TRADING TECHNIQUES
Building An Angled Equity Curve
Risk Management, Position Sizing, And Probability
Implement a well-planned strategy before initiating your next trade so you can sustain losses. This methodical approach allows you to consider all the factors before initiating your next trade so you can build that elusive 45-degree angled equity curve with your trading capital.
Say you’ve booked 16 winning trades in a row. Your account has jumped 12% in value. Your ability to define your edge has never been more focused and your confidence increases with each and every successful outcome. But out of nowhere comes—November 18, 1985, Monday Night Football. Millions of viewers watched in horror as an event still considered to be the most shocking moment in Nfl history unfolded. Within seconds, an attempted blitz literally snapped quarterback Joe Theismann’s leg, causing a horrific compound fracture and putting a definitive end to his career.
This event had the same characteristics that too many traders are all too familiar with, in which a trade we didn’t see coming blindsides us and not only wipes out our profit but cripples our account to the point of “retirement” without a fresh injection of capital. This happens every day in trading and perhaps it has even happened to you.
Most of us have experienced something similar at some point in our trading career. So how could we let this happen, and more important, how can we prevent this from ever happening again? You can do this by employing three simple disciplines: risk management, position sizing, and probability.
The need for three
As a trader and student of the markets, I have suffered more “blitzes” in my 12-year trading career than I care to discuss, and like so many traders before me, I decided to treat my trading like a business. Once I did that, trading became boring, but boring can be so profitable!
Three years ago in March 2006 I decided to get off my personal roller-coaster (otherwise known as my equity curve) and hop aboard the merry-go-round. The ups and downs are minimal and expected, while you are constantly moving in one predictable direction. I created an Excel-based program that I called the m3, an acronym for “Money Management Modeler,” and it has changed the way I approach the markets. It began with a trade I was about to put on, but first, I pulled out pen and paper and answered these questions:
- If I get stopped out, how many points am I willing to lose before I realize that this trade just isn’t going to work out?
- If I do lose, how much money will it cost me?
- In percentage terms, what does that dollar loss represent of my trading capital, and am I comfortable with these numbers (dollar amount lost and the percentage of my trading capital)?
- If the trade is a winner, where do I want to exit or take my profits?
- Do I want to sell all of my position if it is a winner, or do I want to scale out in the event that the trade moves substantially in my favor?
- If I have defined an edge as to why I am initiating the trade, what is the probability of a successful outcome?
I needed a tool that addressed the three disciplines I felt I lacked consistency in: risk management, position sizing, and probability. It has been said that trading is 90% mental and the rest is easy. Let me tell you from personal experience: I couldn’t agree more.
Figure 1: THE two-LEGGED EXIT. On the surface this appears to be the superior option. You can see that it results in a profit of $78,000.