Monday, April 19, 2010

How to keep open equity risk in check

In my own experience, the biggest problem I've seen with relatively inexperienced trend followers is the question of stop placement in an open trade. 

Most trend following systems are used on commodities, FX and indices. I tend to trade stocks, but there is an added complication here in the effect of opening gaps, widening of spreads etc, which need to be factored in when looking at stop placement.

There is a secondary question as well - the risk to your trading account increases when a position goes in your favour. Let me explain.

Assume you have taken a position in a stock that has broken out where your entry price is at say $20, and your initial stop is placed at $18. The initial stop can be placed in relation to a previous low, a moving average, or based on a volatility measure such as ATR.

Your risk on this trade is set at $1,000, therefore you have purchased 500 shares. Now, the market is good to you - your stock quickly rises over the next 2 or 3 sessions to $22. Now where do you place your stop? The moving average hasn't moved much is only 2 or 3 sessions. When a successful breakout occurs, volatility tends to increase, so an ATR based stop will be lagging too. There is no prior low to use other than that used when placing your initial stop. 

So what do you do?

Some traders simply move their stop up based on a percentage distance from the current price. This means that the stop is now placed in a technical 'no man's land' zone on the chart. A retracement after entry (which can be wild as a result of volatility increasing) could get you stopped out for no real reason.

There is another option. Say that you want to keep your risk per trade at $1,000. Based on our example, the stock price is now $22 whereas our stop is still placed at $18. Based on 500 shares, our open risk on this trade has doubled to $2,000. 

If you were fortunate enough to have more than one position acting in this manner, the risk to your open equity has massively increased. 

There is no harm in taking an element of profits off the table - ideally to keep your risk per trade the same. So, in our example, you sell 250 shares. This means you've banked $500, you've re-balanced the open risk on the trade back to $1,000, and you've kept your stop placed in a meaningful position technically.

When trading several positions at one time, no doubt some traders have experienced a large erosion of open profits when the market sharply goes against you for one or two days.

Inexperienced traders would bail out of their positions - usually this happens at the exact low of the retracement, before the markets (and your positions) go back in the intended direction.

The above method (which I call the Uniform Risk Exit) will help keep you on an even keel, eliminating any rash or emotionally driven trading decisions, together with reducing any sharp reduction in your open equity.

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