The Importance of Risk Management and Position Sizing

So here is my initial attempt to get others who might not have a strong statistics background to appreciate the nature of trading.  The plots below were generated by telling a computer to calculate 100 coin-flips.  If head came up, I treated it as a winning trade.  If tails came up, it was counted as a loss.  In probability terms, there was a 50% chance that a trade would win and a 50% chance that it would lose.  Now look at the results if we cut our losses at $100 but only allow the winners to run to $100 (yellow plot).  Not surprisingly, the strategy yeilds no gain because, on average, each win is cancelled out by every loss.  But what if each winning trade was a gain of $200 and each loss was cut short at $100?  The red plot shows the results of this coin-flip run and it shows that a $10,000 account would grow to almost $15,000 in only 100 trades.  If the winning trades are allowed to run to 3 times the losses, the account grows to almost $20,000 in only 100 trades.

Now any experienced trader can quickly point out the flaw in this argument. I’m sure they would agree that finding a trade setup that can produce winning trades 50% of the time is relatively easy, the hard part is ensuring that the winning trades are allowed to run up to 2 or 3 times the amount that was risked while making sure that losses are kept to a minimum. But this is exactly my point. The battle over probability takes place in risk management, not in finding the proper trade setups. Luckily, there are other methods to help traders succeed and the most powerful method is position sizing.

Now consider the same 100 coin flips. What if we were to risk more as our equity curve increased and risked less during losing streaks? Thanks to the hard work of professional gamblers and mathematicians, we have many rigorous position sizing methods to chose from (remember the MIT Blackjack Team?). I will use a very simple, yet powerful, anti-Martingale technique based on risking 1% of trading capital on each trade.  The results are amazing and it shows how using a compounding position sizing strategy can make up for the deficiencies of a trading system.  Let us take a closer look at the plot and how they were generated.  Again, we just told the computer to flip a coin 100 times.  For each trade, we risked 1% of the total trading capital.  In this case the run began with $10,000, so the first trade risked $100 dollars.  As the equity curve increased or decreased, the amount risked on each trade increased or decreased with it.  For example, if the trading capital rose to $20,000, the amount risked on each trade would be $200.  If it decreased to to $8000, the amount risked would fall to only $80 per trade.  The beauty of the position sizing strategy is that is automatically compounds your gains while minimizing loses.  The yellow curve uses a 1:1 risk-reward risk management strategy and is performs the same, telling us that any trading strategy must have a risk-reward ratio that is greater than 1 (no surprise here).  The red curve (2:1 risk-reward) begins to show the incredible power of compounding your winnings on the way up.  A simple 2:1 risk-reward coupled with compounding position sizing takes our test account from $10,000 all the way up to $350,000 in only 100 trades.  A 3:1 strategy goes from $10,000 to an incredible $18,000,000.  (yup, 18 million).

I want to emphasize that this was a very crude simulation, and real trading can never ensure that every winning trade yields 3 times the amount risked, but it does show you why you should strive towards this goal on every trade.   It also reminds me how bad most of the trading advice is out there.  Most people, amateurs and professionals alike, stubbornly think that success in the market relies on picking the right stocks, when in reality, it has more to do with controlling their risk and knowing when to exit once a trade is entered.

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Twitter Weekly Updates for 2012-02-05

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Sequential Breakouts as Day Trade Setups

NTGR Daily Chart

Since there are so many Sequential breakout setups out there, I thought that I would share how I use Sequential signals to point out day trade setups.  In the daily chart you can see that NTGR has been hugging the upper portion of the shaded channel (original sequential sell stop loss).  Today there was a nice price rejection of that area and I noticed an oversold reading on the range expansion index (REI), indicating that a bounce could be coming.  So how should I play it?

First, let’s zoom into the 30 minute chart and look for a good entry point that satisfies our risk management rules.  Remember, we always want a potential reward that is 3 times greater than the amount we risk.  I like to look at the swing points on the chart and work from there.  If we target to highest swing point shown and plan on using a stop loss of 2 times the average true range (ATR) the logical entry point will be somewhere around 39.71, which is also near a 0.382 fib retracement level (yellow dotted line).  This gives us a potential 3:1 risk-reward trade if everything goes as planned.

NTGR 30 min chart

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Adapting Sequential Sell Signals to Wyckoff’s methods

A long position that I put on a few days ago paid off for me today.  DXPE showed up on my Sequential screen when it crossed into the shaded area shown on the chart.  The area is defined by using a modified version of Demark’s TD Sequential indicator.  Basically the Sequential indicator defines an important level that can correspond to a turning point in a move up or down.  Many top money managers use it to help them scale into, or out of a position without driving the price higher or lower, depending on what side of the trade they are on.  To put it another way, the Sequential indicator is a counter-trend signal that is supposed to signal a turning point in a trend.

DXPE Sequential Sell Count

There is an Achilles heel for the indicator, especially for stocks in a bull market, and that is strongly trending prices will breakthrough sell signal after sell signal as markets rally, leaving bears wondering why the Sequential signal has failed them.  Such a situation seems to exist now and instead of lamenting the failure of the signal, I use it to my advantage.

The strategy is simple, watch for a Sequential signal to fail and wait for the retest of the breakout or breakdown to enter in to a long or short position, respectively.  I have attached the latest profitable example on this post.  The chart is DXPE and it recorded a classic Sequential sell signal on December 12, 2011.  I do not use the exact methods of Demark, especially for stocks and waited for my modified signal to occur on December 20th.  In the typical methodology, I should have initiated a short position and looked for the price to move down to at least 29, using a stop loss of 34.21.  But given the overall market conditions I did not and just let the price move while watching it via my Sequential screens.

DXPE retests breakout

As you can see, a breakout above the Sequential sell stop-loss occurred and then it was just a matter of setting an alert and waiting for the retest, which happened a few days ago. Notice that the retest was on lighter volume, giving me the go-ahead to initiate a long position.  The lower end of the shaded area becomes my new stop-loss point.

This simple setup is nothing revolutionary, it is just using the teachings of Richard Wyckoff and adapting them  to Demark’s Sequential indicator.

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Strange Day

CVLT 15 minute chart

WPRT 15 minute chart

While I’m pleased to see that many of the long positions that I put on last week performed very well today, I was puzzled by some of the action in the high-growth stocks.  Volume was muted and there seemed to be a general uncertainty across all the screens that I look at.

Take these two guys, for instance.  CVLT had a huge bullish reversal on relatively high volume while WPRT had a bearish reversal on high volume.  These were #2 and #3 in my high-growth CAN SLIM volume scan.

Oh by the way, my QID stop-loss was triggered today.

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Buy watch list candidates

In a market where everyone is looking for a pullback, I start to wonder if one will come.  The market always has a way of fooling as many people as possible.  Here are a few of the several chart setups that I’m watching to get a sense of the next move.

Intel and FFIV are both pulling back to their breakout levels on lighter volume.  I will buy both if they pull back to the levels marked on the charts.  I am also looking at D.H. Horton (DHI).  I would love to buy this on a low volume pullback to 13.16.

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Short Setup: Sirona Dental Systems SIRO

SIRO Sequential Chart

For the most part, the market seems pretty bullish still and I’m still long with a QID hedge. I did, however, notice a couple of the weaker charts on my scans tonight. SIRO is one such example and it also shows how I like to use (and misuse) Sequential signals. Remember, I’m more interested in spotting important swing points, not the actual TD Sequential signal (as defined by TD).

SIRO Weekly Chart

SIRO is coming up on a resistance level right now and looking at the weekly chart, you can see that the volume is much lower. It should have trouble getting above 49.21. A stop loss could be setup at 50.54.

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Twitter Weekly Updates for 2012-01-29

• Using Sequential Signals to Scan for Classic Support and Resistance Levels : http://t.co/o6l3tEIh #Demark $$ $EL #
• The Sequential Scan: http://t.co/lUg8QzHn #demark $$ $csco #
• Breadth, Price Patterns and Sequential Scans: http://t.co/VFN2TK8w $$ @traderblast #
• Twitter Feeds on Netflix Prompt Stock Service – Bloomberg http://t.co/0ZUyPqir via @BloombergNews #
• Bearish Market Breadth: Nasdaq 100: http://t.co/uyWHC3lt $$ $qqq #
• Interesting TD Sequential backtest article. http://t.co/8rfweHhb #demark #
• Sequential Breakdowns: Trading Demark signals with the trend: http://t.co/DEtr4k8g #demark $$ $quad #
• 10 Thursday AM Reads http://t.co/BhG1GbqO #
• A blog I respect a great deal – stockbee: Money is rotating in to new stocks and new leaders… http://t.co/YEHtzvey #
• Russell 1000 Sequential Breakout Watchlist: http://t.co/0JZEu36h $$ #
• $CSCO is testing its breakout level point. If it holds on light volume, a possible buy #
• Download S&P 500 Sequential Sell Data: http://t.co/S96R5be0 #
• I wonder why Tom O'Brien and the http://t.co/fmcw192i crew don't use the hashtag #tfnn Guess I'll start. #

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Download S&P 500 Sequential Sell Data

I added a new feature.  You can download this weeks Sequential Sell data for the S&P 500 below.  The file contains highs, stop loss, and risk data.  Check it out and let me know if you like the information.

Sequential Sell S&P 500

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Combining Sequential Signals and Gartley Patterns

I saw these two charts in my scan of the Russell 2000. Both are examples of how I like to combine separate signals, which in this case is a combination of a Sequential sell and a bearish Gartley pattern.

So would I trade either of these?  No, because the volume is not confirming the signals.  Ideally, I would like to see volume shrinking at the highs and both of these charts have very strong volume near the highs.  Sure, the trade might work, but I like to have volume confirming all of my bets.  This link is a video of Tom O’Brien and it shows how I like to use volume with pattern recognition.

MUSA Sequential-Gartley Sell

IPHI Sequential Gartley Sell

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