Most traders view the idea of profit protection as a concept that applies to an individual trade. Whenever a trade floats a large profit, they protect the unrealized profit by moving the stop loss closer to the market.
I like to view trading more as a collection of outcomes rather than the result of any particular transaction. This article looks out how to protect realized profits after they accrue in the account rather than protecting the unrealized profit from one trade.
The money management project started off by asking the question, “is it possible to make money with a perfectly random strategy solely using money management.” The strategy is not quite to the point where it will work in the real world. Nonetheless, this new method shows substantial progress toward that goal.
I operate on the assumption that a random strategy is one with 50% profitability and an R multiple of 1.0; we earn a dollar for every dollar we risk. The net outcome over hundreds of trials should average out to the starting balance. My earlier videos and blog on money management modeling verifies that this is indeed the case.
Random outcomes tend to fluctuate above and below the average value. At any given time, half of all possible outcomes should be above average. The opposite holds true for outcomes below the average. The idea here is to get away from standard notions of money management like fixed fractional money management. The risk amount should follow not only the account balance, but also factor in the degree of profit accrued.
The fluctuations above the starting balance are totally random. If a trader is lucky enough to obtain a profitable, realized balance, then it makes sense to decrease the risk. Obviously, decreasing the risk limits the potential profits.
Consider an example. We start with a $100,000 account balance risking 1% of the original balance. Note that all future trades base the risk on the original balance and not the accrued profit and loss.
When a random winner rolls in, it brings the account balance to $101,000. The odds of winning on the next flip are still 50-50. Rather than risking giving it all back, I found that you increase your chances of a final, meaningful profit if you decrease the original risk as profits accrue.
Reducing the original risk by 1% for every $1,000 of profit changes the dollar risk from $1,000 to $990. This may not seem like very much. That’s because it is not. The goal is to suck tiny little advantages as they come. A loss occurs half of the time in this situation. When it does, the account balance still shows a $10 realized profit.
If the second trade (we are now at $101,000) is a winner, the account balance increases to $101,990. A loser following the win drops it down to $100,010. The process is slow, but we’re also making money without a trading strategy. We’re just betting.
Importantly, a change to the risk amount as a balance loses money completely destroys the money management strategy. It is critical that the risk amount not vary in any way whatsoever.