A Discounted View

In his book, Trading Systems and Methods, Perry Kaufman provides some simple, non-mathematical rules that all traders should employ when running a trading program. While there is a purpose and time for using statistics and more advanced mathematical concepts to manage risk, these guidelines will help keep your trading on the path to profitability.   Only risk a small amount of total capital on any one trade . This suggestion echoes the teaching of Dr. Alexander Elder who popularized the 2% Rule . Simply put, when trading you should never exceed a particular amount of risk in any one position that could compromise your performance. In the futures industry, risk-based position sizing algorithms  are commonly used to determine the ideal position size or Optimal f. Know your exit conditions in advance . Kaufman states that “There should be a clear exit criterion for every trade, even if the exact loss cannot be known in advance.” I...

Harry Markowitz, the founder of Modern Portfolio Theory, once said that “diversification is the only free lunch.” Decades since his seminal work in developing mean-variance efficient portfolios that maximize return for a given level of risk, this adage still holds true in most market environments. It is common practice for fund managers to diversify among asset classes based on Markowitz’s findings. However, diversification with his methods can be taken one step further .  While diversifying your account in all suitable asset classes is worthwhile, a trader can also diversify an account with different trading styles which will create uncorrelated return streams. For example, Perry Kaufman suggests that a well-diversified trader has an ideal mix of three, maybe four, unique strategies. Generally speaking, these three trading styles can be categorized as Trend Following , Mean Reversion , or  Pattern Recognition . Furthermore, styles can be differentiated by time horizon....

Executing sound risk management principles in your trading is essential to having any chance of investment survival. If one position is sized too large and generates an enormous loss, this can be catastrophic to your account as well as your psychology as a trader. Fortunately, there are methods you can learn that will protect your account. In The New Trading for a Living , Dr. Alexander Elder proposes a method for controlling risk at the position level which he calls the 2% Rule. This guideline states that the total risk in any position cannot exceed 2% of the current month-end account value. For example, if you have $100,000 in your account at the end of the previous month, the 2% Rule limits your maximum risk on any trade to $2,000. That is, risk is defined as the dollar value of the difference between your purchase price and stop loss and cannot exceed 2% of the account value under this rule. Be sure to not confuse 2% with the total position size. While 2% may seem sm...

Despite the title of this post, this is not another analogy between long-term investing and the story of the tortoise and the hare. Instead, in the trading world a Turtle is known as a protégé of Richard Dennis and William Eckhardt, who ran a Commodity Trading Advisor (CTA) business in Chicago during the 1970’s and 1980’s. These two traders conducted a trader training experiment based on disparate opinions on whether or not trading was an innate skill or could be developed. After the first round of successful training, another round of testing was completed with similar results. That is, the Turtle trader trainees were able to trade profitably using the set of rules taught by Dennis and Eckhardt. One of the trainees was Jerry Parker who went on to found and run Chesapeake Capital Management for the last few decades. His firm specializes in medium to long-term Trend Following  trading principles that he learned while in the Turtle program. In a recent interview Parker highlight...

January can often be a telling month for the stock market. In fact, the results from several studies have shown how January’s performance can be a harbinger of future stock market returns for the year ahead. One such study is referred to as the January Barometer. Specifically this stock market test assesses the direction of the Dow Jones Industrial Average (INDU) after the first five days, then the balance of January, in order to make a statement for the expected performance of the stock market during the remainder of the year. For example, Jay Kaeppel published his results of the January Barometer in Technical Analysis of Stocks & Commodities and found that the direction of the first five days of January, confirmed by a continuation of that pattern throughout the end of January, is often followed by the same pattern for the rest of the year. Also, if the market were to post a positive return for the first five days but reverse trend and end the month in the red, the expectations...

In trading, controlling the risk in a portfolio is determined by position sizing.  Most trading firms employ a fixed fractional contract position sizing method.  Under this methodology, positions are determined using the following formula: Fixed fractional bet sizing: Amount risked per trade = closing equity * fixed percentage risked per trade (e.g. 25bps) Once the Fixed-Fractional Contract Position Sizing Formula has been used to calculate the amount of risk to put on with a trade (in dollar terms), the Risk-Basis Position Sizing method is employed to determine how many shares or contracts of an instrument to buy or sell.  The Risk-Basis Position Sizing method considers the risk for each security, where risk per share is the entry price minus the stop-loss point.  It divides the total risk allowance (e.g. 25bps in dollar terms) by the risk per share to determine the number of shares to trade.  Legendary systems and Trend Following trader Ed Seykota o...