Tuesday, January 08, 2013

Two sharp risers - and how to tackle them

Below are two charts of stocks identified by the system which have shot up over recent sessions. One of these I currently hold a position (and was called in the protected Twitter feed), the other I did not. However the principle for dealing with a stock acting like this is what I want to discuss here.

When a chart breaks out like these have, there is a tendency for a retracement (often a sharp one) that in some cases does not negate the new trend being signalled. Refer to this post, in which I show another recent sharp riser that I traded which shot up and collapsed all within a few sessions).

When confronted with this kind of situation, do you 'panic' and close out all your position, or do you pull up your stop into a technical no-man's land? With the first option, you risk missing out on a pronounced trend that has potentially only just started, thereby leaving a chunk of profits on the table. With the second option, you run the risk of being stopped out on a relatively minor retracement, again meaning that you potentially miss out on further profits. But the open risk (the distance between the current price and your current stop) is significantly higher than your initial risk (the distance between your entry price and your initial stop). There is a third option, which I use ONLY in situations like these, and that is to use what is referred to as the uniform risk exit. This is where you close of a portion of your position, simply in order to bring your open risk down to something akin to your initial risk when you opened the trade.

This is somewhat contradictory to what people like the Turtle traders would have done, as they used pyramid techniques when a trade started going in their favour. This often lead to huge gains when a trend continued in their favour, but conversely made have contributed to their volatile returns when, after pyramiding up to what they called a 'full on' position, the trend promptly reversed.

I read an article about the this sort of approach several years ago, and in the historical backtest showed this form of exit cut down on the volatility of the equity curve, and in actual fact slightly improved the overall peformance. As I say, I only use it for specific trades - if, in these two examples, the current price and the trailing stop kept the open risk within a reasonable parameter, then there would be no need to use such an exit approach. This type of exit also allows the trader to avoid the emotional upheaval of seeing significant profits being eroded.

As it happens, I used the uniform risk exit approach on two of my positions this morning, where the open risk was 3 or 4 times more than my initial equity risked on opening the trade.

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