MARKET WEIGHTING

When the equity moved past the first level at whichrisk increased, the number of S&P contracts to be traded moved totwo whereas the number of corn contracts had to be increased to six!Therefore, when 20 contracts were being traded in the portfolio, 60contracts were actually being traded in the corn markets becausecorn was weighted at 3 contracts per units traded in the S&P. Therefore,when 20 contracts were being traded, it was actually 20 units of3 contracts per unit in the corn market.Market weighting through money management is different. Instead,every market starts off with the same number of single contracts.The difference is the rate at which each market increasescontracts. Through the original way of applying money management,as soon as a level was surpassed in the equity, the risk would be increasedacross the board regardless of the markets being traded becausethe drawdown of the combined markets had already been takeninto consideration. In other words, the markets were deindividualized.It merely became a numbers game to which the markets that generatedthe numbers were completely irrelevant (and rightfully so, as the equitycurve cannot discern which markets generated what numbers).Market weighting through money management attempts to takethe individual characteristics of each market and/or system as well asthe combined effect of the markets and apply money management toeach market according to its own performance while benefiting fromthe other markets or systems that are being traded. If there are threemarkets being traded-the bonds, S&P, and corn markets-each hasits own performance track record. The only characteristic we will lookat on an individual basis is the largest expected drawdown. If thebonds’ largest expected drawdown is $8,000 while the S&P’s largestexpected drawdown is $12,000, and that of the corn is $4,000, thenmarket weighting through money management will apply a differentdelta to each market. However, it will generate the profits to surpasseach increase level from the combination of all three markets.For example, if the combined drawdown of the three markets were$12,000, the original money management method would increase contractsfor all three markets with a $6,000 delta. However, 75 percentof the combined drawdown may be attributed to the S&P, while thebonds and corn markets only made up 25 percent of the drawdown.Therefore, during the drawdown, the S&P is tradingjust as many contractsas the markets that don’t contribute to the drawdown to thesame degree. As a result, the S&P may increase according to a $6,000delta, the bonds according to a $4,000 delta, and the corn according toa $2,000 delta. The corn will be the first to increase, then the bonds,and then the S&P. As a matter of fact, the corn will go to three contractsat the same level the S&P goes to two contracts. But, it will notstart out with more than one contract in any given market.The effects of this method should not be confused with equalweighting the markets prior to applying money management. Weightingthe markets through money management is not equalizing themarkets, but rather applying different weights to the degree of riskeach market offers. If one market offers a much smaller degree of risk,we aren’t increasing that risk to meet the degree of risk of the othermarkets; rather, we are allowing the market to increase contractsmore efficiently than the markets with greater risk. Therefore, we areequalizing the profit potential of the market according to profits thatare generated. Remember, all markets start out with the same numberof contracts, and therefore we are not increasing the risk.There are several things to take into consideration when weightingthe market through money management. First, it is a more efficient1424144 MARKET WEIGHTING THROUGH MONEY MANAGEMENTform of money management. Because it is allowing certain marketsto increase faster than others markets, the effect of geometricgrowth is an increased acceleration rate. Second, even though it isnot equalizing the risk of each market being traded, it increases thedrawdown potential slightly. The market that accounts for the bulk ofthe combined drawdown may be increased at a slower rate and nottrading as many contracts as the other markets, but at the time thedrawdown occurs, the other markets are trading more contracts. As aresult, the increased efficiency allows for the trader to use a moreconservative delta across the board. Instead of using a delta of % thelargest drawdown of each market, the trader may apply a delta equalto 74 the size of each drawdown. This has the potential of yieldingmore profits while keeping the drawdown at, the same level as theoriginal application of the Fixed Ratio money management method.Table 10.1 is a fictitious track record trading crude oil, bonds,and the Japanese yen. The dates are fictitious and are only shown toTABLE 10.1 Trade History for 3 MarketsCrude = $300, Bonds = $600, JY = $900Entry Exit Market P/L*AccountBalance Contractsl/1/98 l/1/98 Bonds $ 500 $ 500 1l/2/98 l/2/98 J Y 1,000 1,500 2l/3/98 l/3/98 Crude 1,500 3,000 3l/4/98 l/4/98 Bonds 1,500 4,500 3l/5/98 l/5/98 J Y 1,500 6,000 3l/6/98 l/6/98 Crude 3,000 9,000 6II7198 l/7/98 Bonds 3,000 12,000 6l/8/98 l/8/98 JY 2,500 14,500 5l/9/98 119198 Crude 5,000 19,500 10l/10/98 1110198 Bonds 4,000 23,500 8l/l l/98 l/11/98 J Y 3,500 27,000 71112198 l/12/98 Crude 6,500 33,500 1 3l/13/98 l/13/98 Bonds 5,500 39,000 1 1l/14/98 l/14/98 JY 4,500 43,500 91115198 l/15/98 Crude 8,500 52,000 1 71116198 l/16/98 Bonds 6,500 58,500 1 3l/17/98 l/17/98 JY 5,500 64,000 11l/18/98 l/18/98 Crude 10,500 74,500 21*All trades under the P&L column were $500 based on single contract.MARKET WEIGHTING THROUGH MONEY MANAGEMENT 145illustrate that all markets are being traded simultaneously. Further,there are no losses in this record and all trades are winning trades of$500. Accordingly, with 18 trades, the net profit of this illustrationwithout any money management is $9,000.The table shows a different delta being applied to each marketusing the Fixed Ratio money management method. The delta appliedto each market was $300 for the crude, $600 for the bonds, and $900for the yen. In other words, once the equity rises above $300 (regardlessof the market that generated the profits), the crude oil will increasea contract. However, both the bonds and the yen will remain atone contract. If the equity dips below the $300 profit level, then thenumber of contracts being traded in the crude drops back to one. Twocontracts are not traded in the bond market until there is at least$600 in profits. This can come from profits trading two contracts inthe crude if necessary. At the $600 level, crude remains at two contracts,the bonds increase to two contracts, and the yen remains atone contract until the equity moves above the $900 level.For Table 10.1:Columns 1 and 2 = Entry and exit date of tradeColumn 3 = Market tradeColumn 4 = Profit of each individual trade(profit is determined by multiplyingthe number in column 6 by $500.$500 was the amount of the profitfrom trading just one contract).Column 5 = Cumulative net account balanceColumn 6 = Number of contracts that weretradedFor Table 10.2:Columns 7-9 = Account levels at which each marketwould increase contracts.For example, row 7 has in column 10 the number 8. Thismeans that the account minimum required to trade 8contracts is $8,400 for the crude oil, $16,800 for thebonds and $25,200 for the yen.Column 10 = Number of contracts to trade at eachlevel (given in column 7 example)146 MARKET WEIGHTING THROUGH MONEY MANAGEMENT MARKET WEIGHTING THROUGH MONEY MANAGEMENT 147This scenario turned a $9,000 profit record based on trading asingle contract into over $74,000! Compare this to simply using a$900 delta for all markets, which decreases the total net profit from$74,500 to only $45,000. The net profit from using a $600 delta on allmarkets is at $62,500 and a delta of $300 across all markets came toonly $111,500. The closest delta across all markets to equal the marketweighting effect would be to use a delta across all markets ofTABLE 10.2 Fixed Ratio Reference Table Using the RatioEfficiently Valued MethodCrude Oil BondsLeveP LevelbJYLevel’ Contracts$ 3009001,8003,0004,5006,3008,40010,80013,50016,50019,80023,40027,30031,50036,00040,80045,90051,30057,00063,00069,30075,90082,80090,000$ 600 $ 9001,800 2,7003,600 5,4006,000 9,0009,000 13,50012,600 18,90016,800 25,20021,600 32,40027,000 40,50033,000 49,50039,600 59,40046,800 70,20054,600 81,90063,000 94,50072,000 108,00081,600 122,40091,800 137,700102,600 153,900234567891 01 11 21 31 41 51 61 71 819202122232425$475 which would yield a net profit of $77,000 while trading 17 contractsacross all markets.The key here is once again, the potential drawdown. If one marketor method has a tendency to produce larger drawdowns, that marketmay also “hold back” other markets because the delta is based on theinclusion of the unusually large drawdown. By using a set deltaacross the board of $475, the market that might be responsible for alarger part of a following drawdown if trading 17 contracts instead ofonly 13 as indicated in Tables 10.1 and 10.2. Therefore, the risk wouldbe slightly higher. Meanwhile, the other markets are increasing contractsfaster and are naturally offset in drawdown by the ability toadvance from all other markets.This method will not yield more profits with lower drawdownsevery time it is applied. However, based on the logic explained in thischapter, the track record for increased returns should be positive. Asa general rule, the geometric growth caused by the implementation ofthe method should begin sooner because the markets with smallerdrawdowns will increase faster than if a single delta were usedacross the board. This method is available in the most recent upgradeof the Performance I money management software if you want to testit out.