The Trailing Stop

Anatomy of a Buy

The single most important thing you can do when buying a stock is manage the risk to your portfolio. Today I will walk you through the process of how, once I have identified a stock to purchase, to size that purchase and manage the risk.

For our example I will use yesterday's pick,  LNET - Lodgenet Entertainment.  I will need to know a few things before I start calculating the purchase specifics.  Grab a stickie and note the following:

• The anticipated purchase price of the stock (17.90)
• the current ATR of the stock. (I use a 14 day - you should use whatever fits your trading time frame) (For LNET today this is .311)
• Your current total account balance ($100,000)

The idea  with this process is that I want to size my purchase based upon the amount of risk in the trade.  With this process, the dollar amount of my trades will vary widely, but the amount of risk in the trade will be approximately the same.

ATR, or Average True Range, helps us to measure the volatility of a stock over a given time range, in this case, the last 14 trading days. With a ATR(14) of .311, you could reasonably expect LNET to move .31 in any given day. Since we don't want to be stopped out of our trade my normal movement, we'll plan to put a stop in below our purchase price (for long trades).  Putting that stop at 2 x ATR allows us room for movement, but protects us in the event of an unusually adverse move. If we were stopped out, we would lose 2 ATR, or 62 cents. This is the amount we are putting at risk in this trade. (I like to use stockcharts.com to get ATR)

I typically risk 1% of my portfolio on any given trade.  This amount fluctuate based on the performance of my portfolio, but never exceeds 2%. At a current risk level of 1%, this means that I am willing to risk $1000 of a $100,000 account. (I always was a math stud.)

With $1000 to risk, and now knowing that we will risk .62 for every share that we trade, we can arrive at the # of share we want to buy by dividing:

$1000 / .62 = 1612.9032 shares

I find that I get cleaner execution in round lots, so I would round this down to 1600 shares. I would place the buy order for 1600 shares  along with the accompanying stop order to sell at 17.28 .

Each of the trades is an equal "unit" of risk.  This method allows you to balance risk across every trade, and further allows to me manage exposure to a given sector. I try to limit exposure to any one sector by balancing the # of units across sectors, and even trying to find inversely correlated sectors to trade when I am heavy in a sector.

Standardizing risk-per-trade lends itself  to system development and measurement, and enables money management to be added to back-testing programs, providing more accurate outcomes for each tested scenario.

How do I get out?

For the majority of individuals involved in the markets, there is a never ending search for the perfect stock.  In today's world of constant technological assault on the senses, even our stream of consciousness has become a recognized for of communication. (Instant Messaging) So is it any wonder that we are always looking for the hot new stock?

What if the hot new stock is the same stock as the one from yesterday, last week, and the month (or even year) before? How do you know if a hot tip that comes along is any better than what you already have? I suspect this same quandary in a personal context  is responsible for most of the failed relationships that have become common.  The January 2001  American Psychological Association  journal  published the results of a study on happiness (here) that found that freedom of choice is a significant contributor to lack of happiness.  In your portfolio, it can also be a significant contributor to a lack of returns.  As you look longingly at a hot new tip that crosses you desk - whether from your brother-in-law or from this morning's WSJ, take heart in the fact that picking the right stock has very little to do with making money in the market.

Far more important than how or what stock you choose is the when and why. The market is ultimately a  measure of human emotion.  This understanding serves as the elixir to soothe you when a perfectly good company's stock continues to go down.  We are talking about perception here - not reality.  At least until the quote comes across the ticker - then the perception becomes reality.

If you've been reading for any time at all, you have likely gathered that I am a technician. And while I am a true believer in the ability of a chart to communicate the emotion and opinions of a mass of people, I also believe that  Graham & Dodd had something as well. More information always helps, so if you have the time I encourage you to dig into the fundamentals.  Given the amount of information available (and not),  it is hard to imagine that I would have access to all of  it as a lowly individual investor.

My time is very valuable, and I am not interested in spending a significant amount of it to compile all of the information relevant to a given stock. Instead, I rely on others to tell me what I want to know - by looking at what they have done with their money.  If enough of them follow a given course of action, they even have the power to overwhelm the fundamentals of a company - making "cheap" stocks go down and "expensive" stocks  go higher.

Today a particularly smart friend of mine made the observation that in illiquid markets, you make money when you buy.  Much of the system development advice that you will read will tell you that in the (very liquid) markets you make money when you sell. It would seem to follow that in real estate, then, you would want to concentrate a great deal of your research on information gathering about the appropriate entry point, while the converse would be true in the much more liquid commercial markets.

I have taken much too long to arrive at my point: Don't worry too much about picking the right stock. Worry more about what you will do after you buy it. Where will you set your stop? When will you add to your position if you are right? And most importantly: When and how will you get out?

Happy Trading!

The System Personality Test

In the the last post we discussed the various elements that comprise a trading system. When combined, these various elements  produce a system that bears a unique signature, or personality. In order to discover whether you and this system will get along, you'll need to know more about it. Today we'll discuss some of the key questions to ask of your new found system so that you can begin to divine the likelihood of a successful future together.

One of the fundamental determinants of this personality is the  expectancy of the system.  Expectancy tells you how much you might expect to make per dollar risked. This is calculated across a large number of trades, and can be calculated as follows:

Expectancy = (CW * AW) - (CL * AL)

where CL is your chance of a winning trade and CL is your chance of losing on a trade. AW is your average gain on a win, and AL is your average loss on a losing trade. Those of you that are mathematicians can transform the equation, further, but this form serves the illustration nicely. If this type of thing gets you going, the I would recommend reading up on game theory, probability, and expectancy, as a solid foundation will only help to better understand system design and behavior. You can start with a few favorites here and here. (Courtesy of bjmath.com)

Next of the list of personality traits is reliability, or the chance that you will make money on a given trade. This is a figure easily produced by any of hundreds of back-testing applications.

Here's a crazy thought: You can lose 80% or more of the time and still make money! In order for this to be true, then you must keep your losses small and your wins big. Again, most back-testing applications can tell you average winner vs. average loser. This will help you to know the  relative size of winners vs. losers.

What is your model for determining trade size? This is key, as many systems break down when they don't have access to large amounts of leverage, or to an unlimited source of funds.

How much do you have to trade? It's amazing to watch the difference in system performance based upon different account sizes. Think of this as "room to breathe".  It is also key in overcoming transaction costs, including commission and slippage, which leads us to:

Transaction costs, or the amount it costs you to make a trade. I am a fan of BrownCo since they only charge $5 each way.  Slippage should be considered as well, and you will often pay higher commissions for split-second fills. You'll need to determine whether your system is dependent on good fills.  Some of the more advanced back-testing software can allow for slippage testing in a random fashion, but it would be best to avoid systems where you are cutting the margin of error this close.

Last, but not least is how often you will get the opportunity to trade, or frequency. I have a killer system on the shelf that gives an average of 30 signals a day. Since I trade end-of-day, this kind of system is not the best.  A system that only generates 2 trades a year may not allow you enough chance to make money (or make money back in the event that the last two didn't go your way.) It's up to you to find a system that will generate the right amount of trades to fit your style.

You should determine the above seven variables for every system you plan to trade.  The testing required to determine these numbers will ensure that you have a good feel for your ability to trade (read: to stick to) the system in question.

Study Probability for Fun!

I forgot most of what I learned in college. After all, I studied Architecture and have never practiced a day.

For those of you looking to bone up on your probability, I have run across a free introductory text at Dartmouth. You can find it here. Did I mention that it's free?

The Basic Elements of a Good Trading System

Every trader has a system. Not every trader knows it.

To do well in the markets, you need to know your system. Knowing your system encompasses a number of elements. The first to note is the your part of the sentence. The system you use should be your system. That doesn't mean you have to come up with every idea and every element on your own - on the contrary, there are many smart folks out there that can give you some good ideas.

Making a system your own means that you have an answer for every element in the system, and you have tested the system to an extent that you have a reasonable understanding of it's performance in different markets.

The following elements are needed in order to have a complete system. Note that the more specific each of the criteria, the better your system. Specificity will be key in tuning your system over the long term.

Personality
To get started in creating your own system, I believe that a very important first step is to understand your own personality in a trading scenario. We'll touch on the subject of trading psychology more in future posts, but for today let's keep it simple by asking ourselves two simple questions: First, what time frame would I like to trade? Second, what is my appetite for volatility?  The answers to these two questions will help you to filter various systems down to those that you can trade.  The most perfect system in the world is no good if you can't stick to it!

Money Management
Some call this rick management or position sizing. All it really means is that you have a system in place to prevent losses and manage risk. One example would be that you never risk more than 2% of your current portfolio value on any one trade. 

Filters
Filters are used to narrow the trading universe down to a starting list to examine for setup conditions. For example, you may with to trade stocks between $10 and $50 only, thus reducing the universe of stocks from over 7000 down to around 3000. Other filters such as fundamental indicators, EPS, earnings growth, etc. should all be defined in  very specific conditional terms.

Setup
A setup is a condition that makes a stock say  "Hey! Look at me!".  The best setups can be programmed so that you can automate the scanning of the market for new issues that meet your setup conditions. Example: Today's high is the highest high of the last 80 days.

Entry
This element alone is often viewed as a system unto itself. Bill O'Neil of CANSLIM and Investors Business Daily fame has a number of excellent entry indicators in his popular book How to Make Money In Stocks. The entry condition will tell you when it is OK to go ahead and watch that stock you've had your eye on in the Setup list.

Exit
The single most important and the single most overlooked element of a system. If you don't have an exit component, then it's not a system! This will be one of the least discussed and hardest elements to design, but don't despair - many others have come before you and successfully designed their own systems. If worse comes to worse, just pick something simple such as "if the issue moves against me for three days in a row". As you begin testing your system you will refine your exits, so don't worry about getting it perfect.

Optional Elements
As you progress through testing your system, you may wish to add additional elements such as portfolio balancing, equity curve analysis, market exposure rules, etc. For now, focus on the basic system and understanding how it behaves in the markets.

In the next post we'll explore how to get to know your system's personality.

New Beginnings Should Come Often

When I peruse a blog for the first time, the question lurking beneath the  placid (or flaccid?) surface of my mind is "Is this blog for me?"

Since the Trailing Stop is a new blog, you can't examine my past posts to get a sense of what is to come, so I'll do a bit of crystal ball gazing for you.  The following is a list of things you are likely to see discussed in future posts on the Trailing Stop:

• Stock systems and stock system development
• Back testing
• Interesting stocks (and WHY they look interesting!)
• Trading psychology
• Trading for a living
• Books, Blogs, Sites, seminars, etc about any of the above

I have made some very large sums of money in the market, most of which I subsequently also lost in the market.  Over the last few years I have been working very hard to learn from my mistakes and begin to shape the beginnings of a next career trading my own account.  Most of this learning has been through a great deal of reading, research, and trial and error, and I'd like to share that learning with those of you that would care to come along.

My hope is that I will learn from teaching, and perhaps help someone else along the way. For those of you that have encouraged me to write a book, this will have to do for now. When I have a yacht to go along with all of the good advice, I'll contact  the nice folks at Addison-Wesley!

In the coming days, I'll discuss why systematic stock development is the right answer for many and how to determine whether it is right for you.

Does Winning Get Your Blood Flowing?

It's getting late, and you should have stopped when you were up by $500.  Or at least by the time you got back down to even.  Now you're $1500 down, and you know that you are getting too tired to play effectively, so you are going to call it a night. Any moment now.

To reduce the agony - and maybe to end up the night even - you slide out what would normally be an insane bet - $1500 - half the entire stake you brought to the table tonight. This goes against every rule that you tell yourself that you have - but sliding it all out there give you a huge rush, and your hear beats in your throat as the dealer makes his way around the table.

The first pass throws you a jack of diamonds. Could it be? Is there possibly an ace in there for me? You glance over at the show and try to remember what has been dealt. The shoe - a five deck shoe - holds no clue, and your fatigue prevents you from remembering. At this point you are depending on hope. The player to your left gets a string of low cards, finally sitting on a 17 and hoping against hope against the dealer's 10.

As the dealer's hand turns over your card - you imagine the slow-mo - you see the ace and the blood rushes throughout your body. Yes! You did it! Not only are you up for the night, you have an amazing, last ditch effort, I-had-the-guts-to-bet-it-all story to tell tomorrow.

Do you recognize this story, or any of the feelings mentioned in it? The thrill of the win is something that a professional trader doesn't feel - or feel is a muted sense. Can you keep from feeling elated when a big trade goes your way? Do you ever slide you chips out on to the table - maybe too many of them - looking for the big score?

I know that I did - and occasionally still do, but this is no longer my standard mode of operation.  This type of trading is very exciting to me - and therefore ruinous! Excitement has no place in day-to-day trading. Ed Seykota often says that we all get what  out of trading - and life.

If it's excitement you are looking for, you will usually get it!

All of this is a lengthy (sorry) prelude to the fact that the only way for most people to trade consistently and effectively is through the use of a well defined and executed system.

In the next post we will talk about the various components that make up a system.