Method to the Madness (Part 1):
- Limit your commitment to any one
stock or financial instrument to only 10% of your trading account. If you
have $50,000 in your account only consider putting $5,000 towards any
particular trade. This applies regardless of how good you think the
opportunity may be.
- Limit your commitment to any
market sector to a maximum of 25% of your trading account, or $12,500 for
the example above. Securities in any particular sector tend to move in
tandem, so you don’t want to have too much of your account riding on any particular
group.
- Limit your possible loss on any
one trade to 2% of your trading account. While this may sound very low,
bear in mind that this is the possible loss, and not the amount you put
into the trade. Some professional traders even think 2% is too much.
- If you are trading in a financial
instrument that may result in a margin call, such as futures, plan to use
a maximum of 50% of your trading account in active trades so that you have
an adequate reserve on which to fall back if things don’t work out.
Many traders will aim for at least a 3 to 1 reward to risk
ratio. So you look for a profit level three times as high as the possible level
of loss. If you don’t stand to gain that much, then it’s probably not worth
trading and taking the risk. Your primary goal should always be preservation of
your account, and if you then take favorable trades your money will grow.
If we are winning we think we are a market
genius while if we are losing we tend to get upset, angry or even depressed.
Such is the nature of trading. Rare is the person who can stay emotionally
balanced in the face of either mounting losses or winnings.
What we need is something
that will tie us to the mast so that we can weather those emotional ups and
downs with objectivity. We need to plan ahead so that when we are about to
experience a losing trade we already have a strategy in place to deal with it.
The first line of defence
is the much talked about and celebrated protective stop loss order. No trader
should begin trading without them.
However I know I am not
the only trader in the world who has violated my own stop loss discipline the
moment my trade started gunning for that magic number.
I am only human and
losses hurt like hell. We are programmed by society to not be losers. Losing is
bad. Losing money is reallybad. It is therefore no surprise the
lengths we go to in order to avoid them.
Stop losses are a good
tool in a traders arsenal but I personally need more. I need to examine in
black and white what an idiot (or market genius) I have been after the event.
Enter the R-Multiple.
What is it? My explanation is best served with an example.
Suppose I have entered a
trade and I have allowed myself a permissible loss of £50 on that trade.
That is my 1R.
If I close the position
out with a profit of £100 then my R-Multiple is 2R. I have doubled my return on
capital.
If I close the position
out with a profit of £150 then my R-Multiple is 3R. I have made three times the
capital I was willing to lose.
And if I have a loss of
£100 then I have a negative R-Multiple of 2R.
In the last example only
one of two things can have happened a) I disobeyed my stop loss discipline
or b) the market gapped seriously lower and the first price I could get
before my stop loss order kicked in was £100 below my entry point. This is
uncommon and though it does happen in all likelihood would rarely result in
such a poor R-Multiple.
Some people use nominal
amounts in analysing their trading results and that’s fine with them but it
does not give a true reflection of how well a trade went.
Every savvy investor
knows its return on capital that counts and not the capital amount itself. The
R-Multiple is merely a measurement of return on capital employed.
There’s an old axiom which is still true, ‘Cut your losses and
let your profits run’, which most traders know, but many find difficult to
apply in practice. It is natural not to want to prove yourself wrong, and in a
sense that’s what you’re doing when your trade doesn’t work out and you have to
close out the position for a loss.
Position Sizing tells
a trader how much stock to buy. Correctly sizing your positions is one of the
most important areas of trading as it affects both diversification and money
management.
Factors that determine
the size of your position include –
- the ratio of risk to reward for
the trade
- risk tolerance of the trader
- trading account size
- current market exposure
- free equity
The
Breakout
Often the price will hang
around in the same general range for a time, with what is called trendless or
sideways trending, or sometimes range trading. Then something happens, and for
some reason the price starts moving either up or down, beyond the range it has
been in.
When the price breaks out
from an established pattern, you may consider that a new trend is starting. The
question is at what point you should decide to take the trade, and there is no
one correct answer. You can take it early in anticipation of the breakout,
acting on signs from technical indicators and chart patterns, but you stand a
risk that the signs are not going to play out as you expect, and the breakout
may not happen. On the other hand, if you hesitate too much, you may find that
the move is nearly over by the time you are sure.
It’s a balance. What many
traders do is identify a price level which they are comfortable with saying is
a level that will not be reached if the price is still trending sideways. Then
by definition any move beyond that level means that a trend has started, and you
can trade with a reasonable expectation that it will work.
Trendlines
If you have an
established trend, you can choose to enter the position when the price is on
the trend line and you’re expecting a continuation of the trend. If the trend
continues to hold, you expect the price to continue up in an uptrend, as the
trendline establishes the lowest point of support. Similarly, in a downtrend
the trendline marks the highest level of resistance.
Breaking
the Trendline
Another use of the trend
line is to watch for a technical sign that the trendline is about to fail, and
the trend may reverse. You can also use this as a reason to exit an existing
trade.
Support
and Resistance
Using support and
resistance is similar to the process described above with the trendlines –
because trendlines are simply angled support and resistance lines, when you get
down to it.
So if you have an
established support level, and the price comes down to touch it, with no
indication that the market has changed you may choose to take a long position,
expecting the support to hold. The same applies with resistance, as a price
that has risen to resistance should be repelled by definition.
Once again you can look
for breaking of the support or resistance. Traders use different indications to
confirm that the price has truly broken, and may not return again to the
previous range, for instance they may require that the price stays outside the
support or resistance for two trading days, or that it is more than 3% away.
This tactic is very
similar to “The Breakout” above, but is generally applicable whenever you have
found solid support or resistance levels, regardless of whether the price has
been trading in a limited range previously.
Retracements
Even in an established
trend, we know that the price will not simply go in one direction all the time.
Periodically, there will be retracements which technical analysis tells us are
commonly from 1/3 to 2/3 of the distance that the last leg moved. By keeping an
eye on a trending price, you should be able to see firstly how strong the trend
is, and secondly when a retracement has started. If it is a strong trend and
likely to continue, you have two ways to play the chart.
First, you can trade
countertrend, jumping on the retracement but watching carefully when
significant levels, such as 33% or 50% of retracement are reached to see if the
move is over; secondly, you can watch carefully for the move to be over before
trading with the trend, and this means that you take an early position on the
price.
Gaps
Even gaps can provide
information to allow a good entry. If the price retraces to a runaway gap, you
may expect that the gap will give support and that the trend will resume. In
this case, you would buy if the price dipped to the gap. The overall concept is
to buy when the price is near support, but to watch carefully for any violation
of the support so that you can exit a losing trade.
Summary
- your main aim in trading is to
preserve your capital
- position sizing is essential in
achieving this task
- don’t trade more than 10% of your
account in one position
- don’t trade more than 25% of your
account in one market sector
- don’t risk the loss of more than
2% of your account on any one trade
- in a losing position, avoid risk
and cut your losses quickly
- in a winning position, seek risk
and let your winners run
- learn to control your emotions and
trade consistently in accordance with your plan
Excellent content. Keep up the great work.
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