PROTECTING PROFITS

Decreasing risk faster than it was increased will protect profitsduring drawdowns. A trader might have several reasons for decreasingrisk faster than it was increased. First, it can limit the size ofdrawdowns. If the strategy or system being traded is prone to sufferinglarge drawdowns, decreasing the risk faster will ensure that thelarger the drawdown becomes, the less capital being risked duringthe drawdown.Second, it allows the conservative trader to be more aggressivewhen increasing the rate of reinvestment. The main reason tradersare not aggressive with money management is because they fear itseffect on the potential drawdown. Decreasing the risk faster insteadof at the same level results in a considerably smaller drawdown.A few negatives can be associated with the faster rate of decrease.These are the trade-offs for the benefits you receive. The biggestdrawback to using the faster rate of decrease is that it increases thenegative effects of asymmetrical leverage. As you decrease risk faster,the ability to gain back those losses also decreases proportionately. Ifall wins and losses are $1,000 in size per contract and 10 contractsare being traded and contracts are dropped from 10 to 9 through theconventional decrease rate, the required amount of money per contractto make up the last loss increases from $1,000 to $l,lll-thedecrease caused an 11 percent loss in ability to make up the previousloss. If the number of contracts dropped to 8 instead of 9 due to thefaster rate of decrease, the ability to make up the last loss dropped by25 percent. It now takes a win of $1,250 with 8 contracts to make upthe loss of $1,000 that occurred with 10 contracts. Obviously, if thenext trade is a losing trade for $1,000, the 8 contracts will lose approximately1 percent less on the next trade than will the 9 contracts.As the drawdown continues, the percentage lost through the fasterrate of decrease will become significantly smaller than the percentagelost through the conventional rate of increase.The math for finding a new rate of decrease when risk increasesat a set level is as follows:Where CL = Current levelPL = Previous levelX% = Variable percentageCL - [(CL - PL) x X%,1 = Next level of decreaseIf CL = $275,000 and PL = $225,000:$275,000 - [($275,000 - $225,000) x 50%1$275,000 - $25,000 = $250,000 (New level of decrease)98100 RATE OF DECREASE PROTECTING PROFITS 1 0 1The original level of decrease would have been at $225,000 instead ofthe new level of $250,000. This will also work just the same with thefixed fractional method. If the level of increase is one contract forevery $10,000, then the same equation applies:If CL = $100,000 and PL = $90,000:$100,000 - [($100,000 - $90,000) x m%l$100,000 - $5,000 = $95,000 New level of decreaseThe following examples illustrate decreasing risk twice as fast asthe rate of increase using the Fixed Ratio method with a $1,000 deltaon a strategy that will suffer an $8,000 drawdown (very aggressivemoney management relationship). Table 7.1 first shows the levels ofincrease starting with an account balance of $20,000. Then it showsthe account balance at $80,100, trading 11 contracts, and lists whatwould happen during the $8,000 drawdown based on the same rate ofdecrease as the increase rate.The drawdown suffered in Table 7.1 was an $8,000 drawdownbased on trading single units but turned into a $58,000 drawdown dueto the aggressive nature of the money management. Keep in mind thatit only took $11,000 in profits based on trading a single unit to makeit up to the $80,000 level in the first place.TABLE 7.1 100% Rate of Decrease with Drawdown of $B,OOOlevel of Level ofIncrease Contract Decrease Contract Drawdown$20,000-$21,000 121,001-23,000 223,001-26,000 326,001-30,000 430,001-35,000 535,001-41,000 641,001-48,000 748,001~56,000 856,001-65,000 965,001-75,000 1075.001-86.000 11$80,100 11 ($11,000)69,100 10 (10,000)59,100 9 (9,000)50,100 8 (8,000)42,100 7 (7,000)35,100 6 (6,000)29,100 4 (4,000)25,100 3 (3,000)22,100 2 Drawdown overTable 7.2 shows the same Fixed Ratio money management increaselevels as Table 7.1; the increase and decrease schedule is for adelta of $1,000 beginning with an account balance of $20,000. However,Table 7.2 has the rate of decrease set at twice the rate at whichrisk was increased.Unlike the first scenarios, which gave back almost all profits, therate of decrease did its job here and protected $16,100 of the profitsoriginally gained. Further, the example with the faster rate of decreasecan suffer an additional $16,100 drawdown based on a singlecontract before the account moves back to breakeven. Therefore, thetotal drawdown of the system being traded can go as high as $24,100and still not be losing money. This is staying power!However, the true test is the same situation without any moneymanagement at all. Remember that it took just $11,000 based ontrading a single unit to punch up to the $80,000 level. Without moneymanagement, the account would only have been at $31,000. After the$8,000 drawdown, the account balance would have been at $23,000without money management. This means that the increased rate ofdecrease coupled with an aggressive Fixed Ratio still produced 57percent more profits. After the drawdown, the single contract onlyproduced $3,000 while this combination of the Fixed Ratio methodand rate of decrease turned that measly $3,000 into over $16,000!This is the main benefit of using the faster rate of decrease.However, to get the full picture, we must now see what happens if theTABLE 7.2 50% Rate of Decrease with $8,000 DrawdownLevel of Level ofIncrease Contract Decrease Contract Drawdown$20,000-$21,000 1 $80,100 11 cm,000)21,001-23,000 2 69,100 9 (9,000)23,001-26,000 3 60,100 7 (7,000)26,001-30,000 4 53,100 6 (6,000)30,001-35,000 5 47,100 4 (4,000)35,001-41,000 6 43,100 3 (3,000)41,001-48,000 7 40,100 2 (2,000)48,001-56,000 8 38,100 2 c2,000)56,001-65,000 9 36,100 1 Drawdownover65,001-75,000 1075,001-86,000 11102 RATE OF DECREASE PROTECTING PROFITS 103-$8,000 drawdown is followed by a positive run of $12,000. With therate of increase and decrease being the same, recall that the accountwent from $20,000 to $80,100 and then back down to $22,100. Thedrawdown is now over and a positive run of $12,000 in increments of$1,000 per winning trade is shown in Table 7.3.The columns on the left show the account size going from $20,000to $80,100 and back down to $22,100 using the same rate of decrease.The columns on the right show the account going from $20,000 to$80,100 and back down to $36,100 using the faster rate of decrease. InTable 7.3, we reincreased contracts at the same levels as they were decreased.Notice that the same rate of decrease ended up making morethan the faster rate of decrease due to the effects of asymmetricalleverage. The difference in the outcome of the example was $112,100for the same rate of increase and decrease and $104,100 for the fasterrate of decrease. This constitutes a loss of $8,000 in profits or slightlymore than 7 percent less profits by using the faster rate of decrease.At the end of the drawdown, however, the faster rate of decreaseshowed a net gain of $14,000, or almost 700 percent more over thesame rate of decrease! Not a bad trade-off when the equal emphasis ison protecting profits.Table 7.4 shows what is called the reincrease switchback. Thistable shows a more efficient way to reincrease risk after the positiveTABLE 7.3 Re-Increasina after 100% and 50% Rates of DecreaseAccount A m o u n t Account A m o u n tSize Increment of Decrease Size Increment of Decrease$ 22,100 2 $ 2,000 $ 36,100 1 $ 1,00024,100 3 3,000 37,100 2 2,00027,100 4 4,000 39,100 2 2,00031,100 5 5,000 41,100 3 3,00036,100 6 6,000 44,100 3 3,00042,100 7 7,000 47,100 4 4,00049,100 8 8,000 51,100 5 5,00057,100 9 9,000 56,100 7 7,00066,100 10 10,000 63,100 8 8,00076,100 11 11,000 71,100 10 10,00087,100 12 12,000 81,100 11 11,00099,100 13 13,000 92,100 12 12,000112,100 104,100TABLE 7.4 Reincreased SwitchbackAccount Amount Account AmountSize Increment of Decrease Size Increment of Decrease$ 22,100 2 $ 2,000 $ 36,100 1 $ 1.00024,10027,10031,10036,10042,10049,10057,10066,10076,10087,10099,100112,1001 01 11 21 33,0004,0005,0006,0007 , 0 0 08,0009,0001 0 , 0 0 01 1 , 0 0 01 2 , 0 0 01 3 , 0 0 037,10039,10041,10044,10047,10051,100(almost 56,100even)65,10075,10086,10098,100111.100,2,0002,0003,0003,0004,0005,0009,000 (switch)1 0 , 0 0 01 1 , 0 0 01 2 , 0 0 01 3 , 0 0 0run begins. Originally, the reincrease in risk remained at the samelevels at which the risk decreased. However, at some point, the originalreincrease catches up and passes the reincrease after using thefaster decrease rate. The original reincrease had to start from an accountbalance of only $22,100 and ended up with an account balanceof $112,100. The faster decrease started at $36,100, more than theoriginal reincrease, but ended up at only $104,100, less than the originalreincrease. The idea behind this strategy is to switch from theincrease levels of the faster rate of decrease to the original reincreaselevels at the point that the original catches up to the fasterrate of decrease.Notice that this switching method causes the faster rate of decreaseto make up $7,000 of the original $8,000 lost due to the effectsof asymmetrical leverage. Using the faster rate of decreasegives the performance level high advantage over using the originalrate of decrease during aggressive money management strategies.However, a few risks are involved that traders should consider ifusing the switching method. The reason the lost profits are gainedback is because the number of contracts increases from five to ninein one jump. This is great if trading continues on a positive run but ifthe very next trade becomes a loser, it loses with nine contracts, notseven. You then would have to jump back down to four contracts,104 RATE OF DECREASE INCREASING GEOMETRIC GROWTH 105which would increase the effects of asymmetrical leverage all themore. Use caution when applying this method around the levels atwhich the rate of reincrease is switched.Also, the drawdown may not always be as large as that shown inthe example. After only a $4,000 drawdown, the account levels arevery similar. If the drawdown stops after $4,000 and the number ofcontracts being traded with the original rate of decrease is eightwhile the faster rate of decrease is only trading six contracts, youcannot use the switching method because you don’t know whether thedrawdown will continue. If you use this strategy at this level, you areactually not decreasing faster. Therefore, you should only consider itwhen there is a significant difference in the account sizes before thepositive run begins.INCREASING GEOMETRIC GROWTH(ABANDONING ASYMMETRICAL LEVERAGE)This is the flip side of using the faster rate of decrease. This strategycan enhance profits significantly if used properly. To illustratethe negative effects of asymmetrical leverage, (and hence the powerof abandoning it) we will go back to the coin-flipping example inChapter 2.The optimal f of that particular situation was reinvesting 25 percentof the profits on each flip of the coin. By doing so, the amountgained was $36,100 compared with the gain of only $4,700 using 10percent and the same using 40 percent. Recall also that this functioncreated a bell curve. Anything to the left or right of optimal f did notyield profits as high as optimal f itself. The bell curve exists as a resultof asymmetrical leverage. Take asymmetrical leverage out of thepicture, and you have an entirely different situation.Asymmetrical leverage is simply losing a portion of the ability toregain losses. If the number of contracts being traded is two and a lossdrops the number of contracts back to one, the ability to regain theloss has decreased by 50 percent. If the loss was $1,000 per contract,the total loss would be $2,000. If the next trade was a winner of $1,000but with only one contract, another winner of $1,000 is needed to makeup the original $1,000 loss suffered with two contracts. The way youget around this is to simply not decrease contracts at all.Going back to the coin-flipping example, trading 10 percent of theaccount balance meant multiplying the balance by .10 and risking thatamount on the next trade. If the account started with $100, theamount risked on the next trade would be $10. If the trade was a winner,the amount won would be $2 for every $1 risked. If the trade lostthe amount lost would only be $1 for every $1 risked. The accountwould either add the gains or subtract the losses and recalculate forthe next trade or flip of the coin. If the next flip was a winner, the accountwould increase from $100 to $120. The amount to risk on thenext trade would be $12. If the f o11owing trade were a loser, the accountwould drop down to $108 and $10.80 would be risked on the nexttrade or flip of the coin.Taking away the asymmetrical leverage says that if the accountrisked $12 on the trade and drops back to $108, the amount risked onthe next trade remains at $12. Take the highest figure risked and remainat that figure regardless of decreases in the account balance.This was applied to the coin-flipping method with the 10 percent, 25percent, and 40 percent fixed fractional increase method as discussedearlier.By taking asymmetrical leverage out of the equation, the 10 percentreinvestment increased from $4,700 to $11,526 (see Table 7.5).Risking 25 percent on each trade without decreasing raised theamount made from $36,100 to $6,305,843 (see Table 7.6). Notice thatthe performance is not subject to the bell curve found with asymmetricalleverage. At 40 percent, the profits achieved are not lower thanthe 25 percent but are at $1,562,059,253 (see Table 7.7). This is the potentialpower of money management when not affected by asymmetricalleverage. There is one catch, though. These results required thateach win be followed by a loss and each loss followed by a win. Usingthis method and risking 25 percent of the account would require onlyfour losses in a row to wipe the account out. Two losses in a row using$40 (or 40% of initial capital) would make it impossible to maintain a$40 bet on the third flip as there would only be $20 left in the account.This example was for illustration purposes only.There are ways of implementing at least a variation of this conceptin real-life trading, but not with the Fixed Fractional trading. Wheredrawdowns are big when using the Fixed Fractional method withasymmetrical leverage, they are downright enormous without asymmetricalleverage. Trading 10 percent would leave the account at zerowith 10 losing trades in a row. It would render the account useless wellbefore that due to margin requirements.However, by applying this concept to the Fixed Ratio tradingmethod, you have an entirely new ball game. Recall that the following114 RATE OF DECREASE SOMEWHERE IN BETWEEN 115TABLE 7.7 (Continued) relationship exists between the drawdown, number of contractsStarting A m o u n t being traded, and the delta being implemented:A m o u n t WonFractionalIncrease Result10,041,00023,429,ooo14,057,40032,800,60019,680,36045,920,84027,552,50464,289,17638,573,50690,004,84754,002,908126,006,78575,604,071176,409,500105,845,700246,973,299148,183,980345,762,619207,457,571484,067,667290,440,600677,694,733406,616,840948,772,627569,263,5761,328,281,678796,969,0071,859,594,3491,115,756,6092,603,432,0881,562,059,2532.00(1.00)2.00(1.00)2.00(1.00)2.00(1.00)2.00(1.00)2.00(1.00)2.00(1.00)2.00(1.00)2.00(1.00)2.00(1.00)2.00(1.00)2.00(1.00)2.00(1.00)2.00(1.00)2.00(1.00)40 8,032,8004 0 (9,371,600)4 0 11,245,92040 (13,120,240)4 0 15,744,2884 0 (18,368,336)4 0 22,042,0034 0 (25,715,670)40 30,858,8054 0 (36,001,939)4 0 43,202,3264 0 (50,402,714)4 0 60,483,2574 0 (70,563,800)4 0 84,676,5604 0 (98,789,320)4 0 118,547,1844 0 (138,305,048)4 0 165,966,0574 0 (193,627,067)4 0 232,352,4804 0 (271,077,893)4 0 325,293,4724 0 (379,509,051)40 455,410,86140 (531,312,671)40 637,575,20540 (743,837,739)40 892,605,2874 0 (1,041,372,835)Expected drawdown = $10,000Delta = $5,000Number of contracts being traded = 10Minimum number of contracts that can be decreased is two.$10,000 / $5,000 = 210-2=8To put this in perspective, if the account was at $250,000 trading10 contracts and a lo-trade losing streak occurred, the account woulddrop down to $159,000. By not decreasing during the drawdown, theaccount would drop down to $150,000 instead of $159,000. Thereforethe risk only increases by $9,000. The total drawdown would be 40percent instead of 36.4 percent. If the same $10,000 winning streakoccurred, the account would be back at the $250,000 level withoutasymmetrical leverage. With asymmetrical leverage, it would be at$248,000. Therefore the asymmetrical leverage has a much smaller effecton the ability to regain profits through application of a conservativeFixed Ratio.SOMEWHERE IN BETWEENThus far, we have discussed decreasing risk faster during drawdowns,decreasing at the same rate of the original increase, and not decreasingat all. In this last section, we discuss decreasing somewhere in betweenthe original rate of increase and not decreasing at all. Asmentioned earlier, not decreasing has a much smaller effect on theoverall additional risk when applied to the Fixed Ratio method. Thereason is the relationship between the delta and the largest possibledrawdown. If the delta is a value equal to the size of half of the largestdrawdown, then no more than two contracts can be dropped should thelargest drawdown be incurred. Should the largest drawdown be exceeded,however, then contracts are free to drop according to how farthe drawdown goes.116 RATE OF DECREASEWith this information, traders have a few ways to take advantageof the benefits of not decreasing up to a certain point. For example, atrader may want to stay at the highest number of possible contractsuntil the drawdown exceeds the largest expected level and then decrease.By applying this method, the trader is waiting to bail outuntil the last possible minute. This also allows the trader to avoidany asymmetrical leverage for all drawdowns that are smaller thanthe largest expected drawdown. Then, if that drawdown is exceeded,the trader will protect profits from that point on until the drawdownis over.Another method I use frequently is to decrease at half the speedthat I increased contracts. If the levels of increase are at 10, 20, 30,40, and 50, once I am over 50, I will not decrease until the accountmoves back down to 45. The original rate of decrease would have medecreasing at 50, 40, 30, 20, and 10. If I use a delta equal to half thesize of the largest expected drawdown, I will not decrease more thanone contract at any time as long as that drawdown is not exceeded.This variation of the rate of decrease accomplishes a slowed asymmetricalleverage effect. There is a situation where asymmetricalleverage can actually turn a $50,000 winning system into a breakevenunder the right circumstances. Albeit these circumstances may neveroccur in the real world of trading, let me illustrate it for you.Suppose you start with $20,000 in your account and will increaseto two contracts at $25,000. At $23,000, you have a winning trade of$2,000 that pushes the account to the $25,000 level. You now tradecontracts on the next trade. The next trade is a $1,000 loser, butsince you were trading two contracts, the total loss on the trade is$2,000. Now the account is down to $23,000 and you are back to tradingone contract. The next trade is a $2,000 winner again and oncemore, pushes the account to the two-contract level. The next trade isa $1,000 loser but again with two contracts.Do you see the cycle forming? The previous scenario based on tradinga single unit was actually up a total of $2,000. But, because ofasymmetrical leverage, the account is at a breakeven. This cycle cantheoretically go on forever. However, by applying a rate of decreaseslower than the increase, you can avoid this. Instead of decreasingafter the first loss, the number of contracts remain at two. The nexttrade is a $2,000 winner with two contracts and pushes the account to$27,000. Now when the losing trade is incurred, the account only goesdown to $25,000, not $23,000. Further, after the losing trade comesanother winning trade of $2,000 per contract. This pushes the accountSOMEWHERE IN BETWEEN 117up to $29,000. Progress is slowly being made with this rate of decreasewhere it would have gone nowhere with the same rate of decrease. Onthe next few series of trades, the account will move above the threecontractlevel and then not decrease unless a series of losing trades aresuffered.The rate of decrease can be placed at any variation the traderchooses. It doesn’t just have to be a percentage relationship to therate of increase. It can also be a relationship to consecutive losers orany other type of scenario that sets a pattern for when contracts willbe decreased. Although it is best to stick with the mathematical relationshipsrather than the trade performance relationships, there isno limit to how it can be applied.