YOU MUST DEVISE A PLAN

If you like my philosophy and follow my system’s trading signals, or if you want to hybridize it some way, or if you have your own trading system – however and whatever way you decide to trade, there is one constant. You must control risk the best that you can, both dollar risk per trade as well as total portfolio risk. We have discussed and explained (Understanding Risk/Reward).  Now how do we implement it?

Deviation from the Mean

Before we discuss constructing your trading model portfolio, there is one other very important concept we need to discuss. Let’s say a hypothetical system generates 60% successful trades and makes $2 for every successful trade and loses $1 for each losing trade. Make 10 trades with this system and you have made $8 (6x$2=$12 – 4x$1 = $8). It appears that this system can’t miss. Right? That is not correct. How can that be, the math is right? Because, unfortunately, it is not the percentage of winning trades that determines the results, but the deviation from the mean of the average range of distribution of those trades. This range can be surprisingly large. Quite a mouth full. Let me explain it in an easy to understand example. A roulette table is numbered 1 to 36, with half the numbers red and half black. Green occurs on the board for zero and double zero or 2 out of 38 possibilities, the house vig of 5%. For the sake of simplifying this example, we are going to assume green never comes up, so odds of red and black coming out are each 50%.

In real life, a typical occurrence if you were sitting at a roulette table could be seeing red come up 4 times in a row, then black, then red twice more. That is red 6 out of 7 times, when on average it will be only be 1 out of 2 that red will come out. Black will have to come out more times than red at some point to balance, for the chance of black or red coming out is 50/50. Now, if you are sitting at that roulette table betting red you are on a hot streak, and if you are betting black you are taking your lumps. The same thing happens with markets and systems. There are hot streaks and cold streaks. The point is that any statistical measure of winning trades is an average, and over short periods of time, the variance from the average (mean) can be great. A real life example was December 2003, when the first 7 out of the first 8 buy signals from the system failed, with the worse losses on the day after Saddam Hussein was captured. The market opened sharply higher then reversed and sold off strongly. I lost 5.9% that month. Then the exact reverse happened in Jan 2004, and I made 18.1% that month.

Constructing Your Trading Model

So how do you design your trading model? First define how aggressive you want to be. The more aggressive, the more you can make AND the faster you can lose. Thus, I suggest you start conservatively. Do not start any account as a margin account.

For an aggressive model, limit the maximum dollar value of any trade to 20% of the equity in your account. And never make a trade that exposes you to a loss of more than 2% of your total equity. If you want to be conservative, lower those numbers to 10% of capital and a 1% loss of equity (or less.)

If you use a 20% of equity rule, you can only trade 5 stocks in a $10,000 account. If you use a 15% rule, you can trade 7 stocks, a 10% rule, 10 stocks. The effect of trading more stocks is that you diversify more, which usually (but not always) has the effect of limiting volatility, meaning you will gain less/slower and lose less/slower. Thus your model will determine what percent of equity you use to trade each stock. Let’s say your objective is to make 30-40% per year, then I would suggest the conservative 10% of equity rule, or $1000 in a $10,000 account. If your objective is to make 60-100% a year, then consider a 20% rule. As a final suggestion, even if you want to be aggressive, start slow until your account has grown at least 10% (or better yet, 20%), then go to the 20% of equity rule.

Note: If you start with the “20% of equity rule” and lose 10-15% of your total equity due a string of losing trades, I would suggest you stick to the original plan and do NOT cut back your exposure by going to the 10% of equity rule. True if you changed and continued to lose, it would be a slower drain on your equity. However, if you start making money on subsequent trades then you will stay in the hole a lot longer if you cut back to 10%. Stay the course, be disciplined!

Ok, you have decided what percent of equity you are willing to place in a single trade. How exactly do you calculate how many shares of a stock you want to buy? Here are two examples:

Example 1 - Conservative $10,000 account ($1500 per stock/1% maximum risk* of total equity per stock.)

Buy XYZ 7.58 stop, if filled, sell XYZ 7.34 stop. Risk $0.24 or $24/100 shares

15% Equity Rule – buy $1500 worth of XYZ ($1500 divided by $7.58 = 198 shares, or rounded to 200). Your risk at $24/100 shares equals $24x2 or $48 plus commissions (typically $10 each side of the trade) or about $68 which is under 1% of your equity – a great reward to risk trade, especially if you think XYZ can advance 25-50%.

*Risk calculations are based on being able to ideally enter at the stop price, as the stock begins it’s rise and being to get out at the stop loss price if the trade fails. These prices may or may not be obtained as a stop order is triggered when the stock trades at the stop price and becomes a market order at that point. In thin or fast moving markets the actual price filled can be quite different. Also, please read all the other types of events that affect market pricing, especially overnight and pre-market trading  (Understanding Risk/Reward).

Example 2 - Aggressive $10,000 account ($2000 per stock/2% maximum risk* of total equity per stock)

The trade signal says buy ZYX today at $4.50 stop, risk to $4.15 stop. How much do you buy? Before you read the answer, you do the math.

You are risking $4.50 - $4.15 or $0.35 per share, or $35/100 shares. Maximum risk to your $10,000 portfolio you defined as 2% of your equity or $200. Thus, you figure you would buy $200/0.35 or 571 shares (which you would actually round to 600 shares). However, 600 shares at $4.50 is $2700 or 27% of equity – too high for the model (max being $2000). The answer then is 400 shares (cost $1800). Risk is then about 1.4% of equity. Learn to think this way ALL the time.

Example 1 started with calculating the number of shares per $1500. Then the risk calculation proved to be under 1%. Example 2 started by seeing how many shares could be purchased such that not more than 2% of total equity would be at risk. Then we calculated what percent of equity that would be, and had to adjust the number of shares lower. Regardless of what trading model you choose, when you calculate how much of a stock you want to buy, you should calculate both the number of shares per the dollar allocation, as well as the percentage risk to your equity. You can do either one first, but you should do both. Whenever either one of these calculations exceeds the model portfolio parameters you have established, you should adjust downward. This way both parts of your model are in balance on the trade. In Example 2, we had to adjust the number of shares downward.

Some Final Thoughts

I follow a lot of stocks and the system generates many trading signals – often far too many for accounts to take positions in all the signals. Sometimes I may be down to only a few stocks being traded and have a large cash position in my accounts, depending on market conditions. Often after a correction in the general market, there are many stocks flashing buy signals. For example, in August 2003 and January 2004 the system generated signals and had open trades in about 40 different stocks. What stock trades I or you take will depend on various factors, including my and your comparative readings of the charts. There is no getting around your doing your research and forming your own opinion. (Disclaimer)

Looking over the choices of signals to take, personally I like lower priced stocks that trade good volume and that offer the lowest risk. A hard combination to find, but when it presents itself, I always try to take it. A good generalization is that a $3.50 stock will get to $5 much faster than a $35 stock will get to $50. If the stop loss is relatively tight on the low priced stock, say $0.35 or 10% of the price, I will tend to take that trade instead of the $35 stock, even if the stop loss is smaller percentage wise. I just lower the number of shares so that the dollar loss will not be more than 2% of total equity if I am trading an aggressive model, or 1% if I am trading a conservative model account. The percent loss of equity is the key measure of risk, not the percent risk per share. Some stocks trade in wide daily ranges which means the dollar risk per share is most likely large. It's OK to take trades like that, provided the number of shares purchased is smaller, and staying within the trading model parameters one has set.

When deciding what stock signals to take, try to be objective about the price/volume action. I do not get enamored with a stock for any other reason. I suggest you ignore what the company makes, what your lovely girl friend thinks of it’s spokesman in the their ads, what the press is saying about it, what your kids think of it’s products, etc. Stay focused and disciplined.

A stock with good fundamentals is great - it is nice to have the wind at your back so to speak. But don't let good fundamentals cause you to lose focus and ignore technical sell signals. At a market top in a stock, the fundamentals always look good. In other words, the market turns (price goes down) before there is a known change in fundamentals. Listen (watch) what the price action of the chart is saying.

If you buy a stock and it does not immediately make a profit, do not get out before your stop loss is hit. You elected to make the trade, stay with it. Often times a stock just takes a couple of extra days to get moving. After you have assessed your risk, taken the trade, do not be afraid to lose on the trade. Stay disciplined. Many times stop loss points are missed by only one or two ticks and the stock goes on to be a big winner. And learn to live with the fact that the reverse happens, you will get stopped out and then the stock will reverse and go on to make big gains. My worse example of that in 2003 was a trade I had in SOHU, got stopped by a few cents at $8.50 and it went on to quadruple from there. Stuff happens. Get used to it. It’s part of trading life. I still made a return of 137% in 2003 being disciplined and following the rules of my trading model. Ignore your stops and guess what will inevitably happen – the next day the bottom will fall out for some reason and you will take a huge loss. Trading is simply putting the odds in your favor and measuring and monitoring risk/reward, then staying disciplined, objective and pragmatic.  

I cannot stress it enough. ALWAYS, ALWAYS, ALWAYS try to control your risk!!!!!