By Teresa Lo*
Posted: Oct 30, 2009
Trading success is made up of many factors, well planned and well practiced. Among the most important are the judicious use of stops, the downfall inherent in focusing on short-term performance to the detriment of long-term results, the three crucial factors in risk management and the primacy of risk management in ultimate success. Herewith, I offer my thoughts on these subjects as put forth in answers to questions to me from fellow traders.
Stops
One of the common complaints about stops (especially in a volatile tape) is that you'll often get stopped out on positions too early. How does one address this problem?
Although using stops cannot be said to produce perfect results, I think it is wise to use them – if only to keep a losing trade from slipping down the slippery "slope of hope". A separate issue that plagues undercapitalized traders is the fact that they use stops that are way too tight because they "can't afford" to place them in the proper location.
If a stop is placed inside the normal fluctuation for the symbol and time frame, one must expect to be stopped out prematurely. The only answer to this problem is to place the stops where they ought to be and trade a smaller size.
Longer-Term Performance Trumps Shorter-Term
In what can only be characterized as an oversimplification, one could say that doing the opposite of what appears reasonable, rational and logical is the higher-risk / higher-reward trade, generally speaking – it's why the majority is always wrong, right?
To answer this question, we can refer to research done in the field of behavioral finance. It has to do with human nature and how people react when they are forced to make decisions under conditions of uncertainty.
People basically maximize their "chances" of making money rather than maximizing profits. This leads them to give losing trades a lot of rope in hopes that the trade will turn into a profit. In the meantime, they take very small profits. William Eckhardt summed it up really well in The New Market Wizards:
Anyone with average intelligence can learn to trade. This is not rocket science. However, it's much easier to learn what you should do in trading than to do it. Good systems tend to violate normal human tendencies. Of the people who can learn the basics, only a small percentage will be successful traders.If a betting game among a certain number of participants is played long enough, eventually one player will have all the money. If there is any skill involved, it will accelerate the process of concentrating all the stakes in a few hands. Something like this happens in the market. There is a persistent overall tendency for equity to flow from the many to the few. In the long run, the majority loses. The implication for the trader is that to win you have to act like the minority. If you bring normal human habits and tendencies to trading, you'll gravitate toward the majority and inevitably lose.
Not many traders extract so much from the market that they end up donating $20 million to their alma mater, making William Eckhardt a standout in an industry filled with blowhards and snake oil salesmen.
What really matters is the long-run distributions of outcomes from your trading techniques, systems, and procedures. But, psychologically, what seems of paramount importance is whether the positions that you have right now are going to work. Current positions seem to be crucial beyond any statistical justification. It's quite tempting to bend your rules to make your current trades work, assuming that the favorability of your long-term statistics will take care of future profitability. Two of the cardinal sins of trading – giving losses 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.
When Eckhardt speaks, I listen. Beyond behavioral finance is recent research by Mordecai Kurz and his theory of rational beliefs.
So, What Is Risk Management, Anyway?
One of the most confusing and frequently least understood, but at the same time, most important aspect of trading successfully is proper risk management. However, if you ask 10 traders what they mean by risk management, you'll often get 10 different answers. Of course, their responses will frequently include "you must use stops", "keep your losses small", "never risk more than X% amount on any trade", and so forth.
However, many traders and investors find that these suggestions are not helpful because they're incredibly difficult to apply consistently and effectively in the real world, especially when real money and emotions are on the line.
That's why many traders have been flocking to systems and indicators that offer buy and sell signals mechanically, much like those I offer through my proprietary InVivo indicators.
It seems to me that risk management has several components. First and foremost, how much leverage does the trader intend to use? I wrote a free book about trading called Own The Zone. In Chapter Four, I go over the logistics of trading and the use of leverage. If there is one single determining factor that can be listed as the "cause of failure" in trading, I think it has got to be the excessive use of leverage.
For example, futures and Forex traders routinely use 2 to 3 percent of their own money and borrow 97 to 98 percent of it on margin. This means that, if they lose the 2 to 3 percent on a trade or a series of trades, they are out of the game.
These traders cannot afford to swing trade off the daily chart because the normal fluctuation is too high, so they move into the intraday time frame where increased commissions and slippage nickel and dime them to death. On top of all that, traders who are not aware of the leverage issue also tend to be novices who don't know much about trading and / or they are not used to making many decisions in the short amount of time required for day trading. This is a recipe for disaster.
The second issue is position sizing. Many people feel that this is an inherently complicated subject, but, if we talk about it in terms of a casino game, such as roulette, and how much of the bankroll to bet on each spin, I think most people instinctively know that it is unwise to bet it all on black and hope for a good outcome time after time.
A lot has been written about position sizing. The basic goal is to reduce the risk of ruin to some small probability. For example, if a trader uses no margin and loses 5 percent of his or her capital per trade (ignoring the declining balance), it would take 20 losing trades for 100 percent of the money to be lost.
Say a stock is trading at $30; the initial stop loss might be indicated at $28. A trader might allocate $5,000 from his or her account to trade each stock with a 5-percent risk budget. We make two calculations and trade the smaller number of shares:
Calculation 1:
$5,000/$30 = 166 shares x $2 loss = $332 of minimum potential loss, which is larger than the risk budget.
Calculation 2:
$5,000 * .05 = $250 of risk budget
$30 - $28 = $2 of minimum potential loss
$250/$2 = 125 shares
125 * $30 = $3,750 to check that the position size does not cost more than the capital allotted
I know other traders use Kelly, fixed fraction or even "R", but I have serious reservations about these schemes and do not use them.
The third issue is diversification. A trader may have a $50,000 trading account that can be divided up into 10 or 20 positions, but the trader must ensure that they are not all in the same sector. When we calculate the correlations, we don't want the positions to be highly correlated to one market; otherwise, we might as well trade that market.
Recently, individual and professional investors have taken tremendous losses. If we took a close look at those losses, we would probably see that those individual traders and professionals mishandled all three issues – leverage, position sizing and diversification – and ended belly up.
Average True Range and Back Testing
What about using average true range for buy / stop signals? And, how about back testing comparisons between my stops and others?
This is going to be a two-part answer. First, on back testing. Many people will buy a system, back test it on a number of stocks over a 10-year period and then declare a system to be either good or bad. You can see how this is loaded with assumptions. Let me list two:
- You are assuming that you would have traded each of these stocks for 10 years. The question to ask yourself is this: "Would these stocks have fit my scan / search / stock-picking criteria for the entire 10-year period?"
- Also ask yourself: "How do I know for sure that my stock-picking criteria can find the winners?" If you look at the cumulative results and analyze them carefully, are you making money when the broad markets are going up? Are you making more money because you're using a lot of leverage? Are you comparing your results with the proper benchmark?
Back testing a trading system on a number of stocks over a certain period of time without knowing if they would have fit your stock selection criteria in the first place does not provide much insight into either the trading system or your stock selection skills, which brings us to the second part of my answer.
If you look at many of the trading systems, their stops are a function of average true range. Many of them calculate stops that appear to be similar, so it stands to reason that the buy and sell signals will be similar; therefore, the results are highly dependent on position sizing and the amount of leverage used.
The "edge", as it were, may not be in the actual entry or exit signal or stock-picking skill, but in superior risk management protocol.
*Reprinted (and modified) with permission from Teresa Lo, creator of "PowerTools for eSignal", the founder of InVivoAnalytics.com and the senior portfolio strategist at a private investment management firm
