Saturday, June 20, 2015

Always think about the risk!

Traders are essentially risk managers – your goal should be to ensure any losses incurred are kept as small as possible. While sometimes this means we possibility miss out on some profits, the overriding aim remains that of avoiding big losses.

We have had two instances this week where thinking more about risk rather than potential profits has proved beneficial to us.

The first example is APR Energy. As we can see from the chart below, this had a decent run up in the early part of the year, before consolidating over the last 2-3 months, where volatility contracted. This was therefore a stock that we had identified as a possible set up to trade.

Those who got into the trade saw the the breakout quickly failed, and by using our aggressive stop methodology, took the small loss, and moved on.

A lot of traders would easily get frustrated by closing out a position for a small loss. This is something we do on a regular basis - you can see here all the small losses we clock up. But this is all part of our overall philosophy – keep the losses as small as possible.

Trend following as a basic approach generally has a win rate well below 50%. Just on that basis, it will not suit a lot of people, as they attempt to seek comfort from a high win rate.

In his book Dairy of a Professional Commodity Trader, Peter Brandt had an interesting take on this which he summarised very well:

“There is no margin of error in the approach that needs to be right 70 percent of the time to produce its expected results.What happens if the 70 percent approach had a bad year?

Professional traders recognize the inherently superior risk management profile of the 30 percent approach. The 30 percent approach intrinsically has a built in margin for error. In fact, the 30 percent approach assumes that most trades will be losers. Every approach has good times and bad times. The expectation of bad times needs to be built into the equation"

As trend followers, we are happy to accept that most trades will be losers - keeping them as small as possible helps the overall expectancy of our approach. In this particular example, we can clearly see the benefit of doing this – the stock paused before starting to accelerate to the downside and then a big gap down following the release of a trading update.

This is the classic example where taking the small loss when it was available was absolutely the right thing to do. We have no emotional attachment to a position, and want to avoid 'hoping' that we don't have to take another small loss, and hold on for price to turn back in our favour. No, we want to eliminate the possibility of a small loss increasing, and possibly turning into a far greater loss. Had you held on to this trade, then following the gap down you'd have been looking at a loss in the region of -4R.

The second is Bankrate Inc (chart below), which had been earmarked as a possible set up a few weeks back. And, earlier this week, the stock did break out and move up quite smartly for a couple of days. However, by now we had no interest in taking a position, even though it met all our basic criteria. The reason for not taking the trade? We have a rule to automatically avoid opening new positions where the company has a scheduled earnings release due imminently.

The result? A big gap down on the open on Thursday after that earnings release.Had you taken that trade, then on the close Wednesday, you would have been +2.4R. The next morning, that would have turned into a loss of -4R on the open.

My own attitude to this is that putting on a trade when earnings are imminent is not trading, its gambling. In such a situation, where is your edge? And for each time you may get lucky and profit from a gap in your favour, there are just as many where they gap against you.

In keeping with my approach to control what I can control, I simply forego the possibility of benefiting from a gap in my favour, so that I can try and eliminate the possibility of suffering a price gap against me.

Avoiding these kinds of trades and results can help you to control your risk, which helps keep your emotions under control, an also helps to keep your equity as large as possible.

If you want to know more about how we trade, then come and join our group.

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