Part One - Reducing Your Risk
One of the most
important aspects of successful trading is not the strategy itself.That
will either work or it won't (all things being equal). We have a 50
/ 50 chance either way. While perhaps not mathematically accurate,
that pretty well captures the spirit of my point; we exercise precious
little control (as in NONE) over how our stocks move.
We ALL have losses from time to time. It's a fact of trading
life! That being a given, one of the most critical aspects of
successful trading is to control any LOSSES we might be facing.
Obviously, it is in our best interest to minimize those losses as much as
we can.
Minimizing losses is important to be sure, but to
complete the picture of successful trading, we cannot ignore the other
eventuality; the profits. While minimizing our losses, we need to
maximize these profits. The system used by most new traders for
managing their positions is the 'watch and see' method. That is,
they put a trade into place and 'watch and see' what it does. While
it sounds like the right thing to do, it has one factor involved which
works against it ... US! Being emotional by nature, we
are all prone to the challenges and 'misfires' which often occur in
manually managed trades. You know ... you BUY when you should SELL
and SELL when you should BUY. We all come equipped with that
ability! Let's talk about how to improve our trading results.
The Stop Loss
Let's begin our discussion of minimizing losses and
maximizing returns by considering the stop loss. In my online trading lab
I spend a good chunk of time encouraging and reminding traders to put stop
losses on their positions when they first enter them. In that way,
their exposure to risk is reduced to the amount of the stop loss.
For example, when you buy a stock, say 1000 shares around $20 per share,
you have $20,000 FULLY at risk. I know ... the common defense here
is that the stock won't devalue to ZERO before we can do something about
it ... true. but it can ramp down three or four dollars on
some really BAD news before many of us can get to a phone! Rather
than chance that, let's just agree to put a stop loss in around $19.50,
for example upon entering the trade. Our exposure to risk has
thereby been reduced from an 'arguable' $3000-$5000 to a more acceptable
$500! While the amount of actual risk in any position might be a
subjective thing, the benefits of putting in a 50 cent stop loss are
UNDENIABLE! But how much of a stop loss should we use? This
needs to be 'second nature' to us.. Here's how I do it ...
ADR
Not wanting to get stopped out only to see my stock then
take off WITHOUT me (I call that being 'wiggled' out), I look at
how much the stock moves each day In the trade lab I refer to this
as the Average Daily trading Range, or ADR for
short.
This range, or my being aware of it is so critical to me
that I have a filter criteria built into my Chart Navigator® which places
it in view every time I look at a stock!
Notice the 3 columns visible in the symbol grid to
the left. The column titled "ADR5" contains for
each stock the average daily range for the past 5 days. This time
period is used on short term trades and is the one I've found most helpful
in determining what value to use for the stops on these trades, those most
often completed in the trade lab for daily cash flow.
The ADR is a 'gauge' of the maximum amount of
movement which can be reasonably expected from the stock. For
example, note that AMGN is highlighted near the bottom of the
symbol grid. The 5 day ADR shown is around $1.40. That
tells me that at most, I should expect the stock to move (between the high
and low values for the day) not more than about $1.40.
A common mistake here is to assume that if we're trading
it up, we're expecting the stock to move up by $1.40, setting our trading
parameters to that movement. This is certainly not the case!
The five day ADR is the average difference between the high and low
values attained by the stock price at the close of the market. We
can use that value at any point during the day to give us a very rough
idea of where the stock MIGHT go . For example, suppose AMGN
opens around $65. At THAT time, we can use the five day ADR
as a gauge of the potential high of $66.40 OR the potential low of
around $63.60. An hour later that could easily change. for
example suppose that one hour after the open, the stock has moved up to
around $66. IF it continues up, it could (on average) move as high
as the earlier expected $66.40, another 40 cents. Additionally, it
could also reverse it's direction. From that current HIGH of
$66, we could anticipate that it would probably move no lower than around
$64.60 ($66 minus the $1.40 ADR) for a LOW. That same
calculation can be made at ANY time during the day to give us an estimated
range of potential highs and lows. As helpful as this might be in
various other parts of the trade, actually selecting the stop loss
to place is a much more simple process.
Setting The Stop Loss
Whatever that ADR is, I'll use 1/2 of it for my
initial stop loss, before making any final adjustments later in the
trade. For example, if a stock moves $2 per day (5 day ADR=$2),
I'll set a stop loss of around $1. My thinking here is that if the
stock moves 1/2 of its daily movement ($1) ALL in ONE direction (against
me) then it's likely to just keep on going in that direction for the other
1/2 of the trip (the other $1).
Here's how that looks in our daily trading plan:
Note the ADR as indicated by the orange line.
Using the method outlined above, I'll use 1/2 of the
$1.09, or about $.54 cents as 'acceptable' risk, immediately placing a
stop loss (after buying the stock around $17) at $16.46. Consider
the risk differential here. Before placing the stop loss, I had $17 per
share invested in 1000 shares for a total "at risk" amount of
$17,000. After placing the stop loss, that risk was reduced to
around $540! This concept of using average daily trading ranges has
enabled me to trim my losses significantly by allowing me to reduce my
exposure to this risk while staying in to trade long enough to take possession
of potential profits!
I stress this in the trading lab by illustrating this
information in great detail in the "DEFENSE" section of
the daily trading plan.
Look at the figure above. The last line shows the
DEFENSE" section with instructions to set a stop loss at 1/2
the ADR ($.55) of the stock we traded that day.
Now that we have our stop loss in place, we know we've
reduced the size or dollar amount of any potential losses should the trade
go against us. But that's only 1/2 the battle! In part two of
this discussion, we'll build a system which will allow our profits from
each trade to increase without restriction!
Until next week, Make It A Great Day
Bob
|
