If there is more risk than the .75 percent of my core equity and 1.25 percent of my core equity, I pass on the trade.
I know that most of my trades will not work, therefore in order to try to mitigate inherent drawdowns I simply pass on these trades. I have no fear of missing out or any greed to think to chase a trade.
Big profits can be pulled out of the markets by taking low-risk bets. Most traders do not realize this, and that is why they overbet. It is the same mistake that traders make thinking that they need a complicated system or methodology in order to make money.
In the upcoming section I will delineate exactly the entry signal and initial exit signal. From the difference from these two attributes you will able to calculate your exact risk per trade.
My simple proprietary robust ideas have the propensity over time to compound money.
Risk per Sector
Earlier in my career I had no idea of sector correlation. Only through big drawdowns and losses did I learn the importance of this rule. There is a statistical function of correlation called the correlation coefficient. Markets that trade exactly the same would have a correlation of 1. Conversely, markets that trade completely the opposite would have a correlation of –1. In today's world it seems when we look at our charts on strong directional days we see a preponderance of a sea of either green or red. This means even many of the markets that we think are not correlated actually are correlated.
There are severe limitations with the correlation coefficient. It only looks at past performance and the markets are always in flux. Actually I wrote an article for Futures magazine demonstrating the fallacy of past correlations. Correlations change and what occurred in the past is not written in stone. However, it would be fair to say that within a particular sector there are correlations. For example, when gold seems to start trending it is not unreasonable to see silver start trending. Another example could be easily found in the grain complex. When you see a move in soybeans, you might see a run with corn and wheat. In the stock market correlations within sectors are also prevalent. When the tech sector is strong, you can anticipate the majority of the shares in that sector will move in unison. Contracts and shares all rise and fall together. When you trade them all in the context and time and if you are long this is great. On the other hand and in reality, you will find this to be the opposite and you are increasing your risk. At times you may achieve nice profits, but in the context of risk control you will expose your portfolio to increased volatility. There will be sharp swings both up and down. At times these swings might be too great to handle. There is always a point at which one goes through a drawdown that is too painful to continue. This is the reason we must be aware of correlations in sectors. When I first began, I would get a signal to buy or sell in the interest rate sector or the grain sector. I would buy five-year bonds, 10-year bonds, 30-year bonds, gilts, bunds, and name it. The same could occur in the grains. I would buy soybeans, bean oil, bean meal, corn, and wheat.
What actually happened to me was there were times these trades worked well, but when they didn't it was a disaster. Even though I thought I was taking low-risk trades with small percentage risks of my account size, these trades were heavily correlated and I was not taking a low-risk bet.
I woke up some mornings and all of these trades went against me and I faced a heavy draw-down. What I learned from these incidents was to cap my sector risk. Today part of my risk plan is that I will only allocate 5 percent of my total portfolio to any sector. Any sector means any stock sector such as tech, retail, and so on, or in the commodities interest rates, energies, grains, metals, and so forth. Putting it in clear terms: If my total account size were $100,000, I would have the total number of positions not exceeding a risk of 5 percent or $5,000 in that particular sector.
Personally, I am not only concerned about the return on investment but how much risk I will have to tolerate to achieve my goals.
Risk per sector is a personal issue. There are others who are comfortable taking on more risk. They are willing to risk more per trade as well as risk more per sector level. However, everything has a price. I might generate lower profits but I will have fewer drawdowns. Contrarily there are those who will generate greater profits and have greater drawdowns.
There is no free lunch when we trend follow.
Consider when you trade a diversified portfolio of 10-year bonds, corn, Australian dollars, and crude oil, it could be expected for them to be somewhat independent of each other as opposed to just trading 10-year bonds, five-year bonds, and 30-year bonds. At times it would be expected that the diversified portfolio would have elements rising, some falling, and some actually doing nothing. When one of the elements trends, it can offset the inevitable losses in the other elements and you smooth out your equity curve. As I stated above there is no free lunch. All we are trying to do is smooth out our equity curve and “trying” has a lot of limitations.
What I have seen firsthand is that when traders actually go through the drawdown they are in shock and can't handle the drawdown both financially and emotionally. This is why I want to maintain a more stringent risk approach.
Overall Risk on the Portfolio
Another overlooked aspect of risk management is overall open trade risk on a portfolio. The more open trade risk, the more potential for increased drawdowns. More so, your biggest drawdowns will probably be after one of your biggest run ups. For this reason when I invest with other trend following money managers I will only try to buy their drawdowns. I will not buy their highs and sell their lows like so many traders who do not have a plan.
I have seen this way too often.
Investors, probably out of greed, will invest with a trader when he or she has a good run. They believe it is almost safer to invest in this fashion. As trend followers do the untraditional, I look to buy successful trend followers when they have a steep drawdown. It is as if I am buying on sale. Every manager will have a drawdown and this is the time to jump on board.
Open trade equity is my open profits at any one time. I am constantly monitoring this. As I stated earlier, I let my profits run and cut my losses short. The greater the profits I have on open trade equity, the greater the risks I am allowing. I compare my open trade profits/open trade equity to my core equity. My core equity is really the true value of my account. Core equity includes my cash equity as well as closed positions. Open positions are not really mine until I close them. If I measure my risks against my core equity and my open trade equity, I am enhancing my risks. Some traders are OK with this; however, as I stated earlier, I am looking to achieve realistic returns over time, all the while controlling my risks to a manageable level.
I cap my total open trade equity versus my core equity at 20 percent of my core equity. When at times I get to that level I stop taking new positions or trades.
This mitigates to some degree the potential of drawdowns. Putting this in simple terms, considering if I have a $100,000 account size (closed equity plus core equity) and my open trade profits are $20,000, I stop taking new trades. That simple!
Additional Risk Measures When Commodity Trading and Forex Trading
Margin to Equity Due to the leverage involved in commodity trading, I use additional levels of risk management. Margin to equity is how much margin money I need to put up versus how much equity I have in my account. I am constantly managing and monitoring my margin to equity every day. The greater the margin to equity, the greater the potential risk. My comfort level is not to surpass 15 percent margin to equity. The same holds when I invest with other trend followers. I do not like to surpass 20 percent.
The higher the margin to equity, the more positions and more potential risk!
Dollar Risk per Contract Over the years I made one mistake after the next. I learned to risk only approximately 1 percent of my account, I learned to cap my sector risk, I learned to cap my open trade equity as well as to cap my margin to equity, but I still made a mistake. What happened was that when my account
was relatively small, $100,000 or $200,000, I would risk a maximum of $2,000 a trade. The issue became apparent as my account grew over time. A 1 percent risk on a $200,000 dollar account size is $2,000 and 1 percent risk on a $500,000 account size is $5,000 for a one-lot trade.
Bearing in mind that most trades do not work, I learned that it was not prudent to risk $5,000 on a one lot. After making this mistake I added the filter to my models that I am not willing to take a trade if I am risking too much on a dollar level risk per contract. In one model of my managed accounts I cap my dollar per contract risk at $2,000 a contract and on my slightly more aggressive managed account model I cap my dollar per contract risk at $2,500.
This approach can be applied to stock market trading. You can look at not just the percentage risk but also the dollar per share risk. As there is a tremendous variance in the stock market, you need to come up with your own dollar max per share risk. My personal preference is $20 a share.
I have learned over the years that that biggest percentage trades that work come from quiet markets and from position sizing.
The smaller the risk per trade, the more shares or contracts that I can put on. The example is that for the same $1,000 risk on one trade I might put on 300 shares and on another trade I might for the same $1,000 risk put on 600 shares. Given the fact that I did not increase my total dollar risk, if the 600 shares move in the direction of the trend, I can make much more money. This is the key to position trading.
Our job as successful trend followers is to try to manage the only thing we can manage and that is the risk!
Profits take care of themselves.
I have learned over the years that anything can happen and actually will happen.
■ Choose Markets to Reduce Risk
We have boundless choices of what to trade. There are thousands of stocks and numerous currencies and commodities. Even when we have a well-thought-out plan with exact entries and exact exits it can be confusing. If we change our time frame this even offers more options.
Too many options become confusing and my goal is to simplify the trading process.
We know we cannot trade everything.
Do not trade the wrong markets!
Trade a market that is MOVING, either up or down, if you can put on a low risk. You know you should buy when the market goes up and sell when the market goes down. It is very obvious. So stay away from a market that is choppy or just moving sideways, and start trading a market with nice trends.
What I learned many years ago from Ned Davis Research, an advisor to many large hedge funds, was to look to buy the strongest trending markets and look to sell the weakest trending markets. What I learned over the years, however, was that I could not just buy the strongest or sell the weakest. I could only buy the strongest or sell the weakest if I could put on a low-risk trade. We have already discussed what a low risk trade is . . . but . . . the question becomes what is a strong or weak market?
The only way to approach it has to be quantitative. There has to be no guessing or interpreting.
The simple way I learned to do this was to look at a rate of change. Another word for rate of change is momentum. We look to measure momentum and identify a potential universe that I am open to trade. This approach is tactical. Almost like how a shark identifies the weakest of its prey. A shark does not look to attack the strongest in a pack of seals. The shark looks for a sick, frail, or young cub that is potentially an easier target. The lion also gets its prey this way as well. In a pack of bison he identifies his target. We as trend followers identify our target.
The strongest markets with the possibility they will get stronger and the weakest markets with the possibility they will get weaker.
It is just a possibility. There are no guarantees and every trade regardless of anything is 50/50.
■ We Are Dealing with Uncertainty!
As I learned over the years: Keep it simple and stupid. In order to determine the momentum, a simple formula is calculated between the differences between two periods. The rate of change calculation compares the current price with the price n periods ago. Depending on your degree of sensitivity you can choose that period. The rate-of-change indicator is momentum in its purest form. It measures the percentage increase or decrease in price over a given period of time.
The problem is that if you look at just one period it can distort. I prefer to look at an average of the rate of change and even look at three periods and average them. Working in this fashion, each market is assigned a numerical value. Depending on your platform or simply in Excel you can quickly identify the strongest markets and the weakest. When I am trading on a daily time frame, I look to the higher time frame of weekly markets. I use several different weekly periods to smooth out the noise.
In Metastock this is a simple code to use an indicator or it can be easily done in Excel.
Inputs: Price(Close), Length1(2),Length2(5),Length3(7);
Plot1(RateofChange(Price, Length1) + (RateofChange(Price, Length2) + (RateofChange(Price, Length3))/3));
Place this code on a chart. If you are looking at a group of stocks or currencies you can rank them in order to determine the strongest and the weakest components. As far as commodities they need to be nominally adjusted.
Once you determine the strongest and the weakest, this becomes your tactical portfolio or the portfolio in which you look for a signal for entry for either a long or a short.
In regard to stock investing, I use the IBD50 as a basis of stocks to look at and within this group rank the stocks by a smoothed rate of change. The IBD50 are the strongest momentum stocks based on Investor's Business Daily parameters based on CANSLIM1, which mostly includes fundamental aspects but is a great place to start identifying strong stocks.
More so I look on a daily basis on 52-week new highs and new lows. This is another area of interest. In conjunction with that I look at all-time new highs and all-time new lows.
This simply becomes a general universe, and then I rank the stocks based on a smoothed rate of change. I will not try to short a stock if it is below $20 and suggest you pass as well. More so I would not look to buy stock if it is under $10. The volatility can kick up in these shares. Another area that needs to be paid attention to is volume. Make sure there is enough volume. Otherwise you can get into a very negative situation.
As another layer of risk management, even though I have risk per trade, risk per sector, open trade equity risk, and margin to equity, I look to cap my number of positions both long and short. I know that having overlapping risk management should help me in my goal of mitigating some of the inherent drawdowns. I cap the number of markets that I trade in each direction. For example, I will not trade more than 10 markets on the long side and no more than 10 markets on the short side. Again, you can determine how many depending on your risk tolerance. This is a personal preference.
As far as the S&P 500 I look to go long when the S&P 500 is above the 200 exponential day moving average. When the S&P 500 is below the S&P 200 I would be more apt to be out of the market or short.
Clearly, when one looks at some of the past big trades that worked from the IBD50, long trades can go much further to the upside while short trades have a floor. Bull markets seem to creep up over time, however, bear markets crash with thunder at times.
That is why it is very important to be aware of the 200 exponential moving average at all times.
If you are above the 200 exponential moving average the coast is clear. If you are below . . . look out and be careful!
■ Note
1 CANSLIM stands for:
C — Current quarterly earnings per share have increased dramatically from the same quarters' earnings reported in the prior year.
A — Annual earnings increase over the last five years.
N — There is something new or innovative in the company such as new products, new management, and other new issues. More so it is to be noted that the company's stock has reached new absolute highs.
S — There is a small supply and large demand for a this particular stock which creates a large demand as well as there is a positive environment in which stock prices can run. Additionally look for low debt-equity ratios.
L — Look for leaders versus weaker stocks within the same industry. Use the relative strength index as a guide. Buy Strength!
I — Look for stocks with institutional support as well as that those institutions have above average performance.
M — Determining market direction by reviewing market averages daily or in my personal opinion verify that the averages are above a 200 day moving average.
CHAPTER 6
Your Complete Robust Trading Plan
Should I enter this trade?
Should I wait?
I made some money; should I take it?
I think the market will come back; I am not going to exit now with my loss!
I am sure the market will continue rising!
Shoot . . . What do I do now?
A trader with a complete robust trading plan will not ever say—or even think—these questions or statements. You MUST have a solid trading strategy. Having a trading strategy is probably the single most important thing you can do in order to succeed with trading. Having a trading strategy means having a predefined set of rules that you have developed or accepted for your trading. It means knowing what you're doing instead of just gambling. Too many people start off trading without a strategy, which means that they're completely unprepared.
When you have a complete, well-thought-out trading plan, you mitigate the emotional roller-coaster.
You will know exactly what you need to do! It is your job to follow the plan. If you can't follow the plan, I strongly suggest you do not start trading.
The Trend Following Bible Page 13