Fixed Fractional Money Management
May 22, 2006
We mentioned several times in last week's newsletter the "risk per trade" a system will issue, and how several trend following systems have not participated in the recent energy or metal market rallies because the "risk per trade" has been too high, but what does all that really mean?
Those references last week begged the question(s) of how do different systems come up with a risk per trade number, and more importantly - what does that risk per trade mean to the individual system investor? As always - we're glad you asked.
A system's "risk per trade" is exactly as simple as it sounds. It is the maximum amount of money the system is willing lose on that particular trade before signaling an exit. Now, there are things like slippage and limit down moves which can cause the end result to be a little larger of a loss than the system intended. But for the most part, a system's "risk per trade" is the amount of risk an investor is taking on the next trade.
Systems come up with their "risk per trade" numbers in a myriad of ways, but the two most common being a hard coded stop loss dollar amount (risk $2,000 on each trade, for example) and a volatility based risk which uses some variant of recent volatility (Avg True Range, 2 Stdev of price, etc) to generate a risk per trade number.
Two real life examples are Trend Simplicity, which risks just $1,300 per trade no matter what the commodity or recent volatility; and the old standby Aberration, which risks the difference between the entry price and the 80 day moving average. For example, Aberration could risk $300 on a Corn trade, or $14,000 on a Natural Gas trade using its volatility based risk per trade.
Because the volatility has been so high in markets like Copper, Gold, and the energy markets - the risk per trade numbers that systems like Andromeda, Aberration, and Brix have shot out recently have been as high as $15,000 in some cases. Say you have a $100,000 account, would you risk 15% of that one just one trade? I sure wouldn't, and most trading systems investors would not as well - because they use Fixed Fractional money management.
Fixed Fractional Money Management
Because a system that uses volatility based risk per trade numbers can see risk per trade as high as $10,000 per single contract - most trend following systems use a simple but effective money management approach called Fixed Fractional money management to handle the varying risk per trade amounts.
Fixed fractional money management sounds quite complex, but really boils down to a simple tenet of risking no more than a fixed percentage of your total equity on any one trade. So if you have a portfolio of $100,000 - a fixed fractional approach risking no more than 2% of your equity on any one trade would have you risking just $2,000 on each trade ($100,000 * .02 = $2,000)
The usual risk percent level for professional managers is somewhere around 1% - 2%, and is more often than not below 1%. It is simply not worth it for advisors managing hundreds of millions of dollars to risk their career on a single big bet, thus they make many small bets instead - knowing there are many markets, and that there will be many trading opportunities in the future.
So if the fixed fractional money management strategy you employ recommends risking no more than 2% of equity on any one trade, you don't take any trades whose risk is more than that level. In our example from above ($100K in capital risking only 2% per trade), a Natural Gas trade which gave its initial risk as $7,500, for example, would be skipped, as you are not willing to risk 7.5% of your money.....you only want to risk 2%. This has the immediate and obvious effect of protecting your portfolio from devastating single trade losses, and the reason most trend following systems have not been involved in the energy and metal markets recently. The risk is just too high in their statistical opinion.
Market Too Risky - Use Minis
Many investors have been rightfully upset that their trend following systems have deemed trades in the energy and metals markets too risk as those markets have continued to add to impressive trends to the upside. If you can't catch the trend with a trend following system, what are you supposed to do?
One option investors now have is to employ mini contracts in their trend following portfolios. Using the above example of a Natural Gas trade risking $7,500 per full size contract, an investor using fixed fractional money management with a risk percentage of 2% and equity of $100,000 would have to pass on the trade.
But if we put the trade in terms of the mini Natural Gas futures contract, which is 1/4 the size of the full contract, the risk per trade becomes just $1,875 ($7,500 / 4) and our fictitious investor wishing to risk no more than $2,000 per trade can now get the exposure to the energy markets she desires.
Normalizing Risk & Return
To normalize, or balance, the risk evenly among commodities, an investor would trade a number of contracts such that the expected dollar risk for trading any particular commodity is roughly the same as that of other commodities in the portfolio. This results in an investor trading a greater number of contracts on lower risk trades.
In the example below, a fictitious system has issued a $500 risk per trade. Using a fixed fractional money management approach with a $100,000 account risking 2% of equity per trade, an investor would normalize risk by trading 4 contracts on this trade.
But a fixed fractional approach does more than just normalize risk - it also normalizes return across each sector of a portfolio, so as to maximize the benefits of diversification. As an example, a portfolio that risks $10,000 on a Crude Oil trade, but just $400 on a Corn trade has not normalized risk. The portfolio is heavily skewed towards Crude Oil, and although both markets are being traded, - the Crude Oil is dominating the portfolio with 25 times the risk.
Nobody knows which market is going to be the next one to have a big move, so you can't normalize the actual returns of each market. But we can normalize the expected returns at given levels of market movement. So if both Corn and Crude Oil increase 10%, we should expect to earn roughly the same amount of money from each market move, as we would be doing more Corn contracts to normalize the risk.
The image below is an example of different contract sizes in a well balanced portfolio normalizing risk and return with a fixed fractional approach.
While our examples have mainly concentrated on using a fixed fractional approach within a diversified trend following portfolio of many commodities, the logic can apply across your portfolio of systems. Too many investors normalize risk across commodities in their trend following programs, but fail to normalize risk across their day and swing trading systems.
In an ideal situation, every trade in an investor's portfolio of systems would utilize the fixed fractional approach. This will insure that your portfolio is balanced correctly between the day, swing, and trend following components, and keep the portfolio from being too heavily skewed to any one system, time frame, or market.
- Walter Gallwas
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can
carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for
everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading
losses are material points which can adversely affect investor returns.
Feature | Week In Review | Chart of the Week |
Feature | Week In Review | Chart of the Week |
***Overview***
US Stocks continued their slide last week as investors decided to take profits rather than wait and see if the markets rebound again. The VIX index, which measures volatility in the market climbed 21% last week alone, signaling traders that investors are becoming much more uncertain about the markets future direction. However, others argue that the recent round of selling is nothing to worry about and is actually necessary in order for the market to continue its upward movement. Regardless, last week was a rough one with SP futures falling -1.82%, NASDAQ futures were down -2.19%, Russell 2000 futures fell -2.20%, and Midcap 400 futures dropped -3.27%.
The commodity markets also saw their own round of selling as traders took profits in the metals, currencies, and energy markets. There were also rumors that a very large hedge fund was unwinding long commodity positions last week which may have exacerbated the selling across hot markets like copper, gold, and oil. The metals markets were hit hardest of all with Palladium falling -11.69%, High Grade Copper fell -10.22%, Gold dropped -7.63%, and Silver fell -1.32% for the week.
Energy futures also took it on the chin last week with Crude Oil dropping -5.44%, Heating Oil -5.70%, Unleaded Gas down -6.84%, and Natural Gas -4.71% lower. Grains were mixed with Soybeans (-4.24%) and Corn (-2.13%) moving lower while CBOT Wheat (+3.67%), Kansas City Wheat (+4.78%), and Minneapolis Wheat (+2.12%) all climbed higher.
The tropical commodity markets were also hit hard with Sugar falling -6.18%, Cotton down -5.17%, and Coffee falling -2.85%. Finally, US Bond futures (+1.51%) and the US Dollar Index (+1.07%) both rallied last week, while Eurocurrency (-1.07%), the Swiss Franc (-1.46%), and Japanese Yen (-1.53%) all moved lower.
***Day Trading***
The spike in volatility gave short term programs their opportunity to shine last week. Last week the CME experienced a surge in trading volume as indicated by Emini S&Ps trading over 1.8 MM contracts on Wednesday alone. Foreign stocks were even more lucrative to trade last week with 7 of 8 systems trading the Dax finishing the week with positive returns. Systems trading CME stock indices were profitable on the whole but several large overnight moves limited the profit-taking opportunity compared to those abroad.
SPmd had a breakout week (pun intended) with profits of +$7,397.20 on three trades trading the full-size S&P (+$1,397.50 per ES). The highlight trade came on Wednesday when the system shorted two contracts and made +$4,472.20. Phi Plus Dax followed a similar path on Wednesday going short two contracts and made +$3,086.62. Theta V1 Dax had a huge winner on Wednesday but finished the week with a small losing trade for total gain of +$1627.73 for the week.
Another group of Dax systems performed well but were less active than those previously mentioned. Beta V2 Dax had one trade on Wednesday for profits of +$1,068.82. BetaCon 4/1 Dax traded just once on Wednesday for a gain of +$1,004.83. BetaCon 4/1 ESX traded three times for profits of +$703.47. Rounding out the other Dax systems was Rayo Plus Dax which made a more modest +$255.79.
Compass SP reached its profit target on Wednesday but surrounded it with two losing trades for a net gain of just +$184.87 for the week. Impetus eRL had a losing trade on Monday but followed it up with two winning trades on Wednesday and Friday for total gains of $144 for the week.
McKenna YM had one trade on Wednesday that profited +$88.56 per contract. For those of you not familiar with the symbol YM or the McKenna system, the program trades the Mini Dow (worth $5 per point).
RC Miracles eMD and eRL were both initially right on several trades but got greedy and lost -$195 and +$1,587.50 respectively. R-Mesa SP was hot and cold but lost -$375 for the week. R-Mesa eRL followed a similar pattern and lost -$480. Kappa Dax struggled with direction last week and lost -$498. Epsilon Bund could not capitalize on the rise in Bund prices and lost -$965. RC Success eRL was off by -$1,003.40. Finally, Tanker CL lost -$1,150 per contract.
***Swing Trading***
Topping the charts among swing trading systems last week were 2 trades from Axiom eMD and eRL which went on to hit profit targets for the first time in several months – Axiom eMD closed out a profitable trade for +$3,775.50, with +$1,870 of that coming last week. Meanwhile, Axiom eRL ended the week +$1,710 after closing out its trade for a gain of +$3,970. Delphi eRL and eMD also hit profit targets last week. Delphi eMD gained +$840 for the week on a closed out trade of +$2,860 while Delphi eRL earned +$540 for the week on a closed out trade of +$3,860.
Other interesting trades from last week included Eclipse eRL which hit a profit target of +$4,400 and then reentered short – the system earned +$1,420 on the week. The always exciting Tzar system also took the opportunity to trade last week- the system had been holding short since late April and reversed long early last week locking in substantial profits. Tzar had the following closed out trades - Tzar eRL +$4,540, eMD +$2,730, NQ +$222.40, and ES +$1,282.50.
Those index system not performing well during last weeks sell off included Ping -$2,222.70, Targets eMD -$1,186.02, Seasonal ST eRL -$1,140, Pivots weekly NQ -$725, and Seasonal ST ES -$322.50.
Over in the FX markets trading picked back up as the markets appear to have consolidated since the last big up move – typical strategies will look to get involved in the markets more actively after market consolidation. Delphi EURUSD ended the week down -$1,570, Delphi GBPUSD lost -$850, and Hurricane FX ended down -$230.
***Long Term***
With energy prices on the rise many consumers are looking to ethanol and other replacements for oil and most consumers are familiar with the use of corn and sugar to produce e-85 type fuels. However, not many people know that other grains like soybean oil can be used to produce alternative fuels like bio-diesel fuel. Plus, even better for trend followers other grain markets like wheat are also rallying due to increased demand on all grain products, creating more trading opportunities for systems.
Several systems have taken advantage of the recent run up in all three wheat (Chicago, Kansas City, and Minneapolis) wheat markets. To be clear each market trades it’s own variety of wheat with Kansas City trading hard red winter wheat, Minneapolis trading spring wheat, and Chicago trading soft red winter wheat , but the results have been the same for trend followers. For those that are curious wheat is considered either spring wheat or winter wheat based on - you guessed it - the season it is planted in.
Systems with long wheat positions include Andromeda which is long KC Wheat for open trade profits of +$5562.50, SEMA4 Symmetry is long in KC Wheat for open trade profits of +$6737.50 per contract and Minneapolis Wheat ("MW") for open trade profits of +$2975.00 per contract, Trend Simplicity which is long MW for open trade profits of +$1050.00 per contract, and Axiom LT which is long in MW for open trade profits of +$1350.00 per contract.
Closed out trades from last week include SEMA4 Symmetry exiting sugar for profits of +$5668.00 per contract, Aberration exiting mini crude oil for a loss of -$2262.50 per contract. Axiom LT exited the Japanese Yen for profits of +$137.50 per contract while also exiting London Coffee for a loss of -$515.00 per contract.
Finally, Trend Simplicity exited a long Eurocurrency trade for profits of +$4637.50 per contract, a short 10 year note trade for profits of +$840.63 per contract, a short US bond trade for profits of +$5146.88 per contract, and a short crude oil trade for a loss of -$550.00 per contract.
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IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can
carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for
everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading
losses are material points which can adversely affect investor returns.