Tuesday, October 15, 2013

Acheiving a goal at Minimum Risk

A given strategy has an entire set of expectations and probabilities of those specific expectations. This along with how much you risk per trade, and the average time per trade (how many trades per year) will determine whether or not you reach your goal, and with how much volatility and risk. Over the short run, luck can certainly play a role which is why you might look for a 10 year goal based upon 10 years worth of compounding at your expected return.

Your goal should aim a little bit higher since these are only "expectations", and then aim at reducing the risk to get to that goal. There are limits to any strategy so your goal has to be something that is mathematically reasonable based upon a long enough sample size of your past history with this model. Any "backtesting" method may show you great returns, but until you also take what worked in the past and see if it continues to work as effectively as it did when you backtested it you simply don't know, and even then it may not work as good in the future and is not without potentially substantial "unknown" (black swan) risks such as a 1987 event. Some common sense and respecting that the possibility for an even greater decline than the 1987 crash in a very short period of time exist, however rare.

If your goal is realistic the next step is minimizing the risk. The best way to do this is determine at what point can you reduce the amount risked and still achieve the goal?

You do this with multiple bets at a low correlation until the point where adding any more bets or reducing the bet size becomes harmful to your return due to the fees making a greater percentage of the trade. Also, each trade should have a slightly lower expectation than the best available trade even though due to uncertainty the first few trades there may not be much difference..

With everyone's bankroll they will have to adjust. You can review your 10 year strategy every year and make adjustments, but by looking 10 years into the future, you seek to minimize your risk and work on a goal that works without being unrealistic and also while understanding that each year at a time you may be on or off track.

This sounds all nice in theory but the actual calculation involving both fees, probabilities, percentage ROI given those probabilities, bankroll size, variability of bankroll over time, changing dynamics of the non-linear system known as the stock market (which may effect your expectations) and money management strategies over time appear to be a nightmare of a calculation.

Fortunately taking things one step at a time and adjusting the spreadsheet over time I believe I will accomplish the construction of this tool. I am very excited to see how it integrates a large bet size meaning a small fee, and more bets at a lower correlation adding to the effectiveness of the trade at various bankroll sizes.

At what point can one no longer "diversify" without reduced long term growth than if they concentrated their portfolio into one bet with the rest in cash? Or perhaps 2 or 3 or 4? This will be real fun to work with because I can come up with some very interesting conclusions about just how much one needs to get started.

Of course, not everyone will be experienced to have the kind of edges I am tinkering with, or the ability to leverage via options or the mental and emotional composure to handle the swings or monitor multiple trades. And reality just doesn't always work out as well as theory. If people just ran with the system completely and totally and managed their money properly every single time they might be able to achieve those kind of results but it simply isn't reality. Everyone wants to bet more after they've won 3 or 4 or 5 in a row.There are psychological reasons people make mistakes and eliminating all of those is a series of several long posts just to scratch the surface and requires the development of discipline on your own.

Most everyone is afraid to risk as much after 4 or 5 losses in a row while some people even risk more than they should after a few losses. Everyone comes across something that convinces them to do something else than their strategy. There may be a few exceptions to some of these statements and perhaps there even are some traders where none of this applies, but it is extremely rare if it exists and most of the people who believe "they're different" are exactly the ones to be humbled by the market the hardest.

But I believe I can take what I know with regards to the spreadsheet and my trading and apply it. And If I can do it, certainly that gives hope to those just starting who are using excuses such as "I don't have enough money" to get started. Certainly the spreadsheet and knowledge that it works in simulation even after some hardships can be helpful.

Also, I must mention that I am not the only one who has proven being low funded isn't something that will prevent you from success entirely. Dan Shy aka Airelon over at investorandtrader.blogspot and nononsensetrading.com has achieved a few "challenges" such as starting with a very small account and adding very minimal capital and achieved success growing account.

Once I complete my spreadsheet, I will be aiming for the moon in returns with a very small account, with minimal volatility to aim for that goal to show not only is starting small possible, but the "big returns" that are reserved for the elite traders are still possible.

I may be overreaching my own abilities and experience here, but I will construct a challenge intended on stretching me and getting me to really focus down on what I can do.

Just an idea what I think I may aim for is a 20% return with $1000 without violating kelly criterion strategy based upon expectations that are at least somewhat realistic. I plan on turning a lot of heads. Maybe I will aim for larger with more capital at risk, I don't know yet.

The big problem is the difference between that strategy having that kind of success and failing miserably is really a fine line. if you have $7 per trade it's $14 to both buy and sell and thus with bet size of say $400 thats 3.50%. That just isn't going to fly because you have winners and losers and it hurts you on both. Averaging 3.5% per trade just doesn't work. So for starters I need $5 commission or less. (possible). Then $10/$400 is only 2.5% and that I can deal with. But if I run a strategy where I gain around 3.% average per trade that turns out to be 1% But I could only afford to do 2 trades at once which would probably be too much anyways. With 1% per trade the volatility makes it worse and the fact I will be using 40% of my portfolio means it will even be less. maybe .2% per trade with a trade a week will be 10.5%. To generate the other 10% I really will have to work some magic. Part of the process will be improved if I get some gains because the fees will be less (but it can go the other way and get to the point of not even being worth the bet).

I may be better off using options, but if I am spending $5 per option contract of say $.50 that's $50 per option contract plus $10 fee or it requires 20% gain per trade. Well if I use 2 contracts I get that down to 10%. With leverage, is it even possible with a small amount to make up the fees at a smaller cost? It may be. I really have to crunch the numbers. The numbers are going to give me the revelations that I need to determine the exact challenge once I am ready with all the spreadsheets I want to have. This will determine the strategy and allow me to maximize it. I can run expectation on trade one and continue on trade two, but keep in mind every individual trade could go one of two ways leading to possibilities that the fees really hinder me if I get a few losses. Especialy if I am trading short term rather than looking for some bigger gains. I am not quite sure what the ideal play is to grow my account but I will figure it out at some point.

Ultimately once you determine the "goal" your idea should be to maximize your chances and minimize your risks while still doing the minimum to obtain that goal. You may fall short, but it's much better than doing too much and potentially falling way short or even losing as a result of being overly aggressive.

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