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.

Using volatility contraction to increase your profits

Often you see people talking about a winning trade, and how far in percentage terms price moved in their favour after entry.

But on its own, this doesn't tell you anything - to me, it is a worthless metric when evaluating performance.

As a trader, I'm far more interested in the size of the profit (or loss) generated when expressed in terms of R.

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.

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.

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:

Time for a rant

It's been a while since I had a rant, but I'm always astonished when I come across some articles like I've read over the last few days relating to the market drop since the turn of the year.

You get the usual comments from people who have lost money - ban short selling, ban hedge funds, the brokers are working in cahoots with the hedge funds, the market's rigged etc...

Combining technicals and fundamentals for investing

Recently I had the opportunity to review an investor’s portfolio. This was valued in excess of £1m. The allocation of the funds was entrusted to a well known brokerage. I was asked for my opinion on the performance and allocation of the fund.

That was the week that was

Last week will have been an educational experience for many people, particularly those who have started trading since 2008.

Since the major market averages bottomed out in early 2009, they have generally been in a steady uptrend. There have been one or two short periods where there has been some downside volatility (August 2011 and early October 2014 spring to mind) but they were small beer to what happened over the last few sessions.

Then again, we still need to put this into perspective, particularly with people calling the beginning of the week a crash or even 'Black Monday'. Last Monday, the FTSE and DAX fell more than 5%, and the Dow fell just over 3.5%, although intra-day it fell a lot more. Back in 2008, the Dow fell more than 7% on more than one occasion.  And further back in 1987, the Dow fell more than 22% in on the real 'Black Monday' - now that's a crash!

2015 - any parallels to 1987?

As a trend follower, I'm not in the business of making predictions - I follow where price goes. Elaine Garzarelli I am not. Also, predictions can easily blow up in your face if you are proven wrong. On this post, however, I am simply observing and pointing out a few comparisons between what is happening now and what occurred twenty eight years ago.

So what happened in 1987? 

• The crash followed a recent move down from all-time highs made a couple of months earlier;
• There was an international situation which contributed to the price move - in this case, it was the spat between James Baker and the Germans;
• Price accelerated to the downside throughout the week, culminating in a big drop on the Friday on heavy volume.

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?

Is this another 'once in a lifetime' event?

As I type this, we still don't know the outcome of the ongoing negotiations between Greece and the EU/ECB/IMF 'troika', and the potential ramifications of any decision taken - from the political, economic or the financial markets point of view.

No doubt there will be traders seeking to profit from this situation, but we have already seen this year how an unexpected announcement created a major market event.

Back in January, we went through a supposed 'once in a lifetime' event with the extreme price moves on the EUR/CHF, and other related currency pairs. Now, less than six months later, we may be on the verge of another.

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.

Intellect, theory, risk taking and reality

From the outside, trading opportunities within the big financial institutions or investment banks seem to be a closed shop. I took a look at job opportunities in the City of London this morning and all of them seemed to want people who were educated to a degree level, and/or who already worked in a financial institution. This obviously rules out bozo's like me, who left school and didn't proceed into further education, or who have never worked within the industry.

A plan on how to get over a major drawdown or price shock

It is an unfortunate part of trading that people can suffer the traumatic experience of losing a significant part of their equity in one go. In extreme examples, some traders may even blow up their account. This may be as a result of some major unexpected news coming out. It may be as a result of your broker putting most of your money in a downtrending stock. It may be because you took a big position just before earnings were released which then gapped against you.

When something like this happens, your mindset will take a battering, and before you commit any fresh funds to the markets, you need to step away for a while and regroup. As hard as it may seem, how you deal emotionally with what has happened is of paramount importance, and may even determine whether you can make money in the future.