By: Fernando Gonzalez, EvolutionTrading.net
January 26, 2010
In the eyes of the short-term trader, the recent volatility is like a ray of warm sunshine after a very long, dark and cold winter. Or perhaps, more appropriately, the sudden arrival of customers in an otherwise empty and lifeless marketplace for now close to 6 months.
PART I: Risk Management
Over this time, the winning strategy was simple: you buy anything, hold it, and you sell it sometime later in the day or the week, and make money eventually. New market participants who have come in to an environment like this will find making money as a short-term trader is easy. But there is a reason why professional traders will not ever trust an easy market. Unfortunately for me as an educator as well, it is always a recurring pattern, as sure as the sun rises and sets, that immediately following the “easy” periods characterized by the “buy now-hold it-sell later-make money-for sure” strategy, I will undoubtedly receive emails or phone calls (usually from strangers, but rarely ever from my own students) that go like this:
“I bought XXXX at $50, it’s $44 right now, help, what should I do!!!”
Being in the business for 13+ years, I can’t even count those anymore. It’s one of the part of business I really don’t like hearing at all. It usually comes when the market turns down and stays down. Sometimes it’s the opposite, when the turn is upwards, and in that case, the position is Short-side. Right in the middle of the trading day last week as the market unfolded into an old-fashioned faceplant, the thought did come to mind: here come the emails.
I always end up responding in the same way, so now is a good time for:
“SOME THINGS TO THINK ABOUT WHEN YOU ARE GETTING CRUCIFIED BY YOUR POSITION”
-or-
“HOW TO DISINTEGRATE A BAD TRADE FROM YOUR LIFE”
1) Everything below is expressed as my opinion, I am a private trader, I am not a broker, it is not investment advice. Please read disclaimer.
2) All comments below are based upon SHORT-TERM TRADING POSITIONS that have gone the wrong way, these are typically multi-day positions, rather than Intraday. With that said, it’s time to…
3) Wake up, the money is GONE.
4) Since the position is still open, it is possible that it returns back up to $50 in a few days, as fast as it went down to $44, it can go back to $50. It is equally possible that it will be $28 in a few days.
5) Take a look at last sentence on #4 again.
6) Bad positions usually win against the trader. Some are able to escape them. But most won’t.
7) The ones who are able to escape will shortly find themselves in the same predicament eventually. Understanding why that happens is no rocket science.
8) Bad positions take over your life. You sleep with them, you wake up with them, you take a shower them. I guess what I’m trying to say is, the psychological burden on you will match the financial burden, dollar for dollar at least.
9) It’s hard to make money while you’re losing money. What that means is, being cornered in a position will prevent you from taking advantage of what is probably an abundance of opportunities on the other side of the fence. There’s a party next door, you’re invited, but you can’t go because your position has you tied-up and gagged in the basement. So, in addition to the current financial burden, plus the dollar-for-dollar (minimum) psychological burden, plus lost opportunity cost, you are probably losing 3 times the amount you are seeing on your bright red P&L figure.
10) Your risk exposure in this trade is what got you into the bad situation. Do not add anymore to the risk exposure. It is important to get into the mindset of LIMITing Risk Exposure, preventing it from growing into a worse monster than it already is.
11) See #3.
12) Risk Exposure is expressed in TIME and MONEY. The longer you hold the trade, the greater your risk. That’s because stocks and markets can travel farther in a larger window of time. And when I say “farther” it can mean FARTHER DOWN if you’re Long, and vice versa. Surprised? Some people think stocks don’t go down, vice versa. So, you have to set a TIME limit. I’ll tell you how below.
13) Next is MONEY. Pouring more money in the trade to average the entry price down can seem a logical option, especially if you think you are rich, or maybe just trying to buy hope. One thing to think about is this: when you challenge the market to a duel, you will not win. You can win this time and have the illusion that you won, but ultimately the market wins. It always does.
14) The most common response/suggestion/guidance/advice to “help me, I’m in a bad position, what should I do?” would be to get out of it immediately. Amputate, cull, eliminate it… now. Which might not be such a bad idea…
15) An alternative would be to take a new mindset and actively manage it through distribution of risk.
16) But how can anyone actively manage a trade in a competent way, when it’s the same incompetent who got himself into this predicament in the first place? Well, incompetence is sometimes just a lack of experience or education, that’s all. Actively managing an already-bad trade is similar to the way at which race cars are designed to deal with a crash – to distribute the energy into many different parts by disintegration. In essence, we “disintegrate” the position through a simple, but specific step-by-step process. It’s damage control remember, the accident already happened… there’s a science to competently getting out, even for the incompetent.
17) Disintegration of a bad trade begins with taking your position size – your exposure – and cutting it into 2, 3, 4 or 5 (at the most) equal parts. So that would be either 50%, 33%, 25% or 20% parts. The larger each part is, the quicker you will reduce risk, you decide, use your good judgment, but I don’t suggest having parts less than 20% in size.
18) Whatever you decide, decide quickly. Take one PART and eliminate it without flinching. Amputate it from the account now, no emotion, no drama. Right now? Yes, right now. You are not Dorothy and your stock is definitely NOT Toto. Take one Part and eliminate it, don’t even say goodbye.
19) This first move is a crucial one, not only that it immediately reduces risk, but it’s essential purpose is to implant a risk-reduction mindset and heightened sense of control, so you can see straight.
20) Next, develop exact exit points for the remaining parts, in both directions. Do not try to be cute and attempt to apply Support/Resistance, but rather utilize probable range of motion over time, and the best measure to use for that, in my humble opinion, is the ATR (Average True Range).
21) Which ATR? The one on the DAILY charts, nothing else.
22) I repeat: ATR ON THE DAILY CHARTS
23) What setting? Just use the standard 14 period.
24) How about the TIME LIMIT you mentioned? You don’t need one anymore – by using the Daily ATR, Time will already be factored in.
25) What do I do with the ATR?
a. Take the value of the ATR and use it as a “measuring stick” for your exit points.
b. Let’s say that the Daily ATR value of your miserable stock-friend is $1
c. So with $1 ATR value as example, calculate ONE ATR ($1) up and $1 down from the exact spot of your first execution (that FIRST PART you removed to initiate disintegration… see #18).
d. The levels you derive by calculating the ATR up and down will serve as the triggers to execute the elimination of the other parts.
e. If you are LONG, eliminate 2 parts if price moves DOWN (against you). Eliminate 1 part if price moves UP (in your favor). Vice versa for Short-side. How many times you will have to do this depends on which PART Sizing you planned (see #17).
f. When the price is triggered, EXECUTE THE PLAN, no drama.
g. Once executed and you still have remaining parts, calculate $1 up and down from your most recent exit point.
h. If the price is NOT triggered before the Close of the day, start again the next day, this time using the prior Close as a starting point to calculate new ONE ATR up and down levels.
i. Actively manage and execute the plan at every level. Keep doing it until you have rid yourself of your misery.
26) As complicated as it may seem to some, the above concept of disintegrating a bad trade from your life is very simple. If you are having a hard time following, just draw the concept with a pen and paper or chart print-out following the instructions.
27) It is important to realize that once a position has spun out of your control, it has transformed from a money-making idea into a serious dilemma. You have to think “damage control,” and the quicker you can execute a good plan to control that damage, the better off you will be.
Well, I hope that helps anyone who might be needing it right now, ‘tis the season, after all.
PART II: This week's Big Picture Analysis
REF: SP Monthly Chart above.There is a lot of buzz over the recent market declines. Based upon the Monthlies, there really is no big deal -- yet. It's still a relatively small reaction to the 50% retracement of the big decline in 07-08, as you can see by the size of the most recent bar. It would be premature to expect a big decline here, as the evidence is not substantial enough to make any bold projections.
REF: SP Weekly Chart above. The recent declines here are a little more evident, although still not a very big deal, although speed is noteworthy. It is the largest fastest decline in 6 months (see shaded area). But how much different would it be than the area designated by the arrow? Momentum is down, no doubt, it's fast, do doubt, although once again still premature to expect larger-scale decline beyond a 10% correction level, which is indicated above and also on the chart below with the Yellow dotted line.
REF: SP Daily Chart above. The speed of the recent decline here is more notable, and undoubtedly a change in character. At this point, there are a couple of gaps underneath the market in play, at least one of which is very likely to be filled in this leg. The Yellow dotted line indicates the 10% correction Area and also a pivotal Swing LO from Nov2.