If you’ve been getting stopped out regardless of the direction you’ve been attempting to trade – you’re probably ready to jump off the proverbial cliff, especially if you have any grain of emotional attachment to your bank balance. Take heart. Help is on its way. Here is how to survive and thrive in the current trading environment.
1. Set Stops Carefully
The golden rule of trading is: “Keep your losses small and let your profits run”. Stop losses provide a sign that it is time to exit your position, as the trade is no longer co-operating with your initial view. Every successful trader has
pre-meditated the point of exit, before entering the trade.
You may remember that there are several methods available to set a stop loss. Volatility and pattern-based systems tend to work well for short-selling, or trading shares. Hard dollar stops are terrific for option/warrants and futures positions.
Pattern-based stops are a very popular way to set a stop loss. When the share is no longer trending upwards, exit your position. An appropriate exit can be made if the share’s price closes below a trendline or below a support/resistance line.
Volatility is a measure of movement, not a measure of direction. Shares can be heading in an overall direction upwards, or downwards, but this general direction is characterised by dramatic peak to trough drawdowns. This is typically characteristic of the current market that we are experiencing.
Volatility based stops imply that you should to exit your position when the volatility of the instrument increases dramatically, or beyond a pre-defined level. To assist in this goal, an indicator called Average True Range (ATR) can be used. For an exact definition of the ATR indicator, refer to the glossary in the FAQ’s at www.tradingsecrets.com.au.
A simple definition of ATR is the move in cents that a share could reasonably be expected to make during a particular period. On a daily chart, it shows how much the share price is likely to go up or down in a day. It typically shows a figure compiled from the last 15–20 days’ price activity. You may choose to exit if the share goes up (for short positions), or down (for long positions) by greater than a multiple of three or four times ATR. For example, if the ATR is 10 cents, and the share goes up by 30 cents, you could exit your short position. A drop in share price of 30 cents, would suggest that you should exit your long position.
During volatile periods, set a wider stop loss. Otherwise you will exit your position only to see the share continue in the expected direction, without your involvement.
A hard-dollar stop can be effectively used for bought options/warrants, or futures. For example, when you’ve lost a maximum of 2% of your allocated trading equity in any particular trade, exit that position immediately. You may decide to exit when your position has a drawdown of $1000, for example. Alternatively, for a trailing stop, you could exit when the option has pulled back your equity $500 from the maximum profit peak that you had attained in that position at any time. This is an effective method of controlling your losses, and letting your profits run. A wide initial stop, but a tighter trailing stop, tends to be the best strategy in the present market conditions.
2. Learn How To Trade Long and Short
I moderate a trading forum for traders where members can ask trading questions and receive answers (located at www.tradinggame.com.au ). Recently I was asked a question regarding searches. A particular trader was wondering whether he should loosen up his search parameters as he could not find any shares to buy that fitted his criterion. Previously, he had identified numerous opportunities. However, in the current market he was struggling to find two or three potential positions a month. Obviously he was frustrated.
Can you see the problem with applying more liberal searches during periods of volatility? By changing our trading system to supposedly more accurately reflect market conditions, sometimes we just end up kidding ourselves about the calibre of opportunity available.
If your trading system is telling you to buy shares – you should buy them. If your system is suggesting that it would be more effective for you to sit on the sidelines and not trade because of insufficient opportunities in the market, ignore this advice at your own peril.
Alternatively, learn how to recognise a downtrend. Reverse the parameters of your usual searches. Use an option or short sold position to capitalise on your observations.
3. Use Margin Wisely
I recently had lunch with a trader who could be characterised as a bit of a “cowboy”, but had managed to generate a good trading plan and consistent profits without the benefit of margin. From the first few minutes of the conversation, I knew that he had a problem. He excitedly explained to me about a new online system that he had discovered that allowed him to trade long and short, using minimal margin to open substantial positions. The conversation went something like this:
“They only want to take 20% margin from my account to open any position. Oh my gosh – do you realise what this means… I can leverage myself up to the hilt! I can open up as many positions as I want. My $100,000 will allow me to trade up to $500,000 worth of shares! I’m going to be rich!!”
Now, at risk of bursting his bubble, I decided to curb his enthusiasm, (lest he couldn’t afford to pay for his own coffee – the next time we wanted to meet). Too many traders decide to position-size based on the margin that they are requested to deposit, instead of the total exposure of their position. If you do not immediately recognise the drawbacks of this rationale, you owe it to yourself to work through this example.
Let’s say that your system suggests that you can short sell $15,000 of a particular share, but your broker only requests a 20% margin. The logical thing to do would be to reserve $15,000 in your equity account, and give your broker $3000 in margin to open your position. (Brokers require a margin in order to open short sold positions and written option positions). Imagine that you had identified a $4 share that you wanted to short sell. This means that you could short sell 3750 shares at $4, which equates to a total position size of $15,000 (even though the broker is only going to take $3000 in margin).
If the share did not co-operate, then at least you would have the remaining $12,000 of liability available at a moment’s notice to answer any potential margin calls. This is a conservative approach. It works. It means that you won’t end up losing your house if the market ricochets upwards against your position with meteoric speed.
On the other hand, you could consider the $15,000 that you have available for this trade to be the margin. Rather than selling $15,000 of the share, now you could short sell a position size of $75,000… Yikes!! Instead of short selling 3750 shares at $4, you would now short sell 18,750 shares! Think of the implications of this move. It is five times the exposure of your original calculation. It leaves no room for error, and opens you up to the threat of a very nasty margin call that you are unlikely to be able to cover.
The current market chews up and spits out non-conservative traders with ruthless efficiency. Position size based on the position itself, not the margin required to open your position. Only use leverage when you have developed your skills as a trader. If you insist on doing otherwise, your career as a trader will be short-lived, but spectacular.
4. Limit Contingent Liability Positions
Writing naked options involves collecting a small fixed premium, yet incurring a theoretically unlimited loss. This is the meaning of contingent liability. Written naked option can surprise novices with their effectiveness to deplete trading equity.
Many traders are attracted to this concept because the chances of success of this strategy are high. Approximately 80% of options are only traded once and never exercised. On the surface, this sounds like a great chance to make money. When you look at the risks involved however, which contain contingent liability, this strategy should be left to sophisticated traders.
With any position that has the ability to wipe out your bank account within one foul swoop, apply caution, limit the number of this type of position, as well as limit position sizes.
To trade “spreads” in options, it is essential to understand both sides of the transaction – both buying and writing options. By spending some time learning about these types of strategies, you can work out creative ways to minimise your risk and maximise your profit.
Trading during volatile times can multiply your rewards. Take advantage of this trading environment, but remember to use caution and common sense.
If you haven’t yet got an effective written trading plan – you need one. Traders who trade without a written trading plan deserve to starve. The game is on. Nobody knows how long your ride will last, but I can tell you – without a trading plan, your chances of survival are zip.
|Louise Bedford (www.tradinggame.com.au) is a full-time private trader and author of four best-selling books – The Secret of Writing Options, The Secret of Candlestick Charting, Charting Secrets and Trading Secrets. Register on her website to receive a free trading plan template and a 5-part e-course to get you trading like a machine.|