Rogue Traderette

Cover of Trade Your Way to Financial Freedom

When most people talk or think about trading systems, they are generally referring to entries and exits.  And while my system obviously has those things I would say they play just a very small role in a much more intricate construction.

The back bone, and main foundation behind my system is money management and risk management.  It’s the backbone in the sense that it is the very thing that holds it all up and stops it from falling apart at the seams.

I’ve coupled both risk and money management together here, because in the system I’m testing they go hand in hand.

I discovered early in my trading career that defining my risk before entering my trades, and making sure of it through the use of stop-losses was a rather prudent thing to do if I didn’t wish to self-destruct within 3 weeks.   (Thanks to Louise Bedford’s book “Trading Secrets”- it was a great read for a clueless newbie!)

My new method relies heavily – in fact hinges upon – the use of a stop-loss, and a predefined maximum loss on each trade.   (I should make it clear that I’ve devised the system to be used with CFD’s, simply because of the availability of guaranteed stop losses (GSL).  These lovely things basically remove the risk of slippage due to gapping.)

My ideas for the money management in this system came from Van K. Tharps book “Trade Your Way to Financial Freedom”.

In it, Tharp talks about opportunity and expectancy.  While they aren’t actually related to money management, I’ve incorporated the ideas into my system through the way I manage my cash.

In a nutshell, the expectancy of your system is basically the (probability of winning * average win per ‘$’ invested) – (probability of losing * average loss per ‘$’ invested). This gives you the average result of your system, per trade.  If the result is a negative number you’re playing a losing game, but if it’s a positive number over time you will come out a winner.

My system works on the theory that my losses are capped small (1R*) with my stop-loss, and the wins are capped by profit targets – but a target hit will return between 2.5 – 4R*.    This way, I can win less than half my trades and still come out a winner overall.

You’d tend to think that the higher the expectancy figure the better – however, you have to add in the amount of opportunity you get to trade.  That is, how many trades the system gives you.

If you have a system that has an expectancy of 2 that gives you 10 trades a year (result -  2*10 =  20), and a system that has an expectancy of 1 that gives you 40 trades a year (result 1*40 = 40), you can see the lower expectancy system is actually far more profitable.

By combining the principles of defined risk^, maximum opportunity and a positive expectancy, then adding the leverage provided by CFD’s, as soon as any position moves in my favour I can take risk capital off the table by moving my stop, and am free to apply it to a new position.  This maintains a steady level of total capital at risk while allowing me to open a large number of positions, thus maximizing my opportunity to trade**.

Even though I’m capping my wins in this system, the positive expectancy coupled with maximum trading opportunity should negate the limited profit potential of individual trades.

So that’s the idea behind daily system.  In my next post I’ll pad it out with a few more principles that are important to me in terms of the trades themselves.