HONORING RISK

Now that we have opened today and have another freefall beginning, I wanted to talk about honoring risk. Remember I did say I was looking for a false breakout of the lows of the wipeout day to get long. Since we have taken out those lows it is time to be looking now. One of the age old debates is how to manage your risk. Should you use stops or not? How do you determine how many of something you will buy or sell? Now that we are in a high risk environment, this should be a good time to cover this. I would argue that we are in a high opportunity environment right now. Volatility and price movement is what we need to make money.

It is my feeling that I always want to know exactly what my risk is so that I can plan to leverage my money correctly. If I know I will only lose 2% on any given trade plus possibly a tad of slippage on fills, it is very easy for me to build my account balances and sleep at night. The only way to do this is to use stops. Those orders are in for me the second a trade is executed, then I just walk away and watch. I then know come hell or high water, the worst thing that can happen is I will lose my 2%. As readers see here, I try and tighten stops as quickly as I can, and in so doing keep my average losses well under 2%.

Now that I know what my downside is, it becomes clear that the upside does not have requirements on it that are so tough, that I cannot move ahead. When you manage your losses well, the rest tends to take care of itself, unless your approach generates too many bad trades. In that case you need to change your techniques for entries. A faulty trading technique cannot be saved by good money management.

THE CATCH 22

When testing trading systems the one truism that is inescapable is that stops hinder performance results. You did read that correctly. Stops diminish returns in every single system I have ever created or tested. How can this be?

The main reason for it is that stops attempt to contain random price activity with artificially inserted levels and as we are now seeing with the stock selloff, artificially trying to contain things does not work. I know that I have been able to design some dynamite systems to trade major reversals in the SP 500, but in doing so had to eliminate stops or make them so big that they are not tradeable. The reason for this is that at reversal points we generally are operating at expanded volatility levels, hence any "normal" stops get blown out right before the reversal happens. The problem is when you take them out you make yourself vulnerable to the "wipeout" trade. It is hard to recover from a trade that takes 30% of your capital in one fell swoop. I have a friend who lost 300k on wipeout Thursday, now his whole life has changed. He had way too much risk in his trades, but had gotten away with it since we have had such a long period of low volatility. However, now in just one day his whole career is now in jeopardy.

The very best book on trading ETF's I know of is one recently written by Larry Connors where he promotes buying into weakness above the 200 day moving average, by legging into the trade in sections. Once you get to a certain oversold level above the 200 day moving average, you start averaging into your trades. The results of the testing are awesome and they have also done well in actual trading. Here is the problem, the approach does not use stops. As a result you are now heavily long stock ETF's with this approach and just getting clobberred. You have to wait for bounces to certain levels in the RSI to exit. This is the biggest problem with this approach, your losses can be wipeouts, so managing your size is impossible.

I am still trying to figure out how to use his approach, because it trades at better than 80% accuracy. However, just like any other high % win to loss method, the losses are generally larger than the wins. I do not like to trade that way anymore even though I had many good years doing exactly that. I make more money now with a lower % accuracy and a much higher $won/$lost ratio. I can only accomplish that by using stops. Alot of what makes someone ultra successful in any endeavor is making good sound judgements not based on emotion. This is certainly no different in trading. It is my judgement that although testing says otherwise, I best protect myself against the downside by using stops. As a trader it is up to you how to best use them but I strongly urge you to do so.

Yesterday I was just dinking around and saw a nice setup for a day trade which I took in the E Mini SP 500. Below is a depiction of it. I show this because it is a micro version of what I am hoping for in the indexes to get long down here.

You can see the triple divergence in an oscillator accompanied by a false breakout to a new low that immediately reversed. I went long right when I saw that and exited pretty quickly. The exit was a judgement call just based on this moving up very quickly in the midst of a big down day. I reasoned we were going back down at least for another test of the low and I had good money in the trade pretty fast. You can see although I did get out a smidge early, ultimately we went way down again, so my logic was sound. Mission accomplished, onward. I do not do much day trading, I did this just for kicks in all honesty. I did not have many contracts so it was really just to entertain myself.

Let's hope we get a similar daily look to this during this decline. Also, for any readers who may have thought I was nuts talking about a Euro bounce, glance at that chart. I picked the exact low so far. I am not long there, but am hoping for a buy pattern to show up down here. The short squeeze in this sucker could be one for the ages.