Sunday, January 25, 2015

10 Ways to control risk

My main goal as a trader is to control risk. I make money by ensuring I do not lose big chunks of equity in a short period of time, or on a single trade. Below are a list of some ideas I use to control risk, which you may want to consider.

One or two of these may also go against widely held views of other traders, or even 'pure' trend following principles, but that's fine - these rules suit me and my approach to risk:

Keep your risk per trade small
Lets start with the obvious one - to control risk, make sure you only risk a small element of your equity on each trade. While trading smaller limits your profits, it also limits the losses. We want to stay in the game, and keeping our losses as small as possible will mean keeping those drawdowns restricted as far as we can.

Take small losses
If a trade starts to go against you, then get out. Do not give a losing position the opportunity to develop from a small loss to a much bigger loss.

As I am a breakout trader, if price moves back into the pre-breakout consolidation zone, that is a signal to me that the breakout has failed, and I get out of the trade.

Trade with the trend 
Studies* have proved that, once a trend starts to develop, it will tend to persist. By trading in accordance with the line of least resistance, you avoid trying to pick tops or bottoms in a market. We don't want to fight the market - when we get a signal, we just look to hop along for the ride. Crude oil and EUR/USD are classic examples of major trends that have developed in recent months, as well as numerous stocks that are in trends (up or down) at any time.

In his book Trend Following, Michael Covel has included a chapter looking at some major market events, where trading in line with the trend was the right (profitable) way to go. As an example, Nick Leeson's trades in the Japanese Nikkei and the subsequent collapse of Barings Bank.

Of course, it doesn't always work, but we are playing the odds here, and all we are doing is trying to skew the odds of success in our favour.

As this article shows, despite the known price barrier in EUR/CHF, some trend following funds were already holding positions in the direction of that price barrier being breached, because that's where price was going, whereas some fundamental based funds were trading in the opposite direction.

Avoid trading around earnings or major economic releases
Does anybody know how price will react on an earnings release? Does anybody know what will happen following to a Non-Farms Payroll announcement? If you open a trade just prior to such an announcement, where is your edge?

The one bit of fundamental information I look for when trading stocks is to see when the next earnings release is scheduled to be. If a signal triggers within a week or maybe two of such an announcement, then I won't take the trade.

Some traders I know do things differently - one trader will still take the position, but will widen his initial stop to factor in the increase in volatility and/or the possibility of a price gap against him, and accordingly will reduce his position size.

Even then, you cannot eliminate the risk associated with earnings. One company in which I was a holding a profitable position decided to announce a 'pre-earnings update' - a profit warning to you and me, two weeks before the next scheduled earnings report. I went from a +2R profit to a -2R loss overnight. This was something that could not have been foreseen.

Some traders I know follow trends, but will close their positions in a stock which has earnings imminent, regardless of if they are in a profit or not, simply to reduce their risk even further.

Day traders will need to be aware of major economic releases which can move the markets in a short period of time. If you got a signal in an index immediately prior to the latest Federal Reserve interest rate decision, would you take it?

Avoid pyramiding
Once I am in a profitable position, I want to reduce my risk, not increase it. It has been several years since I tried to utilise pyramiding in my own trading. More often than not, when I added an additional unit, that seemed to mark the extreme of the move, and I would end up losing the profit I had generated on my original entry.

I am also wary of increasing my risk when a sudden price gap can go against me, meaning I could lose a lot more than the 1R risked on my original position.

This goes against what a lot of traders do, including trend followers such as the Turtle Traders, who were quite aggressive in pyramiding winning positions.

A big issue I have seen with other traders is taking on too much risk in too short a period of time. They may start a week with no exposure to the market, and after getting a glut of signals one after the after, they have ended up that same week in a whole bunch of trades. If the trades work out, then great, but if they don't...

It is for this reason I limit the number of trades I can open on any given day. I will open one or two positions, see if they start moving into profit (whereby I can reduce my risk by use of my stop methodology), and then look to see if other stocks on my watchlist are giving signals. By doing this, I am slowly increasing my level of exposure and risk.

Avoid closely correlated trades. If you trade indices, and you got simultaneous buy signals in the Dow, S&P and the Nasdaq, should you take all three signals? I had a similar situation recently - I got a buy signal in both gold and silver on the same day. I only took the signal in gold, as it was the first to trigger. If you trade a small basket of instruments, then you must ensure you have sufficient diversification in that basket and/or the trades that you have open at any time.

With stocks, I do not focus on a single market or territory. Currently, I have long positions in UK, US and European stocks. Should I get a decent short signal on a stock, then providing my criteria are met I am happy to hold both long and short positions at the same time.

Avoid trading a market where there is a known artificial price barrier 
As we have recently seen, traders should never rely on such a price barrier remaining in place. These can be removed at any time, with little or no warning. Other similar events were covered in some of the Market Wizards interviews - Michael Marcus and his plywood trade, or Randy McKay and his GBP/USD trade in 1976. Some traders are comfortable taking the trade betting such a barrier being breached - but even then as we saw last week, massive slippage on entry caused people who were betting on that lost money on the sharp rebound as well.

Uniform Risk Exit
Occasionally I may get into a trade which massively goes in my favour, and the trailing stop may end up significantly lagging the current price. As a result, the open risk on the trade will have increased - possibly to several multiples of your original risk on the trade. While pure trend following may indicate that you leave the full position open, on a few occasions where this has occurred I have taken a proportion of profits off the table, and left the balance to run, simply to reduce the amount of open risk on the trade.

Follow your rules!
If you have rules such as those listed above, what you must do is actually use them! People can start doing the weirdest things if they fail to do so, and matters can spiral quickly out of control. All semblance of self-control can disappear, leading to a total loss of any discipline. I talked more about this here.

Of course, some of these factors may limit profits as well - for example, if you are able to pyramid a profitable position which continues to move in your favour, or you get into a lot of new trades quickly which move up in unison, you can make a lot of money in a short period of time. However, if they go against you...

Trend followers tend to be durable - we are not looking to make thousands of percent by this time next week. We are in for the long haul. A losing trade should just be one small blip in the journey of the next 10,000 trades. Controlling risk at all times is a key factor in achieving this.

So, while trend following is an absolute returns approach to trading, your primary goal at all times should remain to control your risk.

* One such study on stocks is discussed in Trend Trading, by Daryl Guppy

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