Sunday, April 06, 2014

Controlling portfolio heat when market conditions change

One thing I have found is that, when market conditions change, traders can get too eager and take on too many new trades, too quickly. This is driven by the fear of missing out on a profitable move in the markets.


This normally manifests itself once an index gives a new signal. So, if the FTSE say gives a new long signal, these people would be saying "Great! Better get loaded up", and go on a trading binge. While the signals given on the individual stocks may be perfectly valid, those traders fail to appreciate that, while there is a window of opportunity here, they forget about the increase in risk regarding their equity.

This is not the fault of the system or method that the trader follows, but of the trader. They are too eager to get in the market. They forget that any decent trend will last several weeks or even months. You don't need to go 'all in' on day one.

See how the general market reacts. More importantly, see how one or two new positions react, before committing more equity to new trades.

I have repeatedly talked here about having strict position limits, both in terms of overall portfolio exposure, but also a limit on the number of new trades I can take in any given day.

When a new signal is generated, there is obviously a lot of indecision - will the signal be the catalyst for a new trend, or will it fail? The potential for profits is at its greatest, but the risk of failure is also at its greatest. This principle applies to individual stocks, as well as applying the system signals to the major indices.

The way I like to approach this is to 'scale in' to a new market move. I don't want to see my portfolio heat (overall exposure) jump from nothing to say 30% (the maximum level I have set myself) in one or two sessions. Any increase in heat needs to be controlled.

I will put on one or maybe two trades to test the water. Do they start to move in my favour, or do they quickly fail? If its the former, then I will start to look for other valid setups and signals, and slowly increase my exposure. Remember though that my stop methodology means I quickly reduce my risk on any new trades, normally after 24 hours or so. For example, if on day one I open two new positions, then my initial risk is a combined 2R. After 24 hours, these positions may be closed (if they haven't acted as intended), or my stops are adjusted, so that my combined risk might now be say 0.5R.

"Stocks should be at a profit the first day you buy them. In fact, having a profit on the first day is one of the best indicators that you are going to make money on the trade" - David Ryan, from his Market Wizards interview

Never forget that without equity, you cannot trade. What if the general market itself gives a trend signal that fails? If you've jumped in a number of trades, you may get whipsawed around and have stops hit in those same trades. This leads to drawdowns, and a lot of frustration, or even anger.

The irony here is that these same people cannot stomach taking even a small loss on a trade. Yet they are quite happy to put on a whole bunch of trades in one go, and significantly increase their portfolio heat (or overall risk). Controlling your levels of portfolio heat, and how you increase your exposure, is all part of the discipline a trader needs to acquire.

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