A key of success for the turtles is how they manage their risk or risk management. Risk management is called in many names. Sometime you will find it called money management or position sizing.

For the turtles, they manage their risk by starting with the measurement of daily market volatility. They were taught to measure volatility by using the Average True Range, or ATR. It also known as “N” which can be derived from the following

1. The distance from today’s high to today’s low.
2. The distance from yesterday’s close to today’s high
3. The distance from yesterday’s close to today’s low

The true range is the maximum values of these three choices. For the Average True Range, it is the moving average of the true range. For Example the 20-day, ATR can be simply calculated by taking the last twenty true ranges, add them up, and divide by 20. Repeat each day by dropping off the oldest true range.

Let consider the following example for 5-day ATR calculation.

DAY1: OPEN 512.00, HI 521.50, LO 511.25, CLOSE 516.50
DAY2: OPEN 517.00, HI 524.00, LO 513.00, CLOSE 521.50, TR1 11.00, TR2 7.50, TR3 3.50
DAY3: OPEN 521.00, HI 523.50, LO 515.50, CLOSE 518.00, TR1 8.00, TR2 2.00, TR3 6.00
DAY4: OPEN 510.00, HI 515.00, LO 505.50, CLOSE 506.00, TR1 9.50, TR2 3.00, TR3 12.50
DAY5: OPEN 508.00, HI 513.00, LO 508.00, CLOSE 511.00, TR1 5.00, TR2 7.00, TR3 2.00
DAY6: OPEN 519.00, HI 527.50, LO 515.00, CLOSE 524.00, TR1 12.50, TR2 16.50, TR3 4.00, 5-day ATR = 5.6

Once the turtles determined the ATR or “N”, they would also know the stop level since they were instructed to place their stops at 2N.

The were also told to risk only 2% of their capital on each trade. If they have $100,000, they would risk only $2000 for each trade.

Consider the following example of turtles position sizing.

Suppose N = 5 and the trading capital on hand is $100,000.
So they can risk only $2,000 for each trade.

Therefore the position size will be $2000 / 2N = 200.

That’s it! A example for risk management.

As I have always mentioned that a sound money management is a component of a complete trading system. So, do not wait to manage your trading money until you can prove that a trading system makes money. Although you can gain profits from the system without managing your trading money but, who know, you might gain much more profits with a proper money management.

Of course, if the trading system is a bad one, even the best way of managing money cannot turn it to be a good one.

It is about expectation (as I explained it in earlier articles). You have to make sure that your trading system must has positive expectation. It means that you know the system, over enough time, will generate a positive result. Since, no money management scheme can mathematically turn a negative expectation into a positive gain.

By saying this, it does mean that you do not need to manage your money properly in trading until you can prove that your trading strategy has a positive expectation. There is little additional risk in applying money management from the beginning instead of not applying it at all.

If you are actually risking your money in market, you most likely to do so with a trading strategy that has a positive expectation and start managing your money from the beginning based on your expected performance. The only reason that traders should not manage their trading money from the beginning is the traders actually expects to lose if that is the case, why trade?

An area of common confusion when money management is concerned is whether particular methods of managing money work on currency trading, or whether they work with futures contract, options, stocks or whatever the market. The answer for the questions is it does not matter whether the market is, managing money is based on one thing only, it is account performance.

Another common question, related to the topic, is whether the money management methods can be used on a particular trading style or trading system. The answer is the same as the answer about the market and for the same reason.

In order to get understanding on how money management affects your trading, let’s consider the following example. Although the example is gambling not trading, it is still worth to consider since trading and gambling share many aspects. The following is the example of coin flip to illustrate that why traders need proper money management. Let says if we are betting on coin flip, and we will bet only on heads up.

If we win, each time the coin flip heads up, we will get $2. If we lose, each time the coin flip tails up, we will lose only $1. Since the chances that the coin will land heads up and tails up are 50%, we will simply suppose that if we take a coin and flip it in the air for 100 times, it will land heads up for 50 times and the remaining 50 will land tails up.

Therefore, after we take a coin and flip it in the air for 100 times. The results will be as follows:

50 flips land heads up: Win 50 x $2 = $100
50 flips land tails up: Loss 50 x -$1 = -$ 50
$100 – $50 = $50

According to the example, we end up by gaining profits. If we take it in to consideration, we will see that we have more chance of making profits than losses in long run. We call that this gambling is a positive expectation game. By having a positive expectation, it means must experience a certain degree of positive return.

Now, let’s get back to the money management. From the same coin flip example what will happen if we do not bet the same amount of money every time. According to the Ralph Vince’s “Portfolio Management Formulas”; if our initial account is $100 then if we bet 25% of total account each time, we will get $36,100 after 100 flips. If we bet 51% of total account each time, our account will be dwindled to only $31.

You will see that by changing the amount if bet, the results can be much different. However only proper management is not enough, you will have to get a trading system that has a positive expectation in order to maximize your profits.

Firstly, let me explain what martingale is for those who have never heard about it.
The martingale system is a betting system that is well-known among gamblers. The idea of this system is, if you start betting with a reasonably small amount, and lose it, you can simply continue betting double the previously lost bet until you win.

For example, if you are betting on baccarat and you start with $1 and you lose it, you may lose 5 times in a row. Therefore you lost $1 + $2 + $4 + $8 + $16 = $31 since you doubled the money every time you. Then if you win in the 5th game, while you are betting $32, you will gain $1 profit. It seems like the martingale betting system may result in a steady profit increase over time.

So, what is the problem? Let us imagine if you have 12 consecutive losses you will need $1 + $2 + $4 + $8 + $16 + $32 + $64 +$128 + $256 + $512 + $1024 + $2048 = $4095. That is a large amount of money comparing to the started point as $1.

You may think that it is not possible to lose so many times in a row it is. The risk has always been there and I mentioned about this (risk of ruin) in one my articles. Moreover, as I told you in the beginning, I experienced this myself when I traded with this system as money management.

What about if you have enough money to compensate your losses many times? It seems like the system is flawless this time, right? But do you really think it is worth to bet your large amount of money (maybe thousands) for making $1?

If consider it in term of probability, if you are trading a futures contract, you have 50% that the price will go the same way as your position (long or short). Then if you are stopped from the first position and you find an entry point to open a position again with double lots.

This time, what do you think how many chances for you to win? Someone may think that you chance to win will greater because there is less chance that the price will go against your position 2 times in a row. Actually, the chance in this case is always 50% even you are entering the 10th trade after lost 9 times in a row.

You can fine many experiment of the martingale system, you do not have to lose your money to experiment this yourself. Clever guys learn from other guys’ mistakes.

Everything seemed perfect in the beginning. I earned large amount of money easily. The casino did not let this went on for long time. I started to lose my money. All my profits were gone, even my initial capital was also gone. Eventually, I stopped gambling but did not stop using martingale system. Not until I faced ruin of my one trading account.

How I applied the betting system to my trading later was very simple. I just defined the ranges of stop and exit from the point where I entered a trade. Then I opened a position with an amount of money. The target point and stop loss were set for the position.

If I won the trade, I would enter another trade with the same amount of money. If I lost, I would also enter a new trade but with the double amount of money from the previous one.

It happened all over again, everything was great in the beginning, and I won trades many times in a row. I had never lost more than three times in a row. I got a confidence in this money management system.
Suddenly, a drawdown came by. I faced a string of losses, it swallowed my trading account. Everything was gone. I had to start over again.

You may think that I was not good enough; otherwise I would not lose so many times in a row. You may be far better than me but you also have the risk of ruin which I also mentioned to before.

I hope my experience will be example for other traders. You do not need to face this experience yourself. It takes times to re-raise the trading capital from scratch again.

For example if you are trading a futures contract, when you go long or sell the chances that the prices will move in the same direction as your opened positions is 50 percent. The odds indicate that if you trade ten times, you most likely will get five losses and five wins.

If your capital in trading account is $1000, what is the size of risk you would allow for each position? If you decide that you will get out of the position when you lose $100 which is ten percent of your account size. This means you will wipe out your account if you lose ten times in a row from the beginning.

What is the probability that you will lose ten times in a row? It is mostly impossible. But the problem is you still have chance of losing. As a matter of fact, I experienced this myself.

I thought that it was not possible for me to lose more than five times in a row. Since I technically analyzed the price movement by using charts and indicators, this should give me an edge to win a trade. I thought I have better than 50 percent chances to win. According to the Kaufman’s formula for calculating the risk of ruin as follow:

Risk of Ruin = ((1 – Edge) / (1 + Edge)) ^ Capital Units

Even though I had a period that the trades were in my favor, I won the trades many times in a row. My account continued to grow up but eventually, I faced the string of losses until my account was wiped out.

No one never lose even the greatest traders in the world, the most important aspect is you need the ability to stay in market. If you are wiped out from the market, you have no chance to win.

The most important thing about stops that traders must keep in mind is to define the stops before enter a trade. This is of course not a coincidence that every famous trader has this trading rule in their trading system.

For the turtles, they did not place their stop with the brokers since they did not want to reveal their trading strategies. As they traded future contracts commodities, they used either limit orders or market orders instead.

No trade of turtles could incur more than 2% risk of equity. Because the turtles used N-based stops while N of price movement represented 1% of account equity, therefore the maximum stop allowed 2% risk would be 2N.

According to the entry rule of turtles, that a unit would be added into positions every 0.5N, the stops would be placed at 2N from the most recently added unit to minimize the total position risk.

Example

Crude Oil: N = 1.20, 55-days breakout = 28.30

In this case turtles would enter the first unit at 28.30. Then if price moved to 30.10 the positions of turtles would be as follow.

First Unit: entry [28.30] stop [27.70]
Second Unit: entry [28.90] stop [27.70]
Third Unit: entry [29.50 stop [27.70]
Fourth Unit: entry[ 30.10 stop [27.70]

The turtles were also told of an alternate stop strategy called the whipsaw. This strategy resulted in better profitability but incurred more losses, which resulted in lower win/loss ratio.

For this strategy, the stops were placed at 0.5N for 0.5% account risk. If a given unit was stopped out, it would be re-entered when the market reached the original entry price. Using of the whipsaw did not require moving the stops when a unit added. The maximum risk would not exceed 2% because the maximum unit is four.

Example

Crude Oil: N = 1.20, 55-days breakout = 28.30

In this case turtles would enter the first unit at 28.30. Then if price moved to 30.10 the positions of turtles would be as follow.

First Unit: entry [28.30] stop [27.70]
Second Unit: entry [28.90] stop [28.30]
Third Unit: entry [29.50] stop [28.90]
Fourth Unit: entry [30.10] stop [29.50]

Since the N in N-based stops was adjusted according to the volatility of markets, this resulted in better diversification and risk management.

Most traders believe that entry is the most important aspect in any trading system. For the turtles, they used only a very simple entry system based on channel breakout systems taught by Richard Donchian.

The turtles’ rules for entry consist of two different but related breakout systems called System1 and System2.

System1 was a shorter-term system based on a 20-days breakout. The turtles entered positions when price exceed high or low of the preceding 20-days. The entry signal would be ignored if the latest breakout would have resulted in a winning trade. And this breakout would be considered a losing breakout if the price moved 2N (N was calculated according to position sizing rule) against the position before a profitable 10-days exit occurred.

However if the System1 breakout was ignored due to the winning trade, the System2 would be used for entry to avoid missing of major moves.

System2 was a longer-term system based on a 55-days breakout. The turtles entered positions when the price exceeded by a single tick the high or low of 55-days. All breakouts for System2 would always be taken whether the previous breakout had been a winner or lost.

After turtles entered a single unit positions at the breakout, they would add to positions every 0.5N intervals following their initial entry until the maximum permitted number of units was reached.

Example

Suppose a turtle was trading Gold. The N was calculated as 2.50.
The price broke the 55-days high at 310.

Hence, turtle added first unit at 310.00.
Therefore the second would be added at 310 + (0.5*2.50) = 311.25.
The third unit added at 311.25 + (0.5*2.50) = 312.50 and so on.

The most of profits in a year might come from two or three large winning trades. Therefore the turtles have to be consistency because if a signal was skipped, this could affect the returns for the year.

The first thing traders have to know is what to buy or sell.

The original turtles were commodities traders. They traded futures contracts on most U.S. commodities exchanges. The primary criterion that the turtles used to determine which markets could be traded was liquidity. Since the turtles were trading millions of dollars, they could not be trade in markets that had low liquidity.

The second piece of a complete trading system is position sizing; the turtles determined the position size for each market on the basis of the amount that market moved up and down each day in constant dollar terms.

To learn the concept of turtles’ position sizing, the understanding of the N factor is essential. N is simply 20-days exponential average of the True Range (ATR).

From:
True Range (TR) = Max (H – L, H – PDC, PDC – L)
Where:
H = Current High
L = Current Low
PDC = Previous Day Close.

So:
N = (19 * PDN + TR)/20
Where:
PDN = Previous Day’s N
TR = Current Day’s True Range

To determine the dollar volatility the following formula is used.
Dollar Volatility = N * Dollars per Point

Then a Unit of position is calculated as follow.
Unit = 1% of Account / Market Dollar Volatility

Example:
If the Crude Oil has a Today’s N = 0.0141.
Given the account size $1,000,000 and Dollars per Point is 42,000
The Unit Size = 1% of 1,0000,000 / (0.0141 * 42,000) = 16.88
In real trading the Unit will be truncate to 16 contracts since contract cannot be traded partially.

That is only the first two pieces of turtle trading system. There are still more four pieces covered by turtle trading rules.

No one win every trades; money management help traders to reduce losses on losing trades. Moreover it also maximizes traders’ gains on winning trades.

All traders have ever heard about how important the money management but the most of them are still losing in understanding money management strategies.

To make traders clear and be able to find strategies of managing money that suit to them. Let us talk about a couple of simple and easy money management rules.

The 2% – 6% rules have been introduced in Dr. Alexander Elder’s book “Come Into My Trading Room”

The 2% rule is to protect traders from any single terrible loss that can damage their accounts. With this rule traders risk only 2% of their capital on any single trades. This is for limiting loss to a small fraction of accounts.

Besides a disastrous loss, a series of losses can also damage traders’ account. The 6% rule is lent to handle this. Traders have to set the maximum of accumulated loss for a month. When they reach that level of loss, they have to stop opening any new position for rest of the month.

These 2 rules are designed to protect traders from the two types of losses. Nevertheless the 2% – 6% would be change for each trader. For those who are able to accept the higher risk, they might adjust the 2% – 6% rules to 5% – 10%, where the 5% is used to protect the account from any single disastrous loss. While the 10% rules is used to protect traders from any series of losses in each month.