More on knowns, unknowns and risk

The recent passing of Donald Rumsfeld caused me to reflect again on his (in)famous "known knowns, known unknowns and unknown unknowns" speech (see here), but the truth is that we always have such instances possible in the markets, at any time.

Current market volatility and staying the course

In the last couple of weeks we have seen an ever-increasing level of volatility within the context of a sharp drop in price in the major market averages.

We have also started to see intervention in the markets by governments and regulators - additional liquidity being provided and interest rate cuts, as well as market trading halts (up and down) being triggered and the introduction of short selling bans on certain stocks.

Trend following, absolute returns and controlling open risk

At its core, trend following is an 'absolute returns' approach. You only have to look at the high-octane monthly performance generated by the Turtles back in the 1980's to see that. But to achieve that, you generally cannot impose too tight a control over the levels of volatility you have to endure. That is the other side of the coin.

Another example of a nasty price gap

If you subscribe to the Mark Douglas theory that in the markets anything can happen, at any time, then you will know and accept the potential effect that sudden or unexpected announcements can have on price of a stock or instrument.

Seemingly you can be comfortably sitting in profit on a trade, even with your trailing stop above your entry price, only for a price gap to occur against you, resulting from the reaction to such an announcement.

It is for this reason why I never take into account open profits for position sizing purposes. A profit or loss on a position is not known until the trade is closed. Open profits can disappear - seemingly overnight with little or no warning, and your trailing stop may be rendered worthless.

Ten years on - the critical lessons I learnt from 2008

Ten years ago the equity and financial markets were in the middle of an unprecedented period. My interactions with the markets around that time were the ultimate proving ground for putting into practice what I had learnt and developed over the previous few years, and my experiences over those few months helped propel me forward as a trend follower.

Some of it wasn't easy, and some lessons learnt (and re-learnt!) cost me money. But in the long run, the tuition fees paid have been covered many times over.

Here are some of the lessons I learned from that time, which still form part of my overall approach:

Donald Rumsfeld, Paul Tudor Jones, Facebook and Twitter

“I don't risk significant money in front of key reports, since that is gambling, not trading." - Paul Tudor Jones

When you are trading, the only elements you can control is when to enter a position, where you place your initial stop, your position size and the amount you are willing to risk.

Once you are in a trade, you have no influence over what will happen - the market (being other buyers and sellers) will determine future price direction, and consequently whether your position goes into profit or a loss.

You of course do have control over where you place your initial or trailing stop, but you do not always get out at those prices - particularly if you end up on the receiving end of a price shock and a resultant gap against you. As a result, there is always a risk that you can lose more than your initial risk on any trade.

Earnings releases are, in Rumsfeld-speak, a "known unknown". We know when they will occur, but we cannot predict or quantify their effect on price. Therefore, there is always potential downside risk attached to them. Some announcements may see price move in your favour, others can go against you.

This week we have seen two big-cap Nasdaq stocks suffer large price gaps following earnings releases. The charts of Facebook and Twitter are below.

My biggest loss in 4 years

So, let's not beat around the bush. This morning I suffered my largest loss on a single trade since the summer of 2013.

As of yesterday's close, the position was +1.13R in profit. Within a few seconds of the market open, I was stopped out for a -1.95R loss.

S*@t happens. Let's look at the chart:

Controlling your losses, good trades and bad trades

Good traders continually worry about trying to minimise any potential downside. By the same token, they try to avoid placing any restrictions on the potential upside.

Take the four possible scenarios on any individual trade: 

• Big win; 
• Small win; 
• Small loss; and 
• Big loss. 

Good traders try to avoid the big losses at all costs. If you have a robust trading approach that has a positive expectancy, then the small losses can easily be recovered from.

Two stocks, two earnings reports, two different actions

Here is the story of two stocks which, this week, announced earnings. I had long positions in both these stocks coming up to the announcements however my treatment of the two trades differed. But first, I will explain my general approach to trading stocks and earnings.

Choosing not to play - how one trader approached the EU referendum

"Systems trading is ultimately discretionary. The manager still has to decide how much to risk to accept, which markets to play, and how aggressively to increase and decrease the trading base as a function of equity change. These decisions are quite important - often more important than trade timing." - Ed Seykota

Two weeks have past since the result of the EU referendum here in the UK was announced.

Larry Hite and the EU referendum

"When I was a kid and got my first motorcycle, I had an older friend who would always get into fights. He told me, "Larry, when you are on a motorcycle, never argue with a car."" - Larry Hite, from his Market Wizards interview

This week I have been reminded of the above analogy when thinking about the EU referendum here in the UK. This is a classic example of a major 'event' which may (or may not) cause significant volatility and movement in the markets.

An example of how emotions can affect your risk to reward performance

A couple of years back I had a meeting with a trader who wanted to improve. He had taken a break from the markets, and came to me for help in putting together a clear plan in place with good risk management and having the right mindset at the top of his list of priorities.
I've talked in the past about how closely your attitude to risk can affect your level of emotional control, and ultimately your discipline, as a trader.

With this in mind, we talked at length about his previous trading experiences and in particular his most profitable trade, which was this set up on the a UK stock. Here is the chart:

Some thoughts on stops

There are some inexperienced traders out there who seem to have a strange attitude towards the use of stops. A stop should be based on a price level where:

a) their trade idea should be proven to be invalidated;
b) the loss incurred tallies with the pre-determined amount they are prepared to lose on that trade.

One year on - have the changes worked?

"The great thing about being a trader is that you can always do a much better job. No matter how successful you are, you know how many times you screw up. Most people, in most careers, are busy trying to cover up their mistakes. As a trader, you are forced to confront your mistakes because the numbers don't lie." - Marty Schwartz

It is about a year since I start making some changes to my own trading approach. This followed a poor run of losing trades over several months which eroded most of the gains I had made in the first part of 2014. So, did those changes work?

A three point plan for long-term success

Providing you have got a method of trading which has a positive expectancy, here is a brief three point plan which will keep you moving forward on your trading journey:

When you are wrong, don't stay wrong!

In this recent post, I referred to Ocwen Financial Corp, a US stock that had been on my watchlist, and which broke out to new highs just ahead of earnings, triggering a possible entry.

Now, as I have mentioned numerous times, I do not initiate positions just ahead of such releases - the potential for price gapping against me is a risk I choose to pass on. My own belief is that is gambling, not speculating.

In this particular instance, price did gap down, which, had I taken the trade on the breakout, would have caused a loss greater than my initial risk.

But what if you did take the trade?

A couple of missed trades

NOTE: This post has been updated below following today's price action.

Although I have not been in the markets recently, it hasn't been totally as a result of sitting on my hands. The process of looking out for good setups has continued, and as previously discussed, most of these haven't triggered an entry signal. However, there are a couple of trades that have managed to get away from us, for different reasons:

Dale Carnegie and thinking about losses

These days I am a voracious reader, not so much of books directly related to trading, but to those dealing with the mind, attitudes or psychology. 

Interviews with, or autobiographies of top sportsmen or women are a good resource as well. When reading these, my mind automatically thinks about whatever is being discussed, and whether it can be applied to trading, and my own approach in particular. In that regard, I am always open to new or different ways of thinking.

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.

Losses, your mindset and risk

Most unsuccessful traders fall into the trap of assuming that the next trade will be a winning one. They can only see the potential profits – not the potential losses and the subsequent reduction in their equity.

To avoid this mindset, I recommend assuming that every trade you take will generate a full 1R loss. I do this, even though 99% of my losing trades end up being closed for a loss smaller than that.