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Trading Tips

Maintaining a Position Mindset in a Portfolio

I met with the head of a PhD program yesterday. We had a good discussion of markets and trading, and he brought up a subject that I thought was working a blog post.

This professor talked about how a trader or investor’s mindset can change when going from dealing with individual trades to managing a portfolio of positions. Specifically, he observed how someone who would be very diligent about risk management and following a specific plan of action when managing one specific position could let all that slide when managing one position among many.

For example, a trader whose only position is a long in XYZ stock could be very good about exiting that position on a stop if the market goes against him. If, however, XYZ is only one of ten holdings in a portfolio, the trader might do more rationalizing of letting the position run if the rest of the portfolio is doing well. And you could flip that around to a poorly performing portfolio by dumping positions before they should be sold.

Yes, there are at least some academics who allow for psychological influences on trading decision-making. ūüôā

Of course the point is that unless you specifically have a combination of trades that are meant to work together (hedges, pair trades, etc.) then each individual position should be managed based on its own merits.

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Trading Tips

It’s only a paper loss if you don’t sell

Wow!

I just read an article titled Why Investing With Emotions Doesn’t Pay Off that I had flagged a couple days ago as maybe having something my readers would find interesting. Everything started off pretty well. It was the standard stuff about not making emotional decisions with your investments. No surprises there.

Then I hit a part where the author, who indicates she’s some kind of financial planner, talks about a client wanting to move money out of equity funds and into a money market. The client wanted to wait out the market uncertainty and wait for things to turn back around (I don’t know when this event took place).

Here’s the response she provided:

I explained to my client that he has not yet realized the investment loss, currently it is only on paper because he has not yet sold the investments.  I advised him against selling any of his investments because the current market value was a lot less than his actual cost (book value).

Has not realized a loss? Only a paper loss? I’m sorry, but if the value of your assets has decline, you have taken a loss.

So the advice here is not to realize a loss? Notice there’s nothing in there in terms of actual strategy. The author just doesn’t want her client taking a loss. This is the sort of attitude that kills traders and investors alike (“I’ll get out when it comes back”, etc.). I agree with the article’s basic premise that emotional decisions should be avoided (wrote a little about that yesterday), but there’s nothing wrong with taking a loss. In a lot of cases it’s the best thing you can do.

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The Basics

Taxes and Cutting Your Losers

I’ve been doing quite a bit of reading on the subject of Behavioral Finance of late (and will only being doing more and more in the future). I haven’t been in the academic finance arena since I did my MBA in the late 90s, so some of what I’m going it refreshing my knowledge base and reaquainting myself with the academic viewpoint. It’s really easy to slip away from that when you’re focused very closely on real world markets and regularly interacting with real-world traders, not just the ones imagined in the academic literature. (On the Behavioral Finance subject, I encourage you to watch Mind Over Money.)

One of the things that has come up fairly frequently in the articles and papers I’ve been reading is the idea of cutting your losses and letting your profits run. Now this is an academic discussion, so it has relatively little to do with what most traders think when that sort of advice is being offered. Instead, the academics are referring to the tax implications, especially since they most often are referring to stock trading/investing.

Here’s the logic
When you close a position you trigger a tax event. If you exit a profitable position you’ll have a tax liability – obviously – so it behooves one to hold on as long as possible to defer that event. This is particularly true near year-end when a shortly extended holding period can defer a tax bill by 12 months or more.

As for cutting your losses early, that’s the flip side. When you take a loss you reduce your tax liability. That means it behooves you to book your losses quickly. In effect, the tax impact reduces your net loss. For example, if you’re tax rate is 20% and you’ve taken a $1000 trading loss, you’ve effectively only lost $800. In other words, your account is effectively worth $200 more if you take that loss than if you hold on to the trade. The academics I’ve read seem genuinely incredulous that traders and investors would hold losing positions for exactly that reason.

Know the Law
Now there are all kinds of different tax rules in the global array of√ā¬†jurisdictions and markets. For example, in the US securities (stocks, bonds, options, etc.)√ā¬†fall under normal√ā¬†capital gains where the tax impact is only felt when a trade is closed. Futures and forex are treated differently in that your positions are marked-to-market at year-end. That means the timing of your exits doesn’t really matter. The rules are different in other countries, though, especially when you bring in things like spreadbetting, so make sure you know how your country’s tax laws impact your bottom line.

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Reader Questions Answered Trading Tips

I don’t use stops. What do you think?

I got the question in the title of this post from a “fan” of The Essentials of Trading Facebook page. If you’ve followed this blog for any length of time you know that the topic of stops and how to use them is a frequent concern among new and developing traders (for example Where should I put my stop and take profit orders?). Let me approach this from a couple different angles.

The market will come back
If you are not using stops because you “know” the market will eventually come back you need a history lesson. Sometimes the market never comes back, or if it does it’s after such long period of time or such a big drawdown that you can’t hold on for the duration. Take a look at this S&P 500 weekly chart.

SP500W102009

Imagine if you had bought the market back in the fall of 2007 when the S&P was trading at 1500+. If you had not had some kind of protective downside exit plan you would have seen a loss of more than 50% on that position (not accounting for any leverage, which if employed would have wiped you out). That’s a hard thing to sit through, as many people who attempted to do it can tell you. The market has come back up quite a bit but is still more than 400 points below where it was. How long is it going to take to get back to those 2007 levels? Who knows. It could be years – years to get back to break even, meaning no gains for all that time in the market and your money tied up preventing you from trading anything else.

If you’re thinking “well that’s too long a time frame, I trade shorter-term” then look at charts in your time frame. I guarantee you’ll find examples of formerly choppy markets that would always come back becoming very unidirectional. You play that game long enough you are going to get burned badly.

Want an example? How about what GBP/USD did in a week.

GBPUSDH102009

The market rallied 700 pips between October 13 and 20. That’s a big hit if you were short. If you were trading with a modest 10:1 leverage ratio you might have survived the hit (at least so far), but it wouldn’t take a much higher leverage ratio to have seen a margin call triggered. Poof! Account wiped out. ūüôĀ

My trading systems doesn’t use stops
This is a legitimate reason not to use stops, and is the reason why you cannot accept the blanket statement that all traders must use stops. If you do as much system testing as I have done over the years you will observe that there are types of systems which do not show improved performance when stops are introduced, expect perhaps in the most loose of fashion. These tend to be trend trading oriented systems, particularly those which are always in and/or use close and reverse type approaches.

Be warned, however. Some systems do leave you exposed to potentially large losses because of the timing of when positions are exited and/or reversed. You should be aware of these potential holes and make sure you have some kind of protection plan to guard against extreme moves. That might mean a very loose stop loss order or perhaps an out of the money option.

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Reader Questions Answered Trading Tips

Trading System Testing and Risk Management with Multiple Securities

A reader of my book sent me a question that combines system design and testing issues with risk management considerations.

Hi John,

I backtested a strategy on all S&P 500 plus Nasdaq 100 stocks. After checking for outliers, I selected the 10 best symbols in terms of risk adjusted returns and statistical significance. My idea is to trade 10 stocks to increase the number of trading opportunities in a trend following system. Following your book’s approach, I checked fixed vs variable vs stepped sizing methods and determined that in all cases the variable method was the better one. So I ran the calculations and the comparisons again using variable sizing methods, and finally came up with optimal fixed fractions of equity to trade for each stock, given acceptable drawdown limits.

So now I have the following problem: I have different fractions for each stock but one trading account. I am thinking of allocating one tenth of the trading account to each stock and applying the stock’s fraction to that amount, but I am not sure if it’s the right approach.

Thank you !!

Rod

First, I’d like to congratulate Rod on going through the full design and testing system development process. I will tell you flat out that my work doing these sorts of things early in my trading development helped me enormously to understand how different indicators and systems methodologies work. That, in turn, helped me work through the process of finding my trading niche.

Now, addressing Rod’s question….

There are a couple of things I would suggest need to be looked at and thought about at this point in the process. While it’s admirable that Rod is looking to track a specific√ā¬†group of√ā¬†stocks to provide the frequency of trading opportunity he’s looking for, he needs to consider the risk of all 10 stocks moving against him at the same time. My guess is that the stocks he’s selected are relatively strongly correlated, though that’s worth testing.√ā¬†It means they could all move against him at the same time, which introduces the risk for a substantial loss at some point.

That said, I think Rod would do well to perform an additional set of tests. It sounds like he’s done singular system tests – meaning testing the system’s performance on an individual security basis. It does not, however, sound like he’s tested the system in a unified way. By that I mean running a test which encompasses all the 10√ā¬†securities he’s selected as a full√ā¬†portfolio look. That sort of thing will help identify the risks of correlations and see the kinds of drawdowns it could produce (potentially),√ā¬†and let him determine his position sizing in aggregate rather than just security by security.

Look at the characteristics

The last bit of advice I’d offer Rod at this stage is to try to identify the√ā¬†set of charactersistics which makes those 10 stocks he’s√ā¬†selected good for his system.√ā¬†Individual stocks will change how they trade at different points – sometimes temporarily, sometimes permanently. If you know what makes a stock good for your system you can track the ones you are using to see if they change, and you can keep an eye out for other stocks that are good candidates for inclusion.

Categories
Trading Tips

Minimum Stop Loss

A question came up on Trade2Win that I thought probably was of interest to readers here as well.

Hi, has anyone done a ‘study’ on the minimum stop loss required for different times of the day, when trading eur/usd ? or is this even possible to determine ?

Minimum stop loss = least likelihood of being stopped out with the smallest monetary outlay.

Optimal stop levels are always on the mind of traders, especially those looking to develop systems. The problem is coming up with them is oftentimes a completely worthless exercise. I can tell you from experience that putting in some kind of fixed stop into many (most?) trading systems actually degrades the system’s performance, except in the case of very large stops meant to catch the largest of adverse movements.

All of this is why I constantly make the point that one should think not in strict “stop loss” terms, but rather in “trade exit” terms. By this I mean that the stop point should be placed in line with whatever the exit strategy of the system or method or whatever requires. If you’re trend trading then your stop should be at a point where indications would conclude the trend isn’t in play any longer. In a range trading system the stop would be at the point where it’s clear the range trade is no longer working.

A proper trading strategy has both a well thought out entry point and a well thought out exit point – be they√ā¬†systematically derived√ā¬†or discrectionary. The are each based on the intended focus of the strategy, not totally seperate approaches. If you attempt to mis-match entry and exit you end up with a system that is inefficient all the way around.

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Trading Tips

Adding to Your Winning Trades

At some point just about every trader starts pondering the question of if, when, and how to add to winning positions. After all, part of trading success is getting the most out of your winners, while of course also minimizing the impact of your losers. Let’s look at the two primary strategies for doing so.

Start Small & Build
One approach some trading take is to start with an undersized position when first entering a new trade. For example, if they would normally look to risk 3% on their trades they might start off with only 1% exposed. The idea here is that any given trade could be profitable, and they don’t want to miss out all together, but that they want to see some kind of confirming move from the market before moving up to a full-sized position, or expect to see a counter move that could be used to get a better price.

This approach is often referred to as scaling in. Traders who find themselves often getting in too early on a market turn (like a change in trend) can benefit by this approach because it makes sure they are in should the entry not be too early after all (ensuring some profit), but allows them to move the remainder of the position in at potentially an even more attractive entry point.

This approach generally isn’t great for a strategy where trades tend to be immediate winner or loser types, meaning the market either takes off in favor of the trade or it moves directly against it to get stopped out. It can, however, be very good where there’s some kind of secondary confirmation that the trade is likely to be a winning one. For a chart based trader that could be something like seeing a higher low when in a long position.

Doubling Up, etc.
The other way traders look to add to positions is to use the profits from a winning trade to expand their position. This is particularly the case in markets like futures and forex where gains from open positions are immediately available to be used as margin for new trades. For example, if a trader is long an S&P 500 e-mini contract and the market rises 20 points, they have an extra $1000 in available margin money in their account. That may let them expand their position by doubling up (depending on how much they had in the account in the first place).

Needless to say, adding to winners should be based on a well-defined methodology and not just done willy-nilly.

Your Position Adding Mindset
Doubling up or otherwise adding to positions that are already what would be considered “full-sized” requires a clear mindset when thinking about what it does to your risk. Basically, it comes down to whether you are going to think in terms of risk on your original equity, or risk on your running equity (original plus open position gains).

Generally speaking, if you take the former view you are going to be willing to be more aggressive when it comes to adding to positions because you will in essence see it as playing with house money. That is all well and good as it can definitely make for some really big winners. Be aware, though, that it can lead to major equity swings as the over sized positions moved up and down (a position of 2x is going to move twice as fast as one of 1x). In some cases big gains are going to be wiped out very quickly because of a price reversal. That can be extremely deflating, so the trader needs to balance things out to have the drawdowns at psychologically (and bottom line profitability) acceptable levels.

Traders who look to running equity as the basis for risk assessments will be taking a much more conservative approach. They will be much less likely to add to trades in large chunks because it would generally exceed their risk parameters. For example, if a traders uses 2% as their risk threshold, they start with $10,000, and have $1,000 in position profits their permissible risk on the trade will be $220. That’s only 10% higher than what it was at the start of the trade. Is that enough to be able to add to the position? Probably not.

While it might sound like the “playing with house money” mindset is likely to be the more profitable, it doesn’t make it the right or better one. It’s a much more volatile approach and as such one not suited for many traders. The first time you see a big gain wiped out in a blink because of the bigger size you will know what I’m talking about.

Test, test, test
Adding to positions isn’t something that should be done randomly. You should have a strategy for doing so, both in general terms and on a trade-by-trade basis. Know what your strategy is go in. Test the strategy out with different variations so you know what will work for you and what won’t. That way, when the time comes to add that extra contract or lot or whatever, you’ll be comfortable in doing so with the knowledge of what to expect.