit. We are concerned not with getting a profit on every trade, but on making large sums when we're right. The number of profitable trades may in this case be less than losing, that is, it is possible to use worse-than-random forecasting!

As a famous trader Paul Tudor Jones said: "I may be stopped four or five times per trade until it really start moving". That is, Paul may win only on a measly 20-25% times! Yet he'd had three-figure (percents) of income in five consecutive years with very low capital corrections1. Almost 100% of Steve Cohen's very large profits are taken off 5% of trades, and only 55% of his trades are profitable at all. Despite that in the last seven years he'd made 90% per year on the average, and had only three losing months (the worst losses were -2%)2.

The widely used by professional methods of trend following, as a rule, bring about 30-40% of profit. Profits or losses in any given trade do not matter - as long as the amount of money earned per average trade is positive. This value is called mathematical expectancy. The mathematical expectancy equals the sum of products of profit probabilities minus the sum of products of losses probabilities, multiplied by the losses' size

Simplified, the expectancy may be estimated as the probability of profits multiplied by the average profit minus probability of losses multiplied by the average loss. In terms of the Omega Research TradeStation this looks like: