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Trading System Basics, Part II

July 6, 2015

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This is part II of the newsletter on Trading System Basics. For part I, go back and read the newsletter located here: https://tackletrading.com/tackle-newsletter-system-basics-part-i-6292015/

by Tim Justice

Position Sizing

Position sizing is the process of deciding how many shares to buy. While there are several approaches to position sizing, we will explore three:

1. Scaling in
2. Fixed percentage
3. Scaling out

Scaling In
To understand the concept of scaling into a trade, let’s consider the dynamics of a trend. As a trend begins to develop, its risk level is at its highest. Traders who get in on the beginning of the trend take the highest risk and are also paid the highest return. As the trend matures, the level of risk decreases, but so does your expected return. One way of dealing with the risk at the beginning of a potential trend is to start with a smaller investment; as the trend matures, you can add to the investment. This way, a small portion of your money is in the investment for the big wins. If the big win doesn’t pan out you are not exposed to the high risk.

Scaling in could be a good way to build a position. Using the entry techniques you learned in classes like Master Trader, buying some of your trade on a bullish retracement signal and later adding to it as the stock breaks out would be a classic example of scaling in.

Fixed percentage
Another approach to position size is the fixed percentage approach: it assigns a fixed percentage of your account size to each trade. For example, assume that you are willing to trade 1% of your account on each trade. If you have an account size of $100,000, you’ll risk $1,000 per trade. Given the odds we used in an earlier example where you win 80% of the time and lose 20% of the time, your chances of getting wiped out after the first two trades are impossible since you are risking only two percent of your total account. Although this is an easy way to determine the size of your trade, there may be some subtleties to fixed percentage trading that you may not have considered.

Why Risk is More Important Than Size
Using fixed position sizing is widely accepted as a way to control risk. The thinking goes like this: if I always buy the same amount of size per trade, then I am never at more risk on any given position. Is this correct? Let’s examine two examples. Let’s assume that we take a position on the ETF QQQQ. How fast does it move? On an average week, what kind of up and down can you expect?

The ATR indicator can be added so that we can get an idea of how volatile the stock is. Assume a stock moves 2.00 per week. If we buy 100 shares as a fixed position size, or conversely, invest a set dollar amount as a fixed position size, we can use ATR as a gauge for potential risk. Now let’s add our second position and compare the two.

Imagine a more volatile stock. XYZ company has an ATR over 8.0 on a weekly basis. If you bought 100 shares of the QQQQ and 100 shares of XYZ, you’d be assuming nearly four times the risk in the second position.

When determining the number of shares to buy or the amount of money to spend, you need to always consider the underlying risks that you are taking in the position. If you were trading derivative products like options contracts or futures contracts, they have different risks than a stock position. There really isn’t a hard and fast rule. You’ll need to determine this for yourself. That decision will depend on your account size, risk tolerance, and the assumed success rates and reward-to-risk ratios of the trade’s you are entering.

Scaling Out
Position sizing doesn’t just have application when you buy a stock; it’s also a consideration when you’re looking for a way to get out of a trade. You’ve learned about entry and exit points for your trades, as well as to identify support and resistance zones in an upward trend where a stock is likely to continue its upward rally. These resistance zones can act as opportunities to take profit off the table. You can sell out of a stock entirely at these points if you’re happy with your profit. You can also use these as opportunities to stay in a trade, but to take a portion of your money back.

Imagine an example where scaling out may have been applied. If a trader buys the breakouts on IBM he could use scaling out as a way to take some profit off the table as it hits resistance. Traders who simply get out of the trade will not be there for the bigger move. Traders who never take profits will be exposed to giving back gains. Think of the scaling out strategy as a happy medium between the two extremes.

Stop Losses
One of the most effective methods of controlling risk is to use an order called a stop loss. Stop losses can be used for any type of trade including bullish and bearish positions. The word stop really means trigger. A stop loss order is a triggering order to get you out of a position. It’s the time that a trader tells his broker to exit the trade. If you remember from our examples on trading systems, you can have the best success rate in the world but if you don’t accompany it with an appropriate reward-to-risk ratio, then it may not matter.

While stop losses may not work the way that the trader wants them to work all of the time, they’re an important part of the risk management process. Several different methods of stop losses are used in the market. It’s important for the trader to start with a basic stop loss and then as he works the market, the methods can be shaped for different situations. We’ll discuss several different entry techniques. One of the most important questions you should ask yourself when setting a stop is: where do I no longer want to be in the trade?

Percentage Method
The percentage method of setting stops would be used by a trader looking for consistency and ease. Using the percentage method would mean that you place your stop loss a set percentage below either the current price, the entry price, the low of a candlestick or some other set technical criteria. Which of those points you chose will be a preference. Remember, this is just a starting point. You may have to adjust this depending on market conditions. The advantage of the percentage method is that it is easy and consistent. The major disadvantage is that it’s not based on any technical strategy. What if you use 4% below the price you paid and that level happened to land right on top of a support zone? Would you really want to set a stop loss right above the support that’s supposed to hold the stock up? Probably not. If you decide to use the percentage method you will also want to consider common sense as you’re entering the numbers. Again ask yourself: is this where I no longer want to be in the trade?

Daily Candlestick High and Low
A good method for stop loss placement is to use the current candlestick as a place to enter the order. Candlestick patterns are very important in trading. As candlesticks break above or below the previous bar they start to show signals of strength or weakness in the stock.

As candlesticks develop, a trader using the candlestick method would adjust his stop loss to just below the previous day’s candlestick.  This serves the function of locking in profits as the trade moves upward. One drawback to the candlestick method is that it may get you stopped out prematurely. For example, a rallying bullish position puts in a red candlestick that would have stopped the position out only to rocket higher the very next day. How do you prevent this? Well, using the candlestick method in conjunction with the other methods can help you avoid being whipped out.

Intraday Chart Method
Many traders will use different time frames of charts while trading. One of the best uses of an intraday chart is in trade management. As stocks develop, the intraday chart will give you the most detail of what’s going on with your trade.

By using an intraday chart, a trader can get a more accurate portrayal of where the pricing points are; such as support and resistance. When setting a stop, you may want to go a little bit beyond the point you identify. If you see support at 28.00 you may want to set your stop loss below that at 27.89. Most traders will drop their stop loss slightly below the technical level. The amount below will change from chart to chart. 11 cents below support might work for GE but probably would be too tight for a trade on Google which is priced hundreds of dollars higher.

ATR as a Guide
The ATR indicator can be helpful in setting stops, as well. Since ATR gives us an idea of the average volatility for a stock, we can use the ATR number to let us know where to place a stop loss. Some traders take the ATR and subtract it from whatever the current price is and place the stop. Other traders take the ATR from the low of the current candlestick and set the stop. Whatever stop loss method you decide on, you’ll want to have it written down, consistently apply it, and only change it after you’ve practiced a new more effective method.

Traders constantly debate where to set a stop. It’s mostly a preference based on risk tolerance and trade objectives. If you believe in the long term potential of a move, you may want to loosen up your stop. If you are looking to make a quick-striking trade that you get in and get out with profits, you’ll most likely want to keep a tight stop loss.

Using Several Methods Concurrently
Some of the best trading systems will take into account all of the previous methods and set a stop based on the sum of the evidence. By having a set percentage that you’re accustomed to and then also analyzing the low of the candlestick, intraday pattern and assessing the ATR a trader can make a comprehensive judgment on where the stop loss should be placed.

Money management is one of the most overlooked factors in the investing process. It’s also one of the most important. Most people rely on intuition for their money management, but as we have learned, intuition can have a disastrous effect on your portfolio. Be certain that you know your entrance points and your exit points, and try to calculate your reward-to-risk ratio before entering the trade. You’ll be able to better manage your assets. Develop a set approach to your trading system and be consistent in following it. Money management requires just as much commitment and discipline as choosing your stock. If you’re consistent in your approach, you’ll soon be trading like a pro.

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All investing and trading in the securities market involves a high degree of risk. Any decisions to place trades in the financial markets, including trading in stocks, options or other financial instruments, is a personal decision that should only be made after conducting thorough independent research, including a personal risk and financial assessment, and prior consultation with the user’s investment, legal, tax and accounting advisers, to determine whether such trading or investment is appropriate for that user.

3 Replies to “Trading System Basics, Part II”

  1. DavidCiporkin says:

    Excellent principles! Thanks Tim!

  2. MattWoeber says:

    A lot of detail here, Tim. Thanks.

Comments are closed.

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