Ryan: Yes, 18 years now.

Ryan Jones

Eddie: Can you share a little bit about your background and how you got started in this business?

Ryan: Well it started when I was young chap back in the mid-80s. Phillips Petroleum was based in my hometown, Bartlesville, Oklahoma.

There were rumors that they were going to get taken over. It just so happened that I was involved in a stock trading contest at my school and I was president of that little club. The stock trading contest was not with real money, of course. I had a broker friend from my church who was helping me out picking stocks and I'd go to his brokerage house after school. Essentially everybody was talking about buying Phillips stock so eventually I talked the guy into buying me several hundred dollars worth of Phillips call options for me and I ended up losing money because Phillips was not taken over.

That kinda got me stuck. There are a couple of things I don't like. One of these is losing. And the other thing is losing. That's what got me into the markets and I haven't left it since.

Eddie: So I guess experience got you hooked.

Ryan: Yes. The takeover didn't happen. But what was in the back of my mind was what would have happened if the takeover had happened. I wouldn't have been rich, but I would have been rich compared to what I was used to.

Eddie: So where did you go from there?

Ryan: What happened after that was I began looking at futures options specifically. I ended up scraping up enough money to open up a $2,500 account...

Eddie: Why did you suddenly decide to trade futures options instead of equities options?

Ryan: (laughs) That's a good question. I was actually painting a house one day listening to the radio. And a commercial came on about how heating oil never falls in the winter. So that got me thinking...hmm...maybe I should buy heating oil options. It was about October at the time. What hacked me off was that they only told you part of the story in that heating oil always goes up in the winter, but has to be down first. It was already trading fairly high that year and I ended up buying call options and lost my entire investment in that one.

So that got me into the world of commodities. From that point on it was just like the door was wide open. I did anything and everything that you can possibility imagine over the next two years. I mean I did options spreads, futures, I began selling options toward the end of that period, I used all kinds of strategies...short-term, long-term...everything...I tried everything!

"...Money management was the turning point..."

Eddie: Did you experience any successes? What kinds of things did you learn during those two years?

Ryan: Everything I tried was successful to a degree. When I bought the heating oil options, I had some success. The only problem was that I held on too long. When I eventually traded futures, I developed my own strategy trading across a very broad number of markets. I started with $10,000 and ran it up to $22,000 in the span of 4 months. I was 21 at the time and I thought I was a genius. And about two weeks later, that $22,000 dropped to less than $2,500. That was the ongoing occurrence. Over and over again, I'd do pretty well and...boom...I would just blow out almost.

Eddie: That must have gotten you...discouraged.

Ryan: Yes, that got me very discouraged and very angry at myself. So I took six months where I did not do any trades at all. I went back through every experience that I had gone through and essentially tried to pinpoint why I would do well and then lose it all.

The ultimate conclusion was: Money management. I had not addressed money management. That really was the turning point.

Eddie: So you had systems that had some degree of merit. But the missing piece that you felt would make all the difference in the world was...

Ryan: Money management.

Eddie: Money management.

"...And so I began calling Larry Williams and buggin' the heck out of him..."

Ryan: There were certainly other things that I was learning at the time about how to time the markets and how to pick the right time to enter and exit. In fact, the method I used to take $10,000 to $22,000 is something I use today in modified form from time to time. So I did learn a lot. But ultimately, what I learned is that regardless of how good my trades were, if you don't have a handle on money management, it's inevitable that you're going to wind up losing.

Eddie: One thing I find unique about the path you wound up taking is this: Most traders who go through that initial phase of frustrating losses, continue the search for the Holy Grail trading strategy or system.

They'll keep reading books, attending seminars, buying systems and go through the same cycle of frustration for years. And I think those that succeed are those that realize that money management has to come first. Sadly, many traders never even come to this realization. Is there anything that sticks out in your mind that caused to you understand the importance of money management so early in your trading career?

Ryan: What led me to that conclusion was that during that I came across Larry Williams' record of turning $10,000 into $1.1 million in one year. And so I began calling Larry and buggin' the heck out of him. I asked him all sorts of questions and, of course, he was telling me about money management and he told me that that's what ultimately allowed him to achieve what he did.

I bugged Larry for a while, calling him once every three or four days. As I'm going through everything, I have questions to ask him. And ultimately what I ended up concluding was that Larry's approach was too risky for me. He was risking too much of his account with the money management system he was using for my taste.

That's when I started looking for different types of money management approaches and I guess that's why it stuck out in my mind. I figure that if money management is what allowed Larry to do what he did with that $10,000, then obviously that's where I needed to be concentrating. And when I focused on my poor performance as I traded, I concluded that I had been overtrading, based upon proper money management principles.

"...He had risked something like $1.4 million on three trades!"

Eddie: That brings us to the meat of this discussion. Let's now zero in on money management. You probably have looked at every money management approach in existence. Can you give us an idea of what systems are in use today and what you deem are their strengths and weaknesses? And also, let's talk about what led you to create your own money management system which you call Fixed Ratio Trading.

Ryan: Essentially, what I saw out there was pretty much a couple of money management methods that were recommended without any context or explanation. There was no explanation as to what the risks were. No explanation as why this is the best money management strategy. There's no explanation as to whether you use this if you're an aggressive trader or a conservative trader. It goes on and on. And I'm the kind of person who needs to know WHY. If I don't why about something, it's going to be tough for me to do it. I'm also the type of person that pretty much questions everything that comes comes in front of me.

Especially having analyzed Larry Williams' method of money management, I came to the conclusion that at the very top of his account he had ran it up to $2.4 million during that trading contest. That was the very top of his account that year.

That's what I concluded based on my calculations. And I said to myself, "Larry's da man, but I can't do that."

Eddie: I know that you admire Larry Williams and that he's a friend of yours; Would it be fair to say that there was a lot of luck involved in what he did with that $10,000 account?

Ryan: I think he himself would say that there's some kind of luck involved in the streaks that occurred during that contest. But, ultimately, he was implementing an aggressive money management strategy, but it was one that has proven then when there is a winning streak, it can do very, very well. You just have to keep in mind that there's a lot of risk associated with a losing streak.

There are definitely mathematical principles that were involved. You don't grow a $10,000 account into $1.1 million by chance. It just doesn't happen. So there was definitely more than chance involved. But it was just too risky for me.

Common Money Money Management Approaches And Their Strengths And Weaknesses

Eddie: Drawing that conclusion, you must have looked at what prevailing approaches where around at the time. What did you think of them?

Ryan: That's when I started asking questions. Why are traders told to buy one futures contract for every $10,000 in the account? That's one of the most popular money management strategies in the world. You call brokers and various people that don't focus on money management and that's kind of the default money management strategy they tell you to use.

Here's another common approach that I was questioning. They tell you to "never risk more than 2%" of your account." Well, I asked...what makes that the best approach?

Ultimately, what I figured out was that money management methods were addressing either the growth potential or they were addressing the risk. And as far as I could tell, there was no happy medium.

Eddie: How would you relate that to the approaches you just mentioned?

Ryan: The approach where you "never risk more than 2% of your account" is focused only on the risk side. It's focused on being conservative. But I wanted growth, while at the same time I didn't want it to get too risky. So where's the middle ground? Well at that time, there was none.

Eddie: Among equities traders, you will often hear "always use protective stops." And I think a lot of traders think that's all there is to it and it's a "cure-all" and that is their money management system. But there's more isn't there?

Ryan: I hear this a lot. When I talk about money management, it's often confused with where to place a stop. So I try to make the distinction that trade management is different from money management. Where you enter and where you exit is based your trade management. Money management occurs when, before you enter the market, you ask yourself: How many shares am I going to buy? How many options am I going to buy? How many futures contracts am I going to buy? These are the questions that every trader ultimately has to answer, whether they do it consciously or not. Either they default to some kind of formula or they they're going to just pull something of their hat and say "Well that looks like a good trade. I think I'm going to trade five contracts today." Position size is a decision that everybody makes.

Eddie: I think so many people think that placing protective stops constitutes money management that position sizing becomes an afterthought. Isn't that the case?

Ryan: Exactly.

Eddie: Let's talk about Optimal F. It got a lot of attention a few years back because it's a mathematically-based approach and a lot of traders took it seriously. Tell us what Optimal F is and what you believe are its weakness and strengths.

Ryan: Optimal F is simply the optimum fixed fraction of your trading account to place on any given trade. That fixed fraction, whatever that fraction is, is supposed to achieve the most amount of profits. So if your Optimal F is 15%, you place 15% of your account at risk on each and every trade. Then, at the end of a given amount of trades, you will have built up your account to a larger amount than had you traded 14% or 16% of your account. The problem with that, though, is that it's always based upon the past. So you're taking a track record and you're coming up with a percentage based upon the past and you're applying it to the future. And you're hoping that the Optimal F for the last 100 trades is going to be the same for the next 100 trades. And 99 out of 100 times it's not. So you can be overtrading and turning a winning situation into a losing one. And if you're undertrading, you're obviously not going to get maximum growth.

Obviously Optimal F is not optimal because it's on the past. It's not necessarily going apply to the future.

Another problem that I have with it is that it's a fixed fraction. The problem with a fixed fraction is that if you go too low, you're never going to see growth. And if you're trading very, very inefficiently. And if you go too higher, you're going to very aggressive and you're talking about huge drawdowns. So if Optimal F is 15%, you're talking about close to a 30% drawdown on just two losing trades. That 30% of your entire account.

Eddie: Do you happen to know if Ralph Vince, the man who popularized Optimal F, ever talked about adjusting Optimal F based upon a moving window on a system's recent performance?

Ryan: To be quite honest, I don't remember if he did that.

Ryan Jones' Fixed Ratio Trading

Eddie: Okay, well tell us about your thought process in improving on Optimal F.

Ryan: Well, let me put it this way. If you want to be aggressive, there are ways to be more aggressive without risking 30% or 40% or 50% of your account on two trades which is sometimes what Optimal F will do.

Eddie: Around the period of time we're discussing, did you have any trader friends or acquaintances who shared your views about money management.

Ryan: Quite frankly, while I know some traders and Larry Williams and I became friends, I felt like I was the only one questioning this type of stuff. So it something that I just had to figure out on my own. It was forced by my own experience and my own own conclusion that I couldn't bring myself to trade as aggressively as Optimal F dictated. And yet I wanted more efficient growth than low fix fraction approach would offer me.

Eddie: What forms of money management are dominant among hedge funds, money management firms and other types of Wall Street institutions?

Ryan: I don't know of any hedge fund that would apply Optimal F simply because it is dangerous. It is very, very dangerous. Almost everyone of them, however, applies a fix fraction, but with large account sizes they trade only a small fixed fraction such as less than 1% of the size of their pool of money. In my opinion that is still not the most efficient way to manage their money.

Eddie: Okay, let's talk about Fixed Ratio trading. What is it and what does it do?

Ryan: Fixed Ratio came about in the need for a system of money management for the smaller trader, which I was. Also, I wanted to address the need for a less aggressive approach than Optimal F. So I couldn't use the 2% fixed fractional money management that many brokers give you because it was just far too conservative and efficient. If you go higher, let's 10%, then on three trades you're risking basically almost a third of your account. If you lose three trades in a row, you're risking almost a third of your account. That's too aggressive. It's a very wide chasm to go anywhere in between there. You don't achieve any kind of efficiency by sticking with the fixed fraction.

What I did was break it down and analyzed what fixed fraction really is. It's one contract per every X number of dollars in your account. And to me that was the flaw. You didn't want all the growth to be at the backend, which is what fixed fraction did. If it's 1 contract for every $20,000 in your account, it's going to take you a very long time to get to 2 contracts. Whereas on the backend, once you get to $500,000, it's not going to take you very long at all to be able to add a contract to your position.

Eddie: So what you mean by backend is that with the fixed fraction method, a trader starting with a small account size had to sit there and watch his account grow like molasses. But once you reached a higher account size, the growth of your position size accelerated to a degree which was unrealistic and highly risky.

Ryan: Yes. And what I wanted was something that worked faster NOW for someone with a small account size but without taking big risks. So I analyzed it and said how can I do that? The simple answer was that I would require less profits in my account to begin with in order to increase from one contract. So I would increase my account size faster. But as I began to increase my account size, I would slow that position size growth down compared to the way the fixed fraction had me doing it. Essentially, I would slow the position size growth down so that the risk vs. aggressiveness was equal the entire way as the account size grew.

If I needed $5000/per contract to increase my position size by one contract in the beginning, then I would need $5000 per contract in order to increase my position when the account grew to $10,000.

So I basically equalized it. And what that allowed me to do was be aggressive at the beginning, but not too aggressive as the account began to grow. And it was much more steady. I was able to start seeing growth immediately instead of waiting until there was $20,000 in my account.

I looked at money management as a whole and I determined that you need a money management plan that addresses everything that can happen before you can start trading. You need to know exactly what you're going to do and when you're going to do it so that there are no surprises.

Simulated Results From A "Generic" S&P Day Trading System System
Example A: One contract per trade	Example B: Apply Fixed Ratio method
Fixed ratio trading adjust position size as a function of profits. When a system is performing well, position size is increased. In the above two examples, we're showing how a money management method can affect the outcome of a trading system. In Example A, the system is always traded with one contract per trade. In Example B, the same is system is traded with the number of contracts being determined by the net profits of the system. When profits increased, position size increased as well.

Eddie: Many traders look for a mechanized, non-discretionary method of trading that just generates buy and sell signals that you can follow, no questions asked. It seems as though you've created a system of money management that gives you "signals" that dictate how you control your position size. Tell me what steps readers of this interview can go through in order to implement Fixed Ratio Trading.

Ryan: Well, first of all, whenever you're making a money management decision, you're deciding what your initial position size should be. That is going to be decided on the basis of what strategy you're using. What I tell traders is that there is one goal that you first always address. And if you don't address this goal, you're not going to be able to reach any of your other goals.

The first goal to address is that the number one goal of trading is to survive. That starts with the size of the capital you're beginning with and how aggressive you're being with that. >From that you figure out your position size. And once you know that you can set the levels at which you're going to increase your position size. When you do this, you have to play a lot of what if games. You might say that when you've built your account up to $75,000 you're going to be trading four contracts. And then you have to think to yourself, if I go through a drawdown at that level, I'm going to be risk X amount in my account. If that's too much risk, then you have to adjust accordingly. By going through this process methodically through every conceivable scenario, there are no surprises. When you have this all figured out, everything becomes mechanical once you start trading.

Eddie: In Fixed Ratio Trading my understanding is that position size increases as a function of profit and loss. Can you walk us through the formula that you use to calculate that relationship?

Ryan: The formula that I use is to look at the largest expected drawdown. Ultimately, that's what a lot of my planning revolves around. The number one goal is survival. You've got to look at what you're largest expected drawdown is going to be. I can measure how aggressive or conservative I'm going to be. If I expect my strategy to go to a $10,000 drawdown, then I'm going to use $5,000 as my fixed ratio number in that I'll increase my position size by 1 one contract when I have a $5000 profit in the account. If I'm more aggressive, then I'm going to have a number that is lower than that. For example, I will increase position size when I have $4000 profit in the account. If I'm going to be more conservative, I'm going to go above that number.

Eddie: As the account grows would you use that same level of profit increment as the account grows?

Ryan: If you settle on a $5,000 level in order to increase from 1 to 2 contracts. Since we're using a fixed ratio of $5,000 per contract, and you're now trading two contracts, you'd have to go 2 times the $5,000 and that's how much profit you'll have to have in order to increase your position size to three contracts.. So now you'll need and additional $10,000 in new profits to go to three contracts. Then you'll need an additional $15,000 in profits on top of that in order to go to four contracts. Then you'll need $15,000 in order to go to four contracts. That is pretty much the fixed ratio of the equation. So to answer your question about whether you want to make adjustments, you don't want to do that until you have a very, very solid understand of how this all works and what the consequence of these changes are.

Eddie: I heard a story of a trader who approached you and who'd made a lot of money. And that he wanted you to help him add money management to his trading plan. And you said some sort of intriguing reply. Do you know what I'm referring to?

Ryan: Yeah. Someone came to me, read all of my material and then began trading without using any kind money management method. About a year later, he called me and told me that he was satisfied that his trading system worked. He had made $70,000 over the past year and now he wanted to start using money management. I was kind of shocked because based on the numbers that he gave me and my assessment of how his system performed, I determined that had he used my system of money management from the beginning, he would have made instead of $70,000, almost $700,000 by applying the money management from the beginning. This is something I hear a lot. People focus on getting their systems right first. And then money management is an afterthought. That is a wrong foundation that there working from.

Eddie: Let's take a step back. Let's walk through how the use of Fixed Ratio enables a trading account to grow, given that you also have a good trading system.

Ryan: We all know that a good system goes through winning streaks. The key is to take advantage of those winning streaks. During winning streaks Fixed Ratio trading allows you to be aggressive. But during a losing streak, you're taking away risk by lowering the position size. Let me give you an example. A few years back I turned $15,000 into $107,000 in 90 days. That was in a trading contest in which I daytraded the S&Ps. We basically were through a very nice winning streak in this system I was trading. Without money management, if I had just stuck with one contract the entire time, my $15,000 would have grown to something like $35,000. But because I applied Fixed Ratio money management I was able to capitalize off the winning streaks that occurred. Now during the rest of the year, my system did absolutely nothing! This occurred in April 2000, when the market tanked and the dynamics began to change. But my money management system can cut the number of contracts and protect profits.

Trader A vs. Trader B

Eddie: For purposes of illustration, let's look at a hypothetical situation. How would you contrast Trader A who uses no money management vs. Trader B who uses Fixed Ratio money management? Let's say that they both are using the same trading system.

Ryan: If Trader A uses no money management or perhaps uses a very conservative approach and only trades 1 contract on any given trade, what you're finding there is that his ENTIRE outcome is based on whether his system continues to work or not. Trader A's profit is based on his system. What I want to do with money management is get away from that.

I want to put more of the burden of the profitability, not on whether the system continues to work, but on whether the system will give me a winning streak that money management can take advantage of.

Let's say that Trader A makes $20,000 a year consistently over the course of 5 years, so that at the end of 5 years he has $100,000 in profit. But then his system stops working for the next three years and he loses half of that.

Contrast that with Trading B who applies the Fixed Ratio method using $5000 as his Fixed Ratio. That person will have the ability to increase the profits. At the end of that 5 years, instead of $100,000, he may have almost $1,000,000 trading approximately 20 contracts.

Eddie: And when Trader B's system goes into a drawdown, what is he going to do differently from Trader A?

Ryan: When the system goes into a drawdown and your account begins to lose value, you're pulling contracts, shares of stock, options or whatever it is you're trading. At set increments...as it's dropping, you're also reducing your position size.

Eddie: If the system continues to generate losses and you're reducing your position size, would that mean that eventually you'd stop trading?

Ryan: Yes. If the drawdown continued to exceed reasonable expectations. The key is that you would stop trading with a lot of profits! If you built up your account when the trading system was on a winning streak, here's what happens. Let's say you built up your account to $500,000 in two years, whereas Trader A by then only had $50,000 or $60,000 in profits. In both cases, the system has been profitable not suffered any major drawdowns. Now let's say that the system goes into a major drawdown and it loses $20,000 per single contract. At the end of that, Trader A is left with $40,000 in net profits and he decides to stop trading. It's too big of a drawdown for him to handle emotionally and financially. Whatever. On the other hand, Trader B who applied Fixed Ratio money management worked his account to $500,000 and he may drop it to $400,000. The difference between Trader A and Trader B is just unreal. In both cases, you're out of the market, but in Trader B's case, he took full advantage of the system when it was profitable and consequently, he had a lot more money to take off the table once the system stopped working.

1. The same exact entry and exit was used on both examples. Every trade was exactly the same in both scenarios.

2. The positions sizing strategy (money management strategy) increased the profit by a factor of more than 18 times trading a constant single contract.

3. The number of contracts being traded at the end of the money management example is at 38.

4. A $5,000 drawdown in the non-money management example represents 12.5% of the profits (net profits would be at approximately $35,000).

5. A $5,000 drawdown per contract in the money management example represents 25% of the profits (net profits would still be at approximately $560,000)

6. If the number of contracts would never decrease in the money management example, the per contract drawdown would have to reach almost $19,000 before the total net profits dropped to only $35,000.

7. As shown in the money management example, contracts decrease during drawdown. Because of this, it would take a $35,000 drawdown per contract to drop the money management net profits down to only $35,000. If that were to occur in the NON money management example, the net profit would only be at $5,000.

8. The rate at which contracts can decrease can be faster than the rate at which they increased. Accordingly, in the money management example, if the drawdown persisted in this situation, the number of contracts would drop to 1 at approximately $350,000 in net profits (would require a per contract drawdown of $17,000 to do this). If the contracts being traded dropped to 1 with $350,000 in net profits, the system would then have to continue to see an additional single contract drawdown of $315,000 to drop the performance down to only $35,000 in net profits.

9. The same scenario given above applied to the NON money management example would produce a net LOSS of $292,000!
   In the above example, money management would have a net profit of $35,000 in a system that ultimately had a performance with a net loss of $292,000!

Eddie: How do you respond to the reversion to the mean argument? Basically, from a statistical standpoint, a "good system" is destined to have both winning and losing streaks. But if the system is indeed good, when it goes into a drawdown period, it will likely revert back to its winning bias. Therefore, if you stop trading during a losing streak you have the potential of missing out on the next winning streak that is right around the corner. It's just like what often happens when traders throw in the towel just as the market bottoms out.

Ryan: The great thing about proper money management is that you don't have to guess about those things. You can't rally predict what a system will do in the future. A system that was once profitable may never make money again. Literally, you may go through a nice winning streak and it's a winning streak that never happens ever again.

Eddie: Indeed, many trading systems in the previous decade were developed in a bull market environment using test data that had an overweighted bullish bias.

Ryan: What good money management does is prevent you having to guess and it allows you to make your decisions on the basis of a mathematical fact. Your system is either making money or it's losing money. When it's making money, you can increase position size. When it's losing money, cut back before it diminishes your capital. Always pay attention to what is happening to your account, not just individual trades.

Eddie: Ryan, this has been good. And I suspect for many readers, it may be a revelation. But I caution traders not to try and construct a money management strategy based upon this interview alone. I know your book well and while we've covered the main concept, there are still a number details that are beyond the scope of this interview. Your book is called The Trading Game, Playing by the Numbers to Make Millions. Correct?

Ryan: Yes.

Eddie: And I understand you're on a mission of sorts to help traders realize that they must focus on money management first and trading strategy second, not the other way around.

Ryan: I have a course on money management that is 10-hours long. It reflects a lot of what's in the book and adds to it as well. It's really designed to just give people as deep an understanding of the subject as possible. And it's not just about my method, but about money management in general. I want people to have a good, broad understanding and then be able to make a decision from there. I just try to talk about money management wherever I go. I do some speaking every now and again. To be quite honest, it's not too hard to get traders' attention because most everybody else just lightly touches upon money management or else they totally ignore it. If anyone wants to find out about my money management course, they can go go to: http://www.smarttrading.com/

Eddie: Thank you Ryan.

Ryan: My pleasure.