Sunday, June 29, 2014

Determining your exposure and directional bias

I was asked the other day about how I go about controlling my market exposure and determining my trading bias. To do this, I look at the following three elements:
  • What are the general market conditions? (are the indices trending or non-trending, in an uptrend or a downtrend)
  • How are my existing positions performing?
  • Are there good opportunities coming up on my scans?

My basic strategy is trend following – therefore, the most favourable market conditions for me are a stable, trending environment. If the indices are in a volatile, non-trending state, then it is not so favourable. When that is the case, I will be more cautious in opening new positions.

Generally, I only open new trades when I have been able to reduce the open risk on any existing positions. My overriding concern is to control my risk and any drawdowns – slowly increasing my exposure in this manner helps me achieve this.

I have self imposed limits on the number of trades I can open on any given day, as well as an overall number of trades I may have open at any time. These are the maximum parameters, on the assumption that general market conditions are favourable towards my style of trading. If they are not, then I will further limit the number of trades I may open on any given day.

I also look at how my existing positions are performing. If long trades are performing well, and I have been able to reduce my risk on those trades, then I may look for additional trades which meet my criteria, even if the indices are not necessarily ideal.

Generally, my trading bias is determined by the direction of the general market. However, this is not fool proof. I can recall in periods in the past where I held several long positions in profit, only for the indices to give a short signal. Accordingly I opened one or two short trades. The markets moved down, but my long positions all held up well. Ironically, it was the short positions that I was stopped out of! As it happens, within a couple of weeks, the indices started moving back up towards new highs.

My scans present me with a list of stocks out of which those which meet my criteria are added to my watchlist. A lot of these never trigger, or do not meet all of my criteria. The number and quality of set ups which are presented to me is a further clue of whether there is potential to make money.

As an example, at the moment, I have plenty of setups on my watchlist. But, for whatever reason, they are not as yet hitting the required price level to trigger an entry. That may be due to any number of things (including the current indecision around new highs in the markets). But there are good quality setups there, so if they do trigger, and my overall risk parameters are respected, then I will take those signals.

Similarly, if I start getting a lot of potential short setups appearing on my scans, and a dearth of long setups, then that may indicate some weakness in the market, that may or may not be apparent in the indices. That may also affect my trading bias.

One other point on trading bias - if you have a number of long positions in place, yet an appealing short set up comes along, there is no harm in taking it. To me, a weak strong giving a short signal in a strong market indicates a high degree of relative weakness. Similarly, a long signal in a general downtrend may indicate a high level of relative strength. However, I would only do this if I have a number of trades already in the same direction as the general market.

So you can see how all of the above factors can affect the level of exposure taken, as well as my general trading bias. To a degree, how you use these elements is developed over time – call it intuition if you will. You may want to formularise some overall exposure limit based on these factors. However you do it, a good trading plan would have at least some of these points included – does yours?

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