Fixed Fractional Money Management:
May 16, 2005
While fixed fractional money management is the backbone of the billion dollar plus professional commodity trading universe, its use in individual investor trading system portfolios is often lacking. Do the professional managers know something the individual investors do not? Definitely!
One of the main differences between professional CTAs (Commodity Trading Advisors) and individual trading systems investors is that the professionals manage risk much better, often resulting in them having smaller drawdowns and less volatility. A big part of the better risk profile of professional CTAs lies is their use of different types of fixed fractional money management.
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 Crude Oil 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.
While many investors understand the ability of fixed fractional money management to keep drawdowns and worst case scenarios within acceptable levels, one of the biggest strengths of the approach is its contributions to diversification through the normalizing of both risk and return.
Normalizing Risk & Return
When speaking of normalizing risk or return in a portfolio, we are really saying we want the same risk and 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, with 25 times the risk - the Crude Oil is dominating the portfolio.
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.
Many of you are probably asking how you know the risk per trade.....and that is a valid question. The risk per trade is given by the system, and is either the hard coded dollar based stop level or the dynamic volatility based stop level. In either case, the system must issue a dollar based stop level before the trade entry in order to employ a fixed fractional strategy.
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.
While we have focused on normalizing risk, the goal of a fixed fractional approach is also to normalize returns as best as you can. 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 |
Choppy market conditions in the US Stock market made trading difficult for most systems last week . While Crude oil prices dropped -4.01% and unleaded gas lost -4.22% for the week, stocks were under pressure most of the week. The end result for SP day traders was a back and forth market that was very difficult to predict with SP futures falling -1.24% and NASDAQ futures up +1.09%.
The US Bond markets continue to ignore interest rate increases and inflation numbers as 30 year bond futures climbed 1.45% last week. Just as surprising is the US Dollar’s recent comeback. The US Dollar Index rose another 1.75%, while Eurocurrency fell -1.50% last week. Gold futures fell -1.45% as well, mainly due to the new found strength in the US Dollar.
In commodity trading the grain markets continue to be the most aggressive movers outside of the energies. Much to the delight of trend followers wheat and corn prices continue to fall with CBOT wheat futures moving -4.50% lower while corn futures dropped -2.28% last week.
**Day Trading**
A few systems were able to pinpoint the few and far between profitable trading opportunities last week. Chief among them was Day Breaker, which had another impressive week in making $800 per contract on three trades. The trade of the week for the system came on Wednesday when the market had sold off for most of the morning, and following a large spike down on little volume the system went long using its counter-trend logic to profit $1,550 on the trade. The Electric Day Breaker portfolio performed similarly, making $795 trading across the ES, NQ, eRL and eMD..
AG Xtreme traded just once on Monday for a gain of $325 and was able to avoid some of the choppiness that the other systems struggled with by staying out of the market. Helix ES used its reversal logic on several occasions and profited a total of $312.50 per contract. RC Success also was able to stay above water, making $167.50 per emini.
Compass and Clipper were both unprofitable for the week losing -$558.50 and -$180.80 per contract respectively. Impetus eRL had a few losing trades amounting to a debit of $245.90 per emini Russell contract. R-Mesa couldn’t catch a break last week losing another -$2900 on two trades. Magnitude ES and Cipher ES were both on the losing side of the coin last week giving back- $442.50 and -$87.50 per contract.
The BWT systems struggled across the board both in the SP and Emini Russell. BWT Zones SP lost -$2,612.50 per contract after losing on three out four trades for the week. BWT Zones Russell was overly active last week and was deep in the red for a loss of -$1,765.50 per contract. BWT Rock N Russell got caught up in the choppy conditions as well, losing -$1,886.70 per money management unit using the position manager. RC Miracles ES continues to sink deeper into drawdown, giving back another -$1,560 per contract last week.
For all those contrarian investors out there who love getting in at the bottom of a drawdown instead of at new equity highs, it sure is looking like a good time to get involved with any of the Blue Wave systems.
**Swing Trading**
Last week saw the old adage 'what goes up must come down' hold true, as stocks finished the week lower. Along with the market reversal came several new positions for the Axiom Index portfolio and Eclipse eRL which both operate on intraday charts. In the mean time Tzar and Mesa which utilize daily bars for electing signals held all of their open positions from the prior week.
Including both open and closed trade equity the Axiom Index portfolio continued its recent drawdown by ending the week down -$2,112. The portfolio has been caught in a sideways trend after a few quick momentum shifts resulted in the rapid erosion of open trade equity. Axiom eMD was the only profitable sub system on the week earning +$400.90.
Eclipse eRL is another system that has also been caught in the recent momentum shifts. The system earned +$222.10 last week but is currently down -$311.12 for the month per contract.
In other trading, the Tzar portfolio held short the entire week and was able to capitalize on the down trend. Going into the weekend Tzar 4 market portfolio was ahead by +$1,630. Tzar eRL was earning $1,570, Tzar eMD was ahead by $1,245, while Tzar NQ was down -$850, and Tzar ES was losing -$335 per contract.
Finally, Mesa Bonds and Notes didn't change their long bias last week and are currently holding onto open trade profits of +$5,825 and +$2,559.37 per contract.
**Long Term**
The aggressive moves in the financials and grains continues to help trend followers as most are long in the bonds and short in the grains. Many systems have also entered short in the foreign currencies as markets like Eurocurrency, the Swiss Franc, and Canadian Dollar move lower.
First in the bonds Aberration is holding long in the Eurex Euro-Bund (German 10 year) for profits of +$1580.00 per contract. The Bund is the European equivalent of the US 10 year note and this market has had several great up trends already in 2005. Andromeda is also holding long in the Bund for profits of +$1450.00 per contract. This system has been more aggressive in the bond markets and is also long US 30 year bonds for profits of +$356.25, US 10 year notes for profits of +$1403.11, and Muni bonds for open trade profits of +$356.25 per contract. Finally, Axiom LT has identified a couple good bond trends as well holding long in the 30 year bonds for open trade profits of +$1762.50 per contract and profits of +$1075.00 per contract in the 10 year notes.
Axiom LT is also active in the foreign currency markets with open trade profits of +$990.00 per contract in the US Dollar Index and open trade profits of +$1975.00 per contract in the Swiss Franc. Other position holders include Aberration which is making +$310.00 per contract in the Canadian Dollar and Andromeda which is making +$175.00 per contract in the Swiss Franc, and SEMA4 Symmetry which is making +$237.50 (open trade) in the Japanese Yen and losing -$3160.00 (open trade) in the Aussie Dollar.
Finally, the grain markets have provided several great downward trends for system traders. Andromeda is short in corn for open trade profits of +$1525.00 per contract, although the system gave back -$1237.50 per contract in soybean profits last week. Aberration Plus is also short in corn for gains of +$62.50 per contract but these profits are offset by the systems losses of -$356.50 per contract in soybean oil. SEMA4 Symmetry is in a slew of grain positions as the system is holding long in oats and KC wheat while holding short in the soy meal, corn, and Minneapolis wheat. The short trades are profitable as the system is making +$580.00 per contract in soy meal, +$500 in Minneapolis wheat, and +$625.00 per contract in corn. The system is losing -$887.50 per contract in oats, and -$725.00 per contract in KC Wheat.
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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.