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Friday, August 29, 2008
The Portfolio Assassin
The risk in any trade is a function of several factors and tonight we will cover three of the most important factors of risk in our trading. If these rules are underestimated or ignored, they become what we call "the Portfolio Assassin".
1.) Position size
Placing large bets on trades leads to significant volatility in a portfolio and this contributes to emotional volatility. The bigger the position size, the bigger the swing in our portfolio balance, thus bigger our emotional swings will be. News events and the block buying and selling of large institutions can move prices many points in a short period of time, creating wild swings in our overall portfolio balance, should the size of our position be too large (more than 10%). This also applies to any orders you may have that have not filled yet. For example, imagine you have a sizable bid that is well below the market price because you plan to pick up a huge lot of shares at a limit price near a support level. If some unfavorable news is released on that stock, the stock's violent reaction to the news could fill the limit order and proceed to continue moving much lower against your newly filled position.
This may happen to some traders who plan to buy a certain stock with a limit order near the 50 Simple moving average because this is sometimes a solid price point for support on the stock chart. If you place a limit order then walk away for the day, you could be surprised when returning home to find that the 50 SMA support did not hold and instead, the stock dropped through that support like a hot knife through butter and is on its way down to the 200 SMA instead. If you placed this unfortunate limit order at what you thought was support and walked away, you are going to notice a huge loss on that trade when you return to see if their order filled. The next time you think about placing a limit order, make sure you are going to be around to see the result when you get filled. If you are not careful, you could be buying a portfolio assassin.
2.) Stop Orders
It is common for traders to enter large position sizes relative to their account sizes and hope to balance the risk by entering tight stops. The problem with this strategy is that simple, random price action ensures that the stops will be hit on most occasions, leading to death by a thousand cuts. The opposite problem occurs when placing overly wide stops or not utilizing stops at all. This creates the situation in which a small number of losing trades eat up your capital. By keeping the position size at a manageable level, you decrease risk by being able to afford to use stops which are essential in trading. All trades should be of the same positions size. It is very, very difficult for traders to make money over time if their losing trades tend to be larger than their winners. If you cannot use a stop because the position is too big, you are flirting with disaster. Wide or non-existent stops ensure that large losing trades will eventually be a portfolio assassin.
3.) Holding Time
The longer one holds a trade, the greater the expectable price variation. Prices move more in a day than an hour, and they move more in a week than a day. Extending your holding period is equivalent to increasing your position size, creating more exposure to adverse price movements. When traders hold onto losing trades, they create a double risk exposure as they widen their time frames precisely at those times when they are trading their worst.
If one's trading method calls for a longer holding period, let's say measured in days rather than minutes or hours, stops will need to be wider given the expectable degree of normal, random price fluctuation. This means that position sizing becomes critical to risk management. The risks of a day trade of hundreds of shares and the risk of a long-term trade of the same amount of shares is very different. We could day trade a large position of a stock in a major downtrend because it is bouncing today and we want to capitalize on the move. We know that at the end of the day, we will be out of the stock so the risk is minimal. However, that risk is much larger if we hold the same amount of shares for a longer period of time than just a day trade. Holding time is critical. If a stock is not moving in the desired direction, there is no need to hold it. You could be holding a potential portfolio assassin.
David Colletti
Founder
StockTradersHQ.com
Copyright 2008 StockTradersHQ.com
This article is courtesy of David Colletti, a ten year veteran stock trader and founder of StockTradershq.com. Our staff of professional technical traders analyze 1,000's of potential stocks every day to provide you with a list of stock recommendations nightly with the greatest potential for explosive gains. These stock picks are traded with our real-time portfolio. Email alerts are sent to members for every entry and exit. Our subscription service provides all the resources, stock picks and tools an investor needs to make very profitable, consistent trades while maximizing gains and minimizing losses. StockTradersHQ.com offers a 21 day free trial with full member access.
http://www.stocktradershq.com/
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