About tight stops

Someone had said that he is jumping on stocks, moving with 100 mph with an inch stop for protection. There is a lot of wisdom behind these words. They reveal two essential elements of many systems for consistent profits: momentum and risk management.

Being right and being profitable in trading are two very different definitions. You could be right in 90% of your trades, making a $1 per share. Then you could be wrong on the 10th trade and lose $10 per share there. The final result is -$1 per share from all the ten trades. Percentage of winners is not what traders should be paying attention to.

You might decide to use a tight stop of 10 cents to exit quickly trades that don’t go in the desired direction. As long as you make 50 cents per share on your winning trades, you could afford the luxury to be wrong 4 out of 5 times and still be in a profitable position. The point is to jump on stocks that are moving and have the potential to provide much bigger reward than your initial risk.

Blindly using a tight stop might be useful in the begining stage of the learning curve of a developing trader, as it will teach you to lose. Sometimes you have to lose the battle in order to win the war. Losing will always be painful. The point is to use that pain as a catalyst to work harder and smarter next time. The point is, when you lose to lose small, so you could recover faster.

Using 10 cents as a stop is only an example to illustrate a point. Stop losses should be defined by the individual volatility of each stock and its supply and demand dynamics. 10 cents represents 5% of a $2 stock and it might be a proper stop, but 10 cents is only 0.1% of $100 stock, which is a normal move and might not be a stop that makes sense. Certainly this will depends on your trading horizon and trading skills. Use tight stops, but make sure there is a reason behind that stop. Don’t just randomly chose a number. Let the stop be the signal that will tell you that you are wrong and you should exit in order to chase other trading opportunities with better odds of success.

Trader X take on some important trading matters

I recently found Trader X outstanding blog, where trading is explained in very simple terms. For me simple has always meant ingenious, so I decided to summarize some of Trader X view on trading here. He is a day trader and has shorter horizon than I do, but successful trading principles are the same for all time frames: trade with the trend, cut your losses short, let your winners run, practice sound risk management ( proper position sizing and risk/reward; if you risk a $1 in order to make a $1, you won’t get too far in this business)

On Timeframes:

I will repeat what I said earlier – a chart is a chart is a chart. A quality set-up will appear on all timeframes. But, you have to realize that trading on a 5-minute chart is different than trading on a 30-minute chart, even if you are looking for the exact same set-up.

5-minute charts are fast and unforgiving. If you have been trading for years and are consistently making profits on a larger timeframe, maybe then you want to look at moving to something quicker. But if you are trying to perfect your trading, and you are break-even or losing more money than you make, you need to stick with the higher timeframes. A 30-minute chart gives you time to do some solid analysis (is it really a good set-up?). It gives you time to think. It gives you time to take in and analyze the price action and the chart as a whole. And, it gives you time to manage open positions and protect profits and capital. (the guy has switched to 10 min charts as of 2009)

On momentum:

I also swing trade a few set-ups. I analyze weekly charts of stocks that have doubled over the past 15, 30, and 60-days. When you are looking for stocks that are poised to “explode”, they have usually already doubled in value

On Narrow range:

I search for patterns that include bars narrowing in range – particularly after a wide-range bar(s). The more bars narrowing in range, the more I take notice (NR3 = narrowest range of the last three bars, NR5…five bars, NR7…seven bars). Narrowing range bars indicate consolidation and often lead to a big move when price breaks out of the narrowing range.

On Equity Selection:

I normally trade set-ups on 30 and 15-minute charts. In general, I look for stocks that are moving strongly (up or down), pause (or pullback to key areas), and set-up with narrow range or inside bars. I also look for stocks that are moving strongly in one direction and reverse at an area of support, or reverse and move back through key areas that will trigger a trade for me.

On Risk management:

I risk the same dollar amount on every trade, and adjust my position size based on the distance from my entry to my stop. This approach makes the most sense for me, as I always know my targets and stops when I enter a trade. So, I take the distance from my entry to my stop, and divide that into the dollar amount I risk on every trade – that determines the amount of shares I trade.

On preparation:

“…the job of a trader is to wade through all of the set-ups presented to him every day and discard the bad and mediocre ones”.

On Focus

If you are not having the success you think you should be having, make a resolution right now to spend the next six weeks focusing on one chart pattern. Learn it, live it, trade it. Print off a few examples, and hang them above your computer. DO NOT make a trade unless the set-up you are looking at is at least 90% similar to the examples you printed.I talk to numerous people through email every week who are struggling to be successful at trading. And, I find two common traits in most of them:

1.) They trade too much – most of the people struggling make multiple trades daily, some as many as 10+ round trips.
2.) They have a lack of focus.

I will start with #2. I have discussed this in the past – most people jump from indicator to indicator, timeframe to timeframe, method to method. They will use something for a few days, hit a bump, and move on to something different all together. One day the holy grail is a XX period moving average, the next day it is MACD or an oscillator. One day it is a 30-minute chart, the next day it is a 5-minute chart. One day it is buying the break of the first inside bar, the next day it is a pullback from the high.

I call this “chasing success”. The bottom line is the person does not spend enough time on any one method to really understand and execute it properly. They bounce around, and before they know it a lot of time has passed and they are still struggling.

If you pick something and stick to it, you get good at it. Once you get good at it – once you perfect it, THEN you can add something else to your arsenal.

There are plenty of set-ups I have highlighted in the blog that have a 70%+ success rate. Do you want an idea? Look at 30-minute charts that break the opening range high, then pullback and consolidate with a textbook hammer at a key moving average. You may ask, “well how many of those are there a week?” My answer is a pretty high number – you just have to focus and find them. But, say you can only find 2-3 per week. Would you rather have 2-3 great trades and a positive, money making week? Or 30+ trades and a negative, losing week?

Regardless of what set-up you choose, focus on it and study 1,000’s of charts. Analyze the details – does it work better when the tail of the hammer also touches the opening range (OR) high or the Fibonacci extension? What produces better results – a slow, 3-5 bar pullback or a violent 1-2 bar correction? Does it matter if the bar preceding your hammer is narrow-range or wide-range? What about the hammer being green (closing positive) vs. being red (closing negative)? Learn your set-up inside and out!

A final though on #1 – why do you want to make 20-30 (or more!) trades a week when you are losing money? Stop trading so much! And a way to “force” yourself to do that is to FOCUS on one thing. Pick a timeframe. Pick a moving average. Pick a set-up. And wait for it to happen. What do you do while you wait? Study charts!!! And if a day passes and you do not make a trade, so be it. Look at it as a positive – you did not lose any money!

And one last thing. Help Trader X Good Carma project. Do it for yourself. This is an excellent opportunity for you to make a difference in someone’s life. By changing the future of one person, you are actually changing the future of the world.

Eckhardt on taking profits

“One common adage on this subject that is completely wrongheaded is: you can’t go broke taking profits. That’s precisely how many traders do go broke. While amateurs go broke by taking large losses, professionals go broke by taking small profits. The problem in a nutshell is that human nature does not operate to maximize gain but rather to maximize the chance of gain. The desire to maximize the number of winning trades (or minimize the number of losing trades) works against the trader. The success rate of trades is the least important performance statistic and may even be inversely related to performance.”

No other quote illustrate better my trading during the last two weeks. I was right 14 times in a row, but my account didn’t appreciate significantly due to my premature exits. It is true that my timing was often correct as I was lucky to exit minutes before my position turned against me. This especially well relates to my countertrend trades. But it is also true, that I left too much money on the table by jumping out of stocks that were just beginning to move; trades that for some reason were all in the direction of the trend. In hindsight, I realize that I wasn’t chasing profits. I was trying to be right as often as I could, often scalping for meaningless profits.

Then on my 15th trade I took a big hit, that wiped out half of my two week profits. I made all the mistakes that an amateur could have made. Initiated a position in a leveraged ETF not for a day trade and not to hedge my other positions. Entered a trade that was in the opposite side of the prevailing trend. Essentially I bought the rip – the very place that professionals often use to renew their selling, as it offers excellent risk/reward. I put good money after bad by averaging down in a losing position. I did that even after realizing that my position in a 3x ETF should be three times smaller than the average position I take due to their extreme volatily. I turned a trade into an investment. My initial entry was profitable and I had the opportunity to exit with good gains two days in a row. I didn’t. I saw my position going against me and instead of exiting immediatelly I decided to buy myself some cushion by selling front month OTM calls against my equity. The cushion wasn’t enough, so I averaged down. I created a position that would be normal for my other lower betta trading vehicles, but way too big for this leveraged ETF beast. Last Friday I exited with a 2.5 points loss.

It’s much easier to learn what you should do in trading than to do it. Good systems tend to violate normal human tendencies.

Eckhartd on losses

“The people who survive avoid snowball scenarios in which bad trades cause them to become emotionally destabilized and make more bad trades. They are also able to feel the pain of losing. If you don’t feel the pain of a loss, then you’re in the same position as those unfortunate people who have no pain sensors. If they leave their hand on a hot stove, it will burn off. There is no way to survive in the world without pain. Similarly, in the markets, if the losses don’t hurt, your financial survival is tenuous.”

Losses happen and they are part of our trading education. If you don’t learn anything out of them, it is money wasted. Always ask yourself: what did I learn form that loss? What could I do, not to repeat it again.

Options and Earnings

Options could be very useful tools for your trading arsenal during the highly volatile times of earnings’ season. They offer various combinations for more precise risk and performance management.

Selling a strangle (two OTM options)

Let take for example CME, which reports tomorrow, before market open. It is currently trading for $ 166.14. You look at its option chain and notice that: FEB 150 PUT is trading for $5.80 and FEB 180 CALL is trading for $6.80. You figure out that their earnings’ report won’t cause a significant stock’s move in neither direction. Then, you decide to benefit from the elevated implied volatility before the announcement by collecting premium from selling the above mentioned out-of-the-money contracts. The net result: a premium of 12.60 (1260 for the strangle) in your pocket.
– you keep the entire premium if CME closes in the 150-180 range at option expiration, which in this case is FEB 20;
– the position is profitable in the 137.40 – 192.60 range, since the received 12.60 premium upfront will offset a possible appreaciation in the put option if CME dives (break-even at 137.40 – brokers’ commisions) and it will offset possible appreaciation of the call option if CME jumps up (break-even at 192.60 – broker’s commisions);
– the downside of this strategy is unlimited and losses starts below 137.40 and above 192.60;

Selling a credit spread

Let say you are bearish on CME, but you don’t want to short the stock in front of an earnings’ event that might move it 20 points overnight in either direction. You don’t want to buy a put option of the stock, because premiums before such major announcement are highly elevated. An alternative approach for your bearishness is to use a bear call spread. In our CME example, you might buy FEB 175 CALL for 8.50 and sell FEB 160 CALL for 15.50. The net result is $7.00 in your pocket.
– your maximum gain could be $7.00 (or 700 for the spread) if CME closes below 160 at options’ expiration (FEB 20), because in such case both options will expire worthless and you will keep the credit;
– your maximum loss is $8.00 (or 800 for the spread) if CME closes above 175 at expiration, since at 175 your long call (FEB 175) will be worthless and your short call (FEB 160) will costs $15.00 per share;
– Break-even is at $167;

Call Ratio Backspread

Let say that you expect CME’s earnings report tomorrow to cause a significant move in the stock. You don’t want to buy a strangle or call and to pay premium before earnings and you have bullish expectations. In this case you might sell FEB 160 CALL for $15.50 and use the proceeds to buy 2 out-of-the-money calls. For example you might purchase two FEB 175 CALLS for 8.60 each or a total of 17.20. The net result will be a money outflow of $1.70 (17.2 – 15.5).
– maximum gain is unlimited and starts above 191.70; At 190, the short call cost 30, but the two long calls cost 15.00 each and from 190 + 1.70 up, the long position will appreciate much faster than the short, resulting in a net gain.
– maximum loss is 16.70. If CME closes at 175 at options’ expiration, your short call position will cost $15.00 and your long calls will be worthless;
– if CME dives on earnings and closes below 160 at options’ expiration, all calls will be worthless and your loss will be limited to the paid premium difference of 1.70 per share (or 170 for the whole spread);

There are many other way to utilize options for hedging and speculation and I might talk about them in another post.