Over the weekend I finished this pleasant and instructive book…
Over time I am aiming to build a library reference on this blog with a summary of all the books I have found useful. The idea is to be able to recall quickly the main points of the book. Hopefully you will find it useful too!
Please find below the first instalment of this category:
This book presents several basic but nonetheless important topics in Money Management. It is very accessible from a mathematical point of view and has some good reviews on amazon. The book is not directly aimed at Systems trading but Money Management being a pillar of a successful mechanical trading system, it is of utmost relevance.
The book starts off with an introduction of what is Money Management. It then goes straight into one of the most valuable “assets” in the book:
Dynamics of Ruin
Based on several factors, some of which must be derived from historical backtests, one can simulate the risk of ruin taken by pursuing a specific trading strategy.
Risking 20% of your capital in a strategy with the following characteristics:
– Payoff ration: 2x
– Probability of success: 60%
would result in a risk of ruin of 2%.
The book provides multiple tables with many combinations of parameters. This is very useful as each case needs to be simulated with 100,000 iterations (as opposed to being calculated using a formula).The simulation program code is also provided in appendix (A & B) if you are inclined to re-implementing it.
There is also a part on correlation and diversification. However that party seems inspired by the same conventional approach of the use of variance/co-variance as a measure of risk as applied in the Modern Portfolio Theory by Markowitz. I would suggest reading Mandelbrot: The (mis)behavior of Markets for a good debunking reality check on that theory and why it does might not work.
In any case I am slightly suspicious of relying too much on diversification. As Taleb puts it and as the markets showed us in the 2008 “great markets collapse”: “Diversification works until you really need it” (meaning that in case of severe crises where you need most risk reduction, all correlation tends towards 1 increasing the damage).
The chapter on Market selection (pg 80) introduces the Commodity Selection Index by Welles Wilder. This could be useful as a signal filter on a trend-following system for example
Balsara also covers stops and introduces a novel (to me!) approach compared to the standard techniques (time, volatility and dollar-based stops).
The novel approach (pg 98) consists of analysing the historical drawdowns of profitable trades and derive a cutoff to be used as a stop-loss. That could prove interesting and dynamic approach to setting stop-loss. I am definitely taking that idea away from this book and will try it on a trading system.
Imaging you have just entered a short position in Oil and Iran sends a nuclear bomb on Israel. The next day oil goes through the roof and stays limit-up for a week. This is a nightmare situation for any trader as there is no way to exit your position (at any cost!). Balsara explains (pg 107) how to deal with locked-limit markets (hint: use options to create a synthetic contract).
Exposure and Capital
The later parts of the book touch on controlling exposure and allocating capital. This is mostly derived from Markowitz MPT theory and Ralph Vince’s Optimal f and Money Management strategies. I am planning to read Ralph Vince to get it “straight from the horse’s mouth” and will address these topics at that stage.
Not a bad book, not outstanding either. Additional parts of the book are interesting but not so relevant to Systems trading (Chart patterns, Psychology and discipline). A fairly quick read with 2 or 3 good points to take away, which could move your automated trading systems development forward – so I would still recommend it for your library.