Wednesday, January 05, 2011

Mind the gap(s) - negative surprises

If you read a book like Market Wizards, you will note that these successful traders' most traumatic experiences occurred when price went against them significantly, and they were unable to exit their positions at their desired exit point.

If they were trading commodities, this usually happened when a position went into a run of limit-up or limit-down days, making it impossible to exit their positions.

In the case of the Turtle Traders, the day AFTER the stock market crash of 1987 they managed to lose all of their profits for the year (a 65% drawdown overnight) when interest rates, which they were short, rocketed overnight.

As a trader of stocks, I am continually aware of price gaps, mainly as a result of news releases before the opening bell. It is my job as a trend follower to ensure that any 'price surprises' can be controlled wherever possible. In my own case, as I trade via spreadbetting (and in particular by using IG Index as my trading platform), I can do this by using their guaranteed stops facility. These can control your losses by guaranteeing your exit from a position at a price you have specified, regardless of a price gap occurring.

Below are two charts of stocks showing a negative price surprise. In both cases, a traditional stop would have been rendered useless, due to the size of the gap.

From 2009, here is a chart of Hardy Oil & Gas:

Although there was a significant price gap down, you still would have been able to get out at a price above your original entry point. So none of your original equity would have been lost, however the vast majority of your profits would have been wiped out.

From this week, is a chart of US stock Inspire Pharmaceuticals:

This gap was even more crippling, as the gap down went about 360 points below the original entry point. Had you used an inital stop of say 40 points, this would have resulted in a loss of 9R - risking 2% of your equity on this position, that's an 18% drawdown on one position.

These show why I prefer to use the guaranteed stop facility. At all times, one must control the amount of risk they are exposed to. Against this, there are some drawbacks to using the guaranteed stops:
  • You are required to pay a small premium when opening a position (it is added to the spread);
  • These stops are required to be a set distance away from the entry price (usually 5% - 10% for a UK stock, depending on liquidity, market cap etc, and 10% or more for a US stock);
  • Not all stocks can be traded using a guaranteed stop.
You pays your money, you takes your choice. As your trading equity (hopefully) increases, then you may enocunter problems with using guaranteed stops simply relating to position size. Because of this, if I was not going to use them, I would reduce my risk %age per trade - there's no way I could comprehend losing almost 20% of my equity on a single position, no matter how remote the possibility. The potential downsides to not using them I consider an irritant, but the protection they can give you against adverse price moves protects your trading capital, and enables you to maintain an even keel psychologically.

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