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Square root rule #475582
12/26/18 21:51
12/26/18 21:51
Joined: Jul 2018
Posts: 16
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HamSelv Offline OP
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HamSelv  Offline OP
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Hi laugh

I have read about the square root rule in the Black Book and also in the forum. It makes good sense to me to protect the account from future unknown draw downs with this rule. There is one thing that confuses me a bit. I'm not an expert in statistics so please bear with me:

Let's say I'm trading a Z-system and I want to reinvest all the profits. My starting account is $1000 and I make $200 in profit. According to the square root rule I cannot reinvest the whole $200. I have to reinvest less. Fair enough.

If I stopped trading the system then that would give me $1000 + $200 = $1200 in total in my account. What if I then started trading the same Z-system right away. Then my starting amount would be $1200 meaning I have suddenly reinvested the whole $200 in profits. What am I missing here?

Thanks!

Regards

Last edited by HamSelv; 12/26/18 22:06.
Re: Square root rule [Re: HamSelv] #475584
12/26/18 22:59
12/26/18 22:59
Joined: Feb 2017
Posts: 1,718
Chicago
AndrewAMD Online
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AndrewAMD  Online
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Joined: Feb 2017
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Chicago
Many (if not most) trading systems have an expiration date.

By the time you have acquired your hard-earned $200, how much time has passed? 1 week? month? year? You will need to re-evaluate and fine-tune your system. Then, and only then, can you consider re-adjusting your capital after making a profit.

By the way, if you turn off the system after gaining 200, and then turn it on with the capital set at 1200, you are deliberately disobeying the rule! laugh

Re: Square root rule [Re: AndrewAMD] #475586
12/27/18 00:10
12/27/18 00:10
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HamSelv Offline OP
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Hi Andrew. Thanks for replying. I get your point about re-evaluating and fine-tuning. For a start I'm going to trade a Z-system so I assume it is already re-evaluated and fine-tuned laugh My understanding is that for a Z-system at any given time I can increase the capital after getting profits (according to the square root rule).

What rules am I deliberately disobeying please? Let me try to be more clear:

I stop trading a Z-system after earning $200 in profits so now I'm $1200 in total. Straight away I start to trade the same system all over again with $1200. So starting to trade the system again corresponds to trading the system for the very first time with $1200 start capital. Now I have re-invested all the profits and I don't have to use the square root rule. Does it make sense, I mean is my example clear?

Thanks.

Regards

Last edited by HamSelv; 12/27/18 00:14.
Re: Square root rule [Re: HamSelv] #475590
12/27/18 09:48
12/27/18 09:48
Joined: Jan 2017
Posts: 95
Bulgaria
kvm Offline
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kvm  Offline
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I think your misunderstanding comes from not considering your MM rule at the begging. For example, the Z strategies chapter suggests:

"For avoiding margin calls, we recommend to set Capital not higher than about 80% of the account equity."

So, if you want to start trading with Capital Slider = $1000, your account's equity (or balance) should be $1250.

Re: Square root rule [Re: HamSelv] #475593
12/27/18 13:21
12/27/18 13:21
Joined: Feb 2015
Posts: 652
Milano, Italy
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MatPed Offline
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Originally Posted By: HamSelv
Hi laugh

I have read about the square root rule in the Black Book and also in the forum. It makes good sense to me to protect the account from future unknown draw downs with this rule. There is one thing that confuses me a bit. I'm not an expert in statistics so please bear with me:

Let's say I'm trading a Z-system and I want to reinvest all the profits. My starting account is $1000 and I make $200 in profit. According to the square root rule I cannot reinvest the whole $200. I have to reinvest less. Fair enough.

If I stopped trading the system then that would give me $1000 + $200 = $1200 in total in my account. What if I then started trading the same Z-system right away. Then my starting amount would be $1200 meaning I have suddenly reinvested the whole $200 in profits. What am I missing here?

Thanks!

Regards


You are right not missing anything. Starting with 1200 you are not using the sr rule. The sr rule gives you a statistically protection in long run AND for a winning TS, that you will not face a Margin call reinvesting your profit. The key words are "long run", "winning TS" and " "reinvesting your profit".

Re: Square root rule [Re: MatPed] #475595
12/27/18 15:46
12/27/18 15:46
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Posts: 16
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HamSelv Offline OP
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Hi people.

Thanks for your feedback. Hmm good point kvm even though the 80% is only mentioned for the Z8 system, so I guess it only applies for the Z8 system. For the rest of the Z-systems you need to look in the log files.

(MatPed) Ok, let me try to explain again with another example:

Person A starts trading $1000 using a Z-system. After getting $200 in profits he closes all his trades and removes Zorro from his computer. Now he has $1200 in his broker account.

Person B has never traded before. He gets a $1200 gift from his aunt and wants to trade it all.

Person A and person B now have $1200 each. They now both, at the same time, install Zorro on their computers and start trading the $1200 they each got. The system they trade is the same Z-system as person A traded when getting $200 in profits.

Person A and person B now both have the exact same starting point. Person A has re-invested all his old profits without using the square root rule. Using the square root rule wouldn't make any sense as he is starting all over again and hasn't made any profit (yet). So why should person A not re-invest the $200 in profits right away in the first place?

Maybe jcl would also like to comment?

Thanks! laugh

Regards

Last edited by HamSelv; 12/27/18 15:49.
Re: Square root rule [Re: HamSelv] #475596
12/27/18 16:03
12/27/18 16:03
Joined: Feb 2015
Posts: 652
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MatPed Offline
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you forgot the elapsed time in your example. How much was the elapsed trading time of Person A? One month, or 5 years? the sr rule "protect" your account in the 5 years situation. I had a similar conversation months ago.
The main point is the time, because the probability of a larger draw-down increases with time. So longer time=higher risk.
If the person A of your example is trading from one week, has almost the same risk of person B.

HtH

Re: Square root rule [Re: MatPed] #475597
12/27/18 16:18
12/27/18 16:18
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Posts: 16
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HamSelv Offline OP
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HamSelv  Offline OP
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In my example the $200 profits was made without re-investing any profits. It was made from the starting amount of $1000 and the Capital slider was never touched. So I'm trying to understand why to use the square root rule when I can work-around it using person A from my recent example. Does it make sense?

Regards

Re: Square root rule [Re: HamSelv] #475599
12/27/18 16:40
12/27/18 16:40
Joined: Jul 2000
Posts: 27,977
Frankfurt
jcl Offline

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jcl  Offline

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It's with the square root rule as with all such rules: Don't merely follow it, but try to understand it. Statistics can be a bit counterintuitive, but I hope it's intuitively clear that just stopping and restarting your system is irrelevant for reinvesting.

So, I fear your person A will not keep her hard earned money, regardless of how often she stops and starts. Here's the formula to calculate how long the money will last, under "money management":

https://www.financial-hacker.com/build-better-strategies-part-3-the-development-process/

The square root rule is also explained in the black book and in short also in workshop 6.


Re: Square root rule [Re: jcl] #475603
12/27/18 19:11
12/27/18 19:11
Joined: Jun 2013
Posts: 1,609
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DdlV Offline
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Hi all. OK, I'll take another stab at the square root rule and hope to learn more from the further comments of jcl and others.

As I understand it, the 2 critical things to understand are:

- Initial Capital: The wealth that was originally invested, not whatever it's grown to. Not trading system stops & restarts. Not changing the trading system. Not closing the account and opening another with the same funds. Etc. None of these things change the Initial Capital.

- Trading Time: Drawdown risk and magnitude grow as trading time accumulates. Account Balance is used as a convenient proxy for this in the square root formula.

In the simple case of a single trader trading in 1 account, just apply the formula. Don't try to get around it.

The more interesting cases involve more traders, etc.:

1) Person A gifts the $1200 to Person C. Does Person C trade using $1000 or $1200 as their square root rule starting point? I.e., does the square root rule tie to the Initial Capital traded ($1000) or to the person who's never traded before ($1200)?

2) Person B may never have traded before, but has the $1200 gift come from trading? If so, same question: What's the starting point?!

3) Person B's aunt traded to get the $1200. But she stopped trading decades ago and the $1200 came to Person B as an inheritance. Has so much time now passed that Person B can safely use the full $1200 as the square root rule's Initial Capital?

4) Or, what if Person B doesn't know the source of the $1200? What should Person B then use as Initial Capital?!

Look forward to comments.

Thanks.

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