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Author: hirank4 | Total views: 13 Comments: 0
Word Count: 1277 Date: Thu, 11 Oct 2007 8:54 PM

Reducing Your Risk in BetterTrades

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.

View First BetterTrades Chart

This range, or my being aware of it is so critical to me that I have a filter criteria built into my Chart NavigatorÂ® 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:

View Second BetterTrades Chart

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.

View Third BetterTrades Chart

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