“The only thing that disturbs me is poor money management” – Bruce Kovner, Market Wizard

It’s far too easy to take this Forex thing casually.

You can open an account with a broker is the blink of an eyelid, and in two more blinks you can be trading Forex.

But Forex is a game of skill, played by some of the most sophisticated, well connected and intelligent men and women in the world.  Every time you trade, it’s like playing chess against a chess master. (Not to burst anyone’s bubble!)

So, do you think that having sloppy objectives for what you are trying to achieve is going to cut it?

Nope… you are right – they sure won’t.

The good thing is that once you do understand how to craft proper objectives, a number of nice things happen:

  • You stop losing money (even if you don’t always make it)
  • You trade with purpose
  • Your discipline goes up several notches
  • You start to really capitalize on big moves

Objectives are the first and most crucial step in system development, and where we now shift our focus.

Your Trading Plan Template

Your trading plan template is a carefully crafted document that you can fill out as you go through this next section of the Advanced Forex Trading Course for Smart Traders.

If you have not downloaded it already, you can do so now:

Your Trading Plan Template 

From foundation to system development

“You have to start with your goal” – Ray Dalio

The first lessons in this course have been foundational in nature.

Now we move to a more tactical level, where you will develop a simple, robust and insightful trading system that will eventually meet the financial goals you have been establishing since The Scientific Path to Financial Freedom through Forex Trading.

And this starts with setting objectives for your system.

Every good trading system has very clear and well defined objectives.

In fact, Market Wizard Van Tharp suggests that objectives are so important that up to 50% of system development should be spent on objectives.

The main objectives you will need for your system are:

  • Returns
  • Maximum Drawdown
  • Chance of Maximum drawdown
  • Trading opportunity
  • Win Rate
  • Targeted risk/reward ratio
  • Maximum number of positions

Once you have clarity on these objectives, you will have the ingredients you need to build a powerful and robust position-sizing model, and construct a set of trading rules to achieve these objectives.

Constructing a return objective

“Two of the cardinal sins of trading – giving too much rope and taking profits prematurely – are both attempts to make current positions more likely to succeed, to the severe detriment of long-term performance.” – William Eckhardt, Market Wizard

Saying “I want to make lots of money” is NOT a good objective.

Instead, you want to be very specific about how much you want to make and over what time period. For example:

“I want to return 10% on my capital over a month”

If you are not specific in your objectives, you will make mistakes when you trade. In particular, you will cut winning trades short as you are not clear on what you need to achieve from the trade.

How to decide what is right for you?

You have several considerations:

  • How much capital you are allocating to Forex trading
  • How much time you have for trading
  • If you are day, swing, or position trading
  • The size of the drawdown you are willing to accept
  • The number of different systems you will be running
  • Your individual psychology
  • Your competence level

Ultimately it will be a personal choice specific to your goals, but here is a rough guide based on your trading style:

  • Short-term trading – 10- 25% a month
  • Medium-term – 5-10% a month
  • Long-term – 20-50% a year

If you are struggling to come up with a return objective, don’t get too stressed. Pick something from the list above that fits. It’s your returns in combination with other objectives that matter most of all, and you can always scale up over time.

Objectives based on your financial freedom number

Your objectives could be based on your financial freedom goals from lesson 3. In particular, it’s useful to know your financial freedom number so you can work back towards your profit objective.

For example if your financial freedom number is $5000 a month, then the objective for your trading system could be to make $5000 a month.

If you have $50,000 to trade with, then that would mean your profit objective would be to make a 10% per month return.

 

Future money manager, objectives are critical for you

For those of you that are one day looking to manage money, objectives are of particular significance. You need to understand what objectives you will be assessed against and then build a system that fits.

Here is what a hedge fund head trader, and FX Renew Signal Provider has to say on the topic:

“I’d say gain an understanding of the metrics that they need to achieve, ideally before embarking on creating the track record – then devise a risk management/trading strategy that achieves those metrics.”

 For example you will need to understand Sharp and Sortino ratios if you are managing money.

 Starting out in Forex

Not all of you are going to want to start with the full amount of capital that you will eventually trade with.

That is, of course, OK. Start with an amount that you are comfortable with.

What is critical is that you trade it like it is a smaller version of your targeted account. Don’t use trading a smaller size as an excuse to take a punt, or you will develop bad habits.

Notional Funding

Notional funding is used when you don’t plan to fully fund your trading account.

For example, you may fund your account with $10,000 but you trade it like you have $50,000 in the account. This is a common way to be efficient with your trading capital.

If you are using notional funding in your trading account, then you will base your objective off the notionally funded amount.

 Balancing the equation with a maximum drawdown objective

“Your job as a trader [is to] protect the direction of the [equity line]” – Steve Clark, Market Wizard

In order to make money you need to risk money.

But the good thing is that you are in control of what you risk.

A drawdown is the amount of loss you are willing to sustain in order to go for your profit objective.

For example if you had a trading account with $10,000 in it, and you lost $1,000 then you would be experiencing a 10% drawdown.

While you might never want to have a drawdown, they cannot be avoided altogether (except by not trading!) and should be seen as simply a cost of doing business.  This means you should plan for them, prior to their occurrence.

It is when traders fail to plan for losses that they tend to make mistakes and sell things at the wrong time.

How big a drawdown should you allow?

Drawdowns can be tough.

To make it easy on your trading psychology, you want to them to be as small as possible, but typically the bigger drawdown you are willing to accept, the greater your returns will be.

To use the example from history, the famous “turtles”, who were trained by Market Wizards William Eckhart and Richard Dennis, had a combined return of close to 25% per year, but at the same time had to suffer through a drawdown of 35% and multiple smaller drawdowns.

The turtle traders were mechanical trend followers who, by nature, experienced large drawdowns. If you are a discretionary “rules based” Forex trader, you have the ability to do much better than this.

You generally will want a maximum drawdown of no greater than 50% of your return objective.

For example if you have a return objective of 10% a month, your maximum risk should be no more than 5% a month.

I would suggest that you be even more conservative with your drawdowns, and risk no more than 2-3% a month if you are looking to make 10%, or 10% a year if you are looking to make 50%.

Market Wizard Van Tharp said that if he was a short term trader, he would have the objectives of risking no more than 2% a month in order to make 25% (this inspired our 2&25 position sizing model).

In saying this, it’s important not to constrain yourself from taking the opportunities you have in front of you because of your drawdown limit. For some people taking a large amount of risk allows them to generate very big profits.

Recovering from a drawdown

It’s important to note that once you go past a 25% drawdown it can be difficult to recover.

As you can see on the following table, if you have a have a 25% drawdown you need to make a 33% return on your account to recover. But if you have a 50% drawdown you will need a 100% return just to recover.

Consider the following table:

Loss of capital (%) Gain to recover (%)
5 5.3
10 11.1
15 17.6
20 25.0
25 33.3
30 42.9
35 53.8
40 66.7
45 81.8
50 100.0
55 122.0
60 150.0

Percent chance of the drawdown objective

Once you establish a maximum drawdown objective, you want to consider how comfortable you would be experiencing the drawdown. This will greatly affect your position-sizing model.

For example if you decided that your maximum drawdown is 10% and you are willing to risk a 100% chance of this happening in order to achieve your goals, then you would trade very differently than if you only wanted a 5% chance of ever experiencing your maximum drawdown.

What to do when you have a drawdown

“Managing money is real life, not some bullshit strategist fantasy world” – Martin Taylor, Market Wizard

If you experience a drawdown, you have a few options including:

  • Reduce your position size.
  • Keep trading the same size and wait for the winning trades.
  • Pause your trading and review what’s working and what’s not.
  • Stop trading altogether.

You should have it written in your trading plan exactly what to do.

Market Wizard Michael Platt has a policy that if any of his traders hit their drawdown limit of 3% a year (yes, 3% a year – each of his traders are allocated a billion dollars), then he cuts their allocation in half and allows them to risk 3% of the new allocation. If they lose that, then they would be out of a job.

Trading opportunity

How often you trade will significantly impact your position sizing and trading strategy.

If you place a hundred trades a month you will need a different structure than if you place twenty trades a month.

More is not always better. Many traders tend to overtrade, and their returns suffer because of costs, and mistakes such as the failure to hold on to the big winners.

Warren Buffett himself said that you only need one good idea a year to get rich over the long-term, if you know how to capitalise on it (you capitalise on good ideas with position sizing).

In saying that, more active trading systems can be incredibly good at producing consistent returns if you understand their edge.

You can choose how many trades you get right

“Frankly, I don’t see markets; I see risks, rewards, and money.”- Larry Hite, Market Wizard

It might come as a surprise, but as a trader you get to choose how many trades you get right versus how many you get wrong. This is your win rate.

For example you might have an objective to have 50% of your trades to be winners.

The crux of this decision is your trading psychology.

If you recall in lesson 5, we used an example of three different trading systems with different win rates.

In that example, the system with the worst win rate was the most profitable, as the winning trades were very large.

But for many traders, this would have been a very difficult system to operate, as you would have to experience a lot of losers while you wait for the winners, which can lead to mistakes.

The higher your targeted win rate the lower your profit per trade is going to be.

For example if you want 80% of your trades to be winners, you will generally need to take your profits a lot quicker. Conversely, if you have a targeted win rate of only 20%, by definition you will need to let your profits run for big wins.

Have a think about what win rate you would like to target.

I would suggest that unless you feel you have excellent entries you go no higher than 65%. And unless you feel you have an iron temperament for handling losses, I would suggest you go no lower than 35%.

Winning and losing streaks

Trading systems go through periods of losing and winning streaks.

The lower your targeted win rate, the longer your potential losing streak could be. Conversely, the higher the win rate the longer the potential winning streak could be.

If you can understand how many losses in a row you are likely to have when trading your system, it helps you both remain disciplined and know when something has gone wrong.

Risk/reward objectives

“Knowing when you’re going to exit a trade is the only way to determine how much you’re really risking in any given trade or investment. If you don’t know when you’re getting out, then, in effect, you’re risking 100% of your money.” – Van Tharp, Market Wizard

Once you have chosen your win rate percentage you want to attach a targeted risk/reward ratio to your trade.

For example, if you have a targeted win rate of 50%, then you might decide you want a 3:1 profit ratio. This means that you want your winners to make three times your risk on average.

So, if you win half the time, but make roughly 300% of your risk when you do win, you can still expect a healthy return.

This would mean that if you were risking a $100 loss if the trade goes against you, then you would want to make $300 per trade if it goes for you.

In theory, the higher your win rate, the lower your risk/reward and vice versa. Imagine if you only wanted to win 10% of the time. You would need to make a lot on your winners!

I would suggest that you want to have a risk/reward ratio of at least three to one on your trades.

Targeted expectancy

When building a trading system, a savvier trader will have a targeted expectancy they are trying to achieve. The better the expectancy, the easier it will be for the trader to achieve their goals using their position-sizing model.

 Maximum number of positions

“One of the first lessons my boss taught me is that price is irrelevant; it is all about controlling the size of your position” – Steve Clark, Market Wizard

In Forex trading, you have plenty of leverage available on your account, so it is very easy for the inexperienced player to take on more trades than they, or their risk management model can handle.

In your trading plan, specify a maximum number of positions that you can have open at any one time.

How many is too many?

It really depends on your trading style and your position-sizing model.

Integrating multiple trading systems

“Each strategy develops a track record that we deeply understand and then combine in a portfolio of diversified strategies” – Ray Dalio, Market Wizard

You may find that you want to run multiple trading systems at the one time.

If you do, then you want to set specific objectives for each system, and overall objectives for the combined systems.

You would allocate a specific amount of trading capital to each system, and a risk management model that takes into consideration correlated drawdowns. I.e. what is the overall risk at any one time you will allow across all your systems?

Let’s take a look at how this might work in the following diagram:

FinancialFreedomNr

The benefits of multiple systems

Having multiple trading systems has several benefits.

You can satisfy that part of you that wants to have a play, or be more aggressive, and allocate a small part of your capital to a system it trades, while leaving the majority of your money in your other systems.

If one system is not working, you could have another that is compensating for it, which increases your returns and stops you from making mistakes.

You can have multiple trading systems that work in different market types (the ideal way to trade).

Your turn…

“Defining your style and objectives makes it much easier to stick to your strategy” – Mark Minervini, Market Wizard

There is no success without action.

Setting objectives is something of an art, as they are personal choices about what you want to achieve.

Start by defining the following four objectives:

  • Profit objective
  • Maximum drawdown objective
  • Percent chance of maximum drawdown objective
  • Number of trades objective

In the next lesson, we will take a deeper look at how you can use position-sizing to achieve your objectives.

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Until then,

Sam

Sam Transparent Circle

Course work:

Fill out the My System’s Objectives Work-sheet. This is critical to the system development process so please take your time on this one.

Download your course work here