Bad decisions are usually made at the worst possible time in the trading arena. You know that feeling you get where the market is moving against all your open positions and they all pull back very close to your predetermined exit points at the same time. That is where bad decisions are made and that is also where the market usually reverses. I'm sure you have read many times before that you could give a profitable strategy to a group of traders and only one or two out of the group would actually stick to the rules. The turtle traders spring to mind. Having rules and sticking to them is crucial to successful trading. This tutorial is going to look into a few of my own trade rules and parameters that help me trade just inside of my own trade tampering limitations.
The Trade Tampering Limiter
The plan is to find a sweet spot where you can trade at a size that will compound meaningful year on year account returns but not too big that you continually second guess your own decisions and destroy your trading approach's expectancy every time the market pulls back. This is easier said than done and one thing I can promise is it's never going to feel that good when you get a string of losers. The goal is to become desensitised to losing or winning trades and manage them like a robot would do according to your predefined trade parameters before you entered the trade.
I say desensitised to winning trades also as this is the second area where bad decisions are made. Such as when a swing trade moves through your predefined target and you overthink the plan and decide it might be going to the moon only to watch it reverse and over the next few days trade back down to where you entered the trade or maybe your trend trade pulls back and you snatch at the profit too early not wanting it to dip back into negative territory only to watch it reverse higher the following day and over the next few months turn into one of the best trends in the market as you watch from the sidelines.
Sabotaging Trades
If you find yourself sabotaging trades at the worst possible time then you could be suffering from one of two things.
1, You're trading too big
2, You're trading too many.
You could actually be suffering from both.
Trading too big is usually the result of having too much confidence in a trading idea or method and failing to position size correctly.
Trading too many is the result of taking too many trades over a short period of time and overloading your account with risk (Heat).
Trading Too Big
Now I have no problem building big positions in stocks that are moving in my favour from my initial entry. With a healthy percentage cushion and a second entry at a higher level the gap risk into negative territory is much less than taking an oversize position on your first entry. The worst possible scenario is taking a big position on entry then averaging down at a lower price. Here's the scenario. You wake up tomorrow and your biggest position with your biggest paper loss opens -50% lower. This is why so many people never make it in the investing game.
The exact opposite, building into winners at higher prices, gives big positions a healthy percent cushion so if that dreaded profit warning comes and your biggest paper profit evaporates on the open the damage will be paper profit with limited slippage depending on how you weighted the add point. You can do the simple maths before adding so you know exactly how much that scenario would sting you. I always say if this halves in price how much am I willing to lose. If the worst possible scenario hit me for open profits plus 2% of the portfolio then that’s no big deal. It's easy to recover. The hardest part of the whole game is you need big winners and big winners are the result of big positions in your best idea's. Big positions in your best ideas give you volatility in your winners and watching huge winners retrace back to normal levels makes all but the best investors top slice as they can't stomach the volatility. All trades have their limits but more money is lost top slicing a great growth stock on the way up than is ever lost on a 30% price cut on a profit warning. You make more money riding a full position all the way up.
Here's a quick example.
Top Slicing (scaling out)
You buy BOO when it traded above 6 month highs back in 2015.
Price 32p. Invest £5,000
At 100% profit you sell 1/4 of the position £1,250
At 200% profit you sell another 1/4 of the position £2,500
At 300% profit you sell another 1/4 of the position £3,750
Locked Gains = £7,500.
Open gains at price of 199 (17/11/17) £6,524
Total £14,024
Now if BOO halves in price tomorrow you would be left with £10,137
Adding to a winner (pyramiding)
You buy BOO when it traded above 6 month highs back in 2015.
Price 32p. Invest £5,000
At 100% profit you invest a further £5,000
Open gains at price of 199 (17/11/17) £36,641
Total £36,641
Now if BOO halves in price tomorrow you would be left with £13,320
So in the worst possible scenario you actually ride through a profit warning with your full position when the trend ends. You make more money on the trade than the so called safer option of scaling out. On a dividend paying stock you could also lose out on a huge majority of the available dividends that hopefully are increasing in value over the holding period.
Now what about the best scenario. Well you hold the whole position in the best mover and at this point in time that profit is 2.6 times bigger than the scale out method.
It does look like BOO is now moving into more volatile times after a fantastic ride but the point I'm trying to hit home here is more money is lost scaling out of the best trends / trades / investments early than any profit warning will ever take you for period. If you can't hold a big winner then you will never get an account changing winner. If you average down and then get hit by a profit warning then you will have a huge hole to trade out of just to get back to break even. I prefer to give back open profits than trade out of a huge draw down any day. It's always worth drumming home that you will have many small winners and small losers that cancel each other out. You will get the occasional big winner. The only trade you have to avoid at all cost is the big loser. Averaging down puts you one bad trading statement away from a big loser because you have an increased risk on a trade that is already negative with no percentage cushion.
Now I see trades I've taken profit in three years ago still marching higher today. I make the exact same mistake over and over again. AMS haunts me to this day. The important thing is I don't eliminate the chance of a big winner from the start. I only need one or two good trends a year on the longer time frame to make good returns. There is no perfect but there are some very good guidelines of what is good practice for the account and what is bad.
Hopefully the lesson above will make you explore this area some more.
Trading Too Many
If you plan to hold multiple positions at the same time then you need to be aware of heat.
Heat is the total account exposure at your predetermined exit prices. Where you are wrong on the trades and where your stop loss orders are placed. If you don't have a predetermined wrong area plan before entering a trade then you are in the wrong game as you will be wrong maybe half of the time. That is the reality. Trading too many can be the result of having a few swing trades running that are not making any progress and adding more as new ideas hit your screens. Every new trade adding more risk to the market swing that is struggling to emerge. If you are not moving forward with your first trades of a new market swing then the market could be telling you the environment is not favourable with your strategy or the market is just not ready yet. Maybe you just positioned in the wrong sectors. The important thing to remember is if your best ideas are not moving into profit and you are loaded into multiple ideas then taking on more heat by entering new trades before dealing with the laggards you are holding is probably not the answer. It is also very common to take a group of swings. Get stopped out then form an opinion on the market because you got stopped out then watch the market leave without you. When you trade close to the daily noise of the market it will test the limits of your psychology.
I limit my heat to a maximum of 10% but rarely need to use more than half of this amount. As winners move out and let you trail the wrong area stop to break even it frees up heat to add another trade.
So How Big and How Many Can I Trade?
If you risk 1% of account per trade you can take 10 trades within the 10% heat limit.
If you risk 1/2% of account per trade you can take 20 trades within the 10% heat limit.
First of all you shouldn't be trading real money if you don't have a profitable strategy. Once you have a profitable strategy that has been forward tested at minimal size over a big enough sample then the next step is to decide on the amount you need to risk per trade to achieve a meaningful yearly growth rate. This can be calculated very easily if you know how many trades opportunities your method throws up a month, a quarter, a year. You will still find that you need to build up to that size gradually to limit the urge to sabotage your method in extreme market moves. Make sure you journal all your forward testing so you have these important stats. You will also need to know the average trade life in days and calculate how many trades you can take within your open heat limits. There is a tool called the Trade Opportunity Calculator we use at www.tradingbases.co.uk that does this for us.
Limiting Heat Using Past Results
This could be limited by using the last quarter's closed profit or the last market swing's closed profit. Market swing being from the retrace through to the market pulling back again after trading another step up in a bull market leg. If you made 4% in the last quarter (closed profit) then limit your open heat to maybe half of that amount in the new quarter so if the market collapses and takes your trades with it you are still only one step back from the previous quarter. Remember it's not a free trade. We're not trading with the market's money here. Two steps forward and one step back but one step back would be maximum loss if the market crumbles under our feet.
Let's Do The Maths
If you closed 4% in profits over the last quarter then limit new open heat in the new quarter to 2%. Now I risk 1/2% per trade at stop on swing trades so that would let me have 4 trades open with un-trailed stops. As I trail stops on an open winner it would free up more open heat so I could add another trade. Only building on success with open trades whilst only risking half my gains from the previous quarter.
Here are some risk limit ideas I use for swing trades
1 - 1/2% risk per trade (of account at stop)
2 - Half of the previous swings gains risked on open positions
3 - 5% maximum combined heat (of account at stops) for all open trades overriding #2
Obviously if you are following a losing quarter then you have no profit cushion so then you need to look back at your average gain per quarter to get a ballpark figure but basically speaking if you have two or three of your best trade ideas loaded and none of them are moving into profit then there is no need to throw more money at more ideas in the hope that something will stick, which leads us on to the next point.
Easy on the Gas Pedal
Even if you are trading well within the limits of your risk control it is important not to just flick the buy switch and load into all your best ideas at the same time. From my own experience this is where it can all turn bad very quickly even if at first it works.
You end up with very volatile swings as all trades entered together swing up and down with the overall market swings. This usually results in tampering with the trading plan and totally blowing the trading parameters that give the results. When this happens to you a couple of times in a row only then will you start to understand how important the previous point of "Only Building On Success" is.
But Where Is The Action?
When you start to trade within the parameters of your own results you might feel like everything has come to a grinding halt. You will feel like a trader that isn't trading. Less really is more in trading. At the end of the day doing the right thing rarely feels natural. I really struggle with the quote "you must find a trading style that suits you" as if there is some magical methodology holy grail that will make all the important trade management decisions effortless. There isn't.. It's a constant battle not to tamper with a proven plan when trading at meaningful size and when the market is fantastic you will be tempted to keep adding more risk late in a swing and when the market is awful you will be tempted to choke longer term trends with tight stops. Hopefully this short read has opened your mind to some heat limitations that you can use in your own trading.
Next Tutorial - The cost of Learning
Jase
@stealthsurf
The Trade Tampering Limiter
The plan is to find a sweet spot where you can trade at a size that will compound meaningful year on year account returns but not too big that you continually second guess your own decisions and destroy your trading approach's expectancy every time the market pulls back. This is easier said than done and one thing I can promise is it's never going to feel that good when you get a string of losers. The goal is to become desensitised to losing or winning trades and manage them like a robot would do according to your predefined trade parameters before you entered the trade.
I say desensitised to winning trades also as this is the second area where bad decisions are made. Such as when a swing trade moves through your predefined target and you overthink the plan and decide it might be going to the moon only to watch it reverse and over the next few days trade back down to where you entered the trade or maybe your trend trade pulls back and you snatch at the profit too early not wanting it to dip back into negative territory only to watch it reverse higher the following day and over the next few months turn into one of the best trends in the market as you watch from the sidelines.
Sabotaging Trades
If you find yourself sabotaging trades at the worst possible time then you could be suffering from one of two things.
1, You're trading too big
2, You're trading too many.
You could actually be suffering from both.
Trading too big is usually the result of having too much confidence in a trading idea or method and failing to position size correctly.
Trading too many is the result of taking too many trades over a short period of time and overloading your account with risk (Heat).
Trading Too Big
Now I have no problem building big positions in stocks that are moving in my favour from my initial entry. With a healthy percentage cushion and a second entry at a higher level the gap risk into negative territory is much less than taking an oversize position on your first entry. The worst possible scenario is taking a big position on entry then averaging down at a lower price. Here's the scenario. You wake up tomorrow and your biggest position with your biggest paper loss opens -50% lower. This is why so many people never make it in the investing game.
The exact opposite, building into winners at higher prices, gives big positions a healthy percent cushion so if that dreaded profit warning comes and your biggest paper profit evaporates on the open the damage will be paper profit with limited slippage depending on how you weighted the add point. You can do the simple maths before adding so you know exactly how much that scenario would sting you. I always say if this halves in price how much am I willing to lose. If the worst possible scenario hit me for open profits plus 2% of the portfolio then that’s no big deal. It's easy to recover. The hardest part of the whole game is you need big winners and big winners are the result of big positions in your best idea's. Big positions in your best ideas give you volatility in your winners and watching huge winners retrace back to normal levels makes all but the best investors top slice as they can't stomach the volatility. All trades have their limits but more money is lost top slicing a great growth stock on the way up than is ever lost on a 30% price cut on a profit warning. You make more money riding a full position all the way up.
Here's a quick example.
Top Slicing (scaling out)
You buy BOO when it traded above 6 month highs back in 2015.
Price 32p. Invest £5,000
At 100% profit you sell 1/4 of the position £1,250
At 200% profit you sell another 1/4 of the position £2,500
At 300% profit you sell another 1/4 of the position £3,750
Locked Gains = £7,500.
Open gains at price of 199 (17/11/17) £6,524
Total £14,024
Now if BOO halves in price tomorrow you would be left with £10,137
Adding to a winner (pyramiding)
You buy BOO when it traded above 6 month highs back in 2015.
Price 32p. Invest £5,000
At 100% profit you invest a further £5,000
Open gains at price of 199 (17/11/17) £36,641
Total £36,641
Now if BOO halves in price tomorrow you would be left with £13,320
So in the worst possible scenario you actually ride through a profit warning with your full position when the trend ends. You make more money on the trade than the so called safer option of scaling out. On a dividend paying stock you could also lose out on a huge majority of the available dividends that hopefully are increasing in value over the holding period.
Now what about the best scenario. Well you hold the whole position in the best mover and at this point in time that profit is 2.6 times bigger than the scale out method.
It does look like BOO is now moving into more volatile times after a fantastic ride but the point I'm trying to hit home here is more money is lost scaling out of the best trends / trades / investments early than any profit warning will ever take you for period. If you can't hold a big winner then you will never get an account changing winner. If you average down and then get hit by a profit warning then you will have a huge hole to trade out of just to get back to break even. I prefer to give back open profits than trade out of a huge draw down any day. It's always worth drumming home that you will have many small winners and small losers that cancel each other out. You will get the occasional big winner. The only trade you have to avoid at all cost is the big loser. Averaging down puts you one bad trading statement away from a big loser because you have an increased risk on a trade that is already negative with no percentage cushion.
Now I see trades I've taken profit in three years ago still marching higher today. I make the exact same mistake over and over again. AMS haunts me to this day. The important thing is I don't eliminate the chance of a big winner from the start. I only need one or two good trends a year on the longer time frame to make good returns. There is no perfect but there are some very good guidelines of what is good practice for the account and what is bad.
Hopefully the lesson above will make you explore this area some more.
Trading Too Many
If you plan to hold multiple positions at the same time then you need to be aware of heat.
Heat is the total account exposure at your predetermined exit prices. Where you are wrong on the trades and where your stop loss orders are placed. If you don't have a predetermined wrong area plan before entering a trade then you are in the wrong game as you will be wrong maybe half of the time. That is the reality. Trading too many can be the result of having a few swing trades running that are not making any progress and adding more as new ideas hit your screens. Every new trade adding more risk to the market swing that is struggling to emerge. If you are not moving forward with your first trades of a new market swing then the market could be telling you the environment is not favourable with your strategy or the market is just not ready yet. Maybe you just positioned in the wrong sectors. The important thing to remember is if your best ideas are not moving into profit and you are loaded into multiple ideas then taking on more heat by entering new trades before dealing with the laggards you are holding is probably not the answer. It is also very common to take a group of swings. Get stopped out then form an opinion on the market because you got stopped out then watch the market leave without you. When you trade close to the daily noise of the market it will test the limits of your psychology.
I limit my heat to a maximum of 10% but rarely need to use more than half of this amount. As winners move out and let you trail the wrong area stop to break even it frees up heat to add another trade.
So How Big and How Many Can I Trade?
If you risk 1% of account per trade you can take 10 trades within the 10% heat limit.
If you risk 1/2% of account per trade you can take 20 trades within the 10% heat limit.
First of all you shouldn't be trading real money if you don't have a profitable strategy. Once you have a profitable strategy that has been forward tested at minimal size over a big enough sample then the next step is to decide on the amount you need to risk per trade to achieve a meaningful yearly growth rate. This can be calculated very easily if you know how many trades opportunities your method throws up a month, a quarter, a year. You will still find that you need to build up to that size gradually to limit the urge to sabotage your method in extreme market moves. Make sure you journal all your forward testing so you have these important stats. You will also need to know the average trade life in days and calculate how many trades you can take within your open heat limits. There is a tool called the Trade Opportunity Calculator we use at www.tradingbases.co.uk that does this for us.
Limiting Heat Using Past Results
This could be limited by using the last quarter's closed profit or the last market swing's closed profit. Market swing being from the retrace through to the market pulling back again after trading another step up in a bull market leg. If you made 4% in the last quarter (closed profit) then limit your open heat to maybe half of that amount in the new quarter so if the market collapses and takes your trades with it you are still only one step back from the previous quarter. Remember it's not a free trade. We're not trading with the market's money here. Two steps forward and one step back but one step back would be maximum loss if the market crumbles under our feet.
Let's Do The Maths
If you closed 4% in profits over the last quarter then limit new open heat in the new quarter to 2%. Now I risk 1/2% per trade at stop on swing trades so that would let me have 4 trades open with un-trailed stops. As I trail stops on an open winner it would free up more open heat so I could add another trade. Only building on success with open trades whilst only risking half my gains from the previous quarter.
Here are some risk limit ideas I use for swing trades
1 - 1/2% risk per trade (of account at stop)
2 - Half of the previous swings gains risked on open positions
3 - 5% maximum combined heat (of account at stops) for all open trades overriding #2
Obviously if you are following a losing quarter then you have no profit cushion so then you need to look back at your average gain per quarter to get a ballpark figure but basically speaking if you have two or three of your best trade ideas loaded and none of them are moving into profit then there is no need to throw more money at more ideas in the hope that something will stick, which leads us on to the next point.
Easy on the Gas Pedal
Even if you are trading well within the limits of your risk control it is important not to just flick the buy switch and load into all your best ideas at the same time. From my own experience this is where it can all turn bad very quickly even if at first it works.
You end up with very volatile swings as all trades entered together swing up and down with the overall market swings. This usually results in tampering with the trading plan and totally blowing the trading parameters that give the results. When this happens to you a couple of times in a row only then will you start to understand how important the previous point of "Only Building On Success" is.
But Where Is The Action?
When you start to trade within the parameters of your own results you might feel like everything has come to a grinding halt. You will feel like a trader that isn't trading. Less really is more in trading. At the end of the day doing the right thing rarely feels natural. I really struggle with the quote "you must find a trading style that suits you" as if there is some magical methodology holy grail that will make all the important trade management decisions effortless. There isn't.. It's a constant battle not to tamper with a proven plan when trading at meaningful size and when the market is fantastic you will be tempted to keep adding more risk late in a swing and when the market is awful you will be tempted to choke longer term trends with tight stops. Hopefully this short read has opened your mind to some heat limitations that you can use in your own trading.
Next Tutorial - The cost of Learning
Jase
@stealthsurf