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. 🙂

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.

Trading Tips

Drawbacks to packaged trading systems

There’s a post on the Winners Edge Trading blog that looks at automated trading systems. The article takes a very negative view on these systems, focusing mainly on ones that are being marketed and sold. The case against them are as follows:

  1. Many system sellers don’t actually care whether they work for you or not.
  2. The system creator(s) don’t do sufficient testing to come up with significant, trustworthy results.
  3. The system is built around recent market conditions, which stops working as soon as conditions change.

Of course the post then goes on to talk about all the things they do with their own system(s) – which they then promote – in order to overcome these three issues. Unfortunately, even the most sincere, honest, and ethical system developer cannot account for the fact that most systems won’t work for most people because they are not a good psychological fit for the user.

I am personally not in favor of buying trading systems. You are much better off researching and developing your own. It’s much more likely to be a good fit for you and to be something you can stick with.

Trading Tips

Testing Trading Exits vs. Reversals

I’ve been reading a book of late that I will shortly be reviewing. There was a comment of the author’s that I wanted to address now, though. In talking about system testing the author made the statement that it’s better to run strategy tests based on position reversals (long to short, short to long) rather than position closures. It’s a statement with which I’m not very comfortable.

Now, to provide a little context, the focus here is mainly a longer-term investment one, so it’s generally looking at things from long-only perspective. That means a sell signal is an exit signal. It’s not really meant to be a short entry signal, though obviously there’s the potential for playing the short side as well. The author’s argument for testing a strategy as if shorts will be entered is that it will provide the best selling signals.

Here’s the thing, though. Good long exits are not necessarily the same thing as good short entries.

Pure traders, of course, have somewhat different considerations, but investors should be thinking about total return considerations. If the market is going to go sideways for a lengthy period, for example, it would be better to be out of your long near the start of the move into consolidation than it would be to wait until a short signal was triggered at the end of it. That would save a lot of emotional capital being wasted during a choppy back and forth period and provide the opportunity to put the money to work in a way which would actually provide a return (fixed income investments, for example).

My point is that optimal short entries do not necessarily make optimal long exits (or vice versa). Of course, it always comes down to testing.

Trading Tips

Using Secondary Indications in Your Market Analysis

Yesterday Adam at Forex Blog put up a blog post looking at the British Pound, specifically in terms of GBP/USD. He throws a lot of different stuff into his assessment of the UK currency, part of which is looking at the prospects for a rate hike by the Bank of England. To that end, let me share two charts I keep an eye on in my work.

This first chart shows the spread of UK 2 year Gilt rates over the US 2yr Treasury Note rate, with the spread’s correlation to GBP/USD in red as the lower plot.

The second chart is the same as the one above, but swapping German Bunds in place of US Treasuries and running the correlation against EUR/GBP instead of GBP/USD.

I offer up these charts for a couple of reasons. One is to show the sort of secondary analysis professionals use to assess the markets. Another is to show how frequently market correlations can change. We would expect a positive linkage between the UK/US rate spread and GBP/USD and a negative one between the UK/German spread and EUR/GBP, but that’s not always the case.

The third reason for showing these charts is to show what’s been going on in these spreads lately. The UK/German spread has fallen sharply, strongly indicating the market’s view on whether it will be the ECB or BoE the moves first to hike rates has moved strongly in favor of the former. Things are less dramatic in the UK/US spread, but the breakdown there hints that fixed income traders have become less confident about a BoE rate move in the short-term in general, not just as opposed to the timing of the ECBs action. These are the sorts of things the professionals are looking at and thinking about in making their market judgements. It’s all related.

Trading Tips

Quick and Dirty Position Sizing Rule for Traders

There’s all kinds of discussion and advice about how much risk should be taken on a trade-by-trade basis. Figures like 1%-2% are often tossed out in the active trader community. William O’Neil suggested 8% in his book How to Make Money in Stocks. If you really want to do it right, and you have the appropriate statistics, you can come up with a risk level based on your strategy’s/system’s win rate and the relative sizes of the winners to the losers. We don’t always have a really good set of performance metrics to work with, though, so here are a couple of quick and dirty ways to get to per trade risk.

Fixed Risk
If you’re planning on taking the same nominal risk (say $100) then it’s very simple. You take the maximum amount you’re willing to risk over a given period and divide that by the number of trades you expect to make in that period.

Let’s say you’re maximum risk for the week is $500 and you expect to make 10 trades. Take $500, divide that by 10, and you come up with $50 risk per trade.

Alternately, if you want to think in percentage terms, let’s say you want to set your max risk at 5% for the week and will do 10 trades. In this case you’re per trade risk would be 0.5% (5%/10).

Fixed Ratio
The math gets a bit more complicated when you start talking about setting your risk as a percentage of your account equity. This means, for example, that if you decide to risk 5% and your first trade was a loss, your second trade would mean risking 5% of the now 5% smaller account equity (95% of the initial value). That would be 4.8% of the initial account balance (95% x 5%). This sort of strategy means as your account balance falls from a series of losing trades you’ll actually take smaller and smaller risks through a negative compounding process.

Let’s bring back the 5% risk for the week and the 10 expected trades.

We can figure out what the per trade risk would be by using this base formula in Excel:


Where r is the total risk for the period we’re looking at and n is the number of trades expected for that period.

Plugging in our 5% total risk and 10 trades we get:



= 1 – (0.95^0.1)

Which works out to 0.512% for the per trade risk.

Note that this is actually slightly larger than what we got in the fixed risk calculation above. That’s because of the negative compounding involved.

Scale it Up!
Note that you can use this same sort of process for setting up your per period risk limits. For example, you could figure out what your per week risk limit should be given where you want your per month risk cap to be. It’s the same math, just scaled up from trades to time periods.

Very Conservative
Now, in both of the sets of calculations above we’re going on the assumption of a worst case scenario where every one of our trades in the period in question is a loser (or in the case of time periods, that each of the smaller ones sees a maximum loss). That makes it inherently very conservative in nature. To that end, it’s good for setting the floor in terms of how small you should trade. As such, new traders can make very good use of these quick and dirty calculations to keep them trading conservatively during the learning process (so long as they are pretty close in their estimates of how many trades they’ll do). More experienced traders will want to adjust up based on rational assessment of performance.

How do you set your risk?
I like to use the quick and dirty stuff above when looking at more position-oriented trades. They are inherently less frequent, so as such more subject to strings of losses because the law of large numbers cannot necessarily come in to play.

What about you? How do you decide what to risk on your trades?

Reader Questions Answered

Using Daily or Weekly Trading Goals

Day traders usually talk about their daily and weekly goals. Someone told me that this is typical advice from day trading coaches.

The daily goal makes some sense. A day trader should know that there is a certain average daily range and that it is unrealistic to expect to make more than x% of that range.

But I don’t get the weekly goal. It implies that if I made my weekly goal by Tuesday, I need to forget about trading for the next three days. Why would this be sound advice? After all, if you are certain about your edge in the markets, then it seems to me that you would be better off applying that edge as frequently as possible.

This is from frequent emailer (and commenter) Rod.

The gentleman I generally consider my own markets/trading mentor in many ways used to have a daily profit target when he and his partner day-traded S&P 500 futures. I think it was something like $300. If they made that amount by early in the session they’d take the rest of the day off and go golfing or something. Many, but not all day traders have this sort of approach. And there are many traders who have weekly profit targets based on their income requirements.

I would, however, make sure there’s a clarity of what’s meant by targets. My mentor had a hit it and quit it type of target. He wanted to make a certain amount each day and that was it. Others, when they talk about targets, however, are referring more to averages. Their target is to average $X/day or week with the realization that some periods will be better and some worse.

Rod’s wondering about using a hit it and quit it targets is a legitimate one. It really depends. There’s a lot to be said about maximizing your edge – meaning doing as many trades as you can using a system that has a positive expectancy. From a purely rational perspective it makes no sense to stop trading when there might be more money to be made.

That said, though, personal trading performance can be variable. My own personal experience is that my best trades when day trading are almost always the first ones in the morning. My performance tends to drop as the day progresses. Admittedly, my style of trading is more discretionary than mechanical, so it’s more subject to my state of mind, distractions, etc. Still, market conditions vary through the day. Sometimes it just doesn’t make much sense to trade, even with a strong system, because the market is unlikely to give you much of the type of action you need.

So it comes down to knowing yourself and knowing your trading system.

Trading Tips

A Few Bits of Trading and Market Wisdom

At the beginning of the year, Barry Ritholtz published a list of Market Truisms and Axioms from Arthur Huprich. The full list is well worth reviewing, especially if you’re a stock market trader or investor. Here are the ones that I thought the most worthwhile.

 – There is nothing new on Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again, mostly due to human nature.

 – Understanding mass psychology is just as important as understanding fundamentals and economics.

 – Learn to take losses quickly, don’t expect to be right all the time, and learn from your mistakes.

 – When trading, remain objective. Don’t have a preconceived idea or prejudice. Said another way, “the great names in Trading all have the same trait: An ability to shift on a dime when the shifting time comes.”

 – Wishful thinking can be detrimental to your financial wealth.

– Technical analysis is a windsock, not a crystal ball. It is a skill that improves with experience and study. Always be a student, there is always someone smarter than you!