Time Crunch Trading

The probability of loss on any given trade is most often assigned to the timing of position entry and exit. That is a function of the trading system or methodology employed, which will be discussed later. Predicting the market return of any given period, even in a binary up/down fashion, is a difficult proposition at best. In other words, whether any given trade ends up a winner or loser is often entirely up to chance.

As a trader, you will do your best to put the odds in your favor, or at least to know what the odds are likely to be (we hope!). Despite that, you will never really know what is going to happen on any given trade, so the control of whether a specific trade is going to be a winner or loser is out of your hands. Even a trading system with a 99% win rate will have a loser somewhere along the way, and it is virtually impossible to accurately predict when that one loss is going to occur.

While you may not be able to do much about whether a specific trades is profitable or not, you can manage the size of the loss, should one occur. This is done in two primary ways – stops and position size.

Stops

Stop orders (stops) are a commonly used type of market entry or exit order. In particular, they are a tool employed by traders with open positions to get out of them at some predetermined point. Someone with an active long position can place a sell stop below the market to cap a loss at a certain point.

For example, a trader who buys 100 shares of XYZ stock at 100 might put a stop at 95. That stop would be triggered if the market moves down to 95, at which point the shares would be sold. The trader would lose $500 on the trade, but would be protected from a larger loss should XYZ continue to move lower.

In the same manner, a short position would be protected by a stop placed above the current market price.

In some cases, traders will adjust the stops as the market moves in the intended direction to lock in profits.

Let us say, for example, that a trader sells gold at $400 and places a stop at $410, meaning her position would be exited if the market rose to $410 or higher. If gold drops to $350, the trader could move her stop down to something like $370. That would lock in $30 in profits, while keeping the trade open for further gains. These kinds of orders are called trailing stops. As the market moves, the stop is trailed along.

The basic idea here is that with a stop you are trying to prevent a loss greater than some amount, or to prevent a winning trade from losing too much ground. In this way, stops are a staple of most traders’ money management strategy.

Trade2Win Board Quote I also ensure any total position size will not destroy me given a catastrophe (i.e. assuming the market closes mid session thus destroying the protection of any market stop losses). This normally limits how big I can run a system rather than anything else. Tuffty http://www.trade2win.com/boards/showthread.php?t=15424

It must be stated, however, that stops are in no way guarantees. A stop order becomes a market order when the order price is reached or exceeded. If the market is moving rapidly at the time the stop level is hit, the actual execution price of the trade could vary from the order price.

For example, if you have a sell stop at 9.75, you could see that filled at 9.76, 9.70, 9.50, or any number of other places. Generally, it will be close to you order price in active markets, but you cannot assume a specific price for a fill, even in electronically traded markets, because there must be an order on the other side as well.

This sort of risk is especially apparent where there are discrete openings and closings, like in the stock and futures markets. If prices move between one day’s close and the next day’s open, as could happen if there was a significant news item, the stop can get filled significantly away from the order price. It is unavoidable when it happens, and is something to take in to account when developing a strategy for stop placement.

Trading Limits
Adverse overnight moves are not the only thing that can cause order fills well away from the expected level. In many markets, especially futures, there are price movement limits known as daily trading limits. These are daily barriers based on the previous day’s close beyond which prices may not trade during a given session.

Corn futures, which trade on the Chicago Board of Trade (CBOT), are an example of this. They have a 20 cent per bushel limit, which is equivalent to $1000 per futures contract. That means the price cannot rise or fall more than 20 cents on any given day.

Limits can lead to a situation in which a market goes lock limit. Basically, that means the price at which the market wants to trade at is beyond the allowable one as per the exchange’s limits. When that happens, prices move to the limit, but no actual trading takes place. No trading means no stop order fills, which means you could be stuck in a position going rapidly against you.

Other Restrictions

There are other forms of trading limitations across the markets, sometimes referred to as circuit breakers. They range from restrictions on the types of trades allowed (such as the well known “up-tick” rule in the stock market where one can only sell short at a price higher than the last one transacted) to actual trading halts if certain daily barriers are hit (as instituted in the U.S. stock market following the Crash of 1987).

The reasoning behind daily price limits and circuit breaker type actions is to calm the markets in the face of extreme volatility. The idea is that if traders are given some time to gather themselves and settle, it should lead to less frantic activity.

Even though these restrictions are fine in principle, they actually can increase a trader’s stress level. No one wants to be left wondering if, when, and at what price he/she will be able to exit a position which is under pressure. It is a horrifying situation.

Position Size

Stops are one way traders try to control their potential losses for a given trade. The other way to do that is in the decision of how large or small a position is taken.
Determining your proper trade position size can sometimes be very easy. There are markets which force you to take on positions of a certain minimum size. That makes position sizing very direct. Alas, that sort of circumstance can lead to trouble, though.

Consider the futures market where there are fixed contract sizes. If you want to trade the e-mini S&P 500 index contract, for example, you have to take on a position with a $50 per point value. Say you want to risk $500 on the trade. That means 10 points, so you place your stop 10 points away from your entry price.

That all sounds good, but what if the normal volatility of the index for the timeframe of your intended trade exceeds 10 points? That means there are pretty good odds your stop gets hit. It is too tight.

This is a mistake a lot of traders make. They decide first how many contracts they want to trade. Then set the stop so they are only risking the amount they want to risk. In this way, they think they are being prudent because they are using stops and not taking too big a loss. Sounds like a solid money management plan.

Why is this a mistake?

Because it leads them to place their stops too close. That, in turn, increases the likelihood of the trade being a loser. Sure, they may not take a big loss. Instead, they will take a series of small ones. It will be a slow death instead of a fast one. Placing stops too tight will turn a good, profitable trading method or system into a losing one. It will produce more losers than it should.

Stops have to be placed outside of what would be the normally expected trading range for the market in question over the holding period expected. They will be closer for short-term trades than for longer-term ones. They will be further away for more volatile markets than for quieter ones. Trades must allow for market fluctuation room because they do not often go in straight lines.

So what is the right way to do it?

Selecting the right position size is done quite simply. You figure out what you are willing to risk on a given trade, for example $1000. Then you figure out what the expected risk for a position is going to be. Maybe it is $500 per unit. You then take the first number and divide it by the second to get your position size. In this case, that would be two units ($1000/$500).

Trade2Win Board Quote You look at where you need to set your stop (your risk). You look at how much of your capital you wish to assign to that risk. You calculate the number of shares/points you can buy/sell. You take the trade (if it meets your entry criteria) and set your stop. TheBramble www.trade2win.com/boards/showthread.php?t=18576&page=2&pp=10

Here is the catch for many part-time traders, especially those with only small portfolios. Sometimes the second number is bigger than the first number, meaning the risk on the trade in question is more than they have decided is acceptable. What do you do then?

The answer is easy. You do not enter that trade. You let it go and wait for another that fits your risk profile. Remember, you do not have to trade. That is one of the advantages of being a part-time trader. Your livelihood does not depend on it, so you can pick and choose only the best trading opportunities.

We know that it is hard to let what appears to be a good trade pass you by with getting in. That is part of the discipline of the money management process, though. It is important that you stick to the strategy you put together. It is there for a reason – to ensure you do not take on too much risk and cause major damage to your portfolio. Remember, as good as that trade looks, it could still be a loser. How would you feel after losing more than you should have?

Hedging

There is a third way to control the downside of a specific trade, hedging. Hedging is the process by which you use a second position to offset some of the risk associated with a particular trade. It is not a common part of trading when thinking primarily of speculation, but you can do it. In this regard, the type of hedge you would use is to offset one or more risks which are not specific to the instrument you are trading, but which may have influence on its price activity.

For example, if you expect Intel to report good chip sales you might take a long position in the stock to profit from a move up in price, and simultaneously short the S&P 500 futures or buy S&P 500 put options. By taking a short position in the index (in some ratio to the Intel position), you would profit from a fall in the overall stock market. This offsets that risk as it relates to your Intel position. The trade is then left with only risks related to Intel itself.

On the flip side, if the market rallies then your short position in the S&P 500 loses money (at a minimum the option premium). In this way, a hedge is like an insurance policy—it protects against a certain kind of exposure, but also has a cost.

The primary reason the vast majority of traders do not hedge is their time-frame. Most traders are fairly short-term in nature. Hedging in that time horizon may not make sense given the relatively small size of the moves in question, and the costs of the additional transactions for entering and exiting the hedge.

For example, interest rates tend to change gradually and their rise or fall takes some additional time to impact the general economy and other markets. A trader who is in and out of positions in days, or perhaps even weeks, is unlikely to feel the impact of such changes. In that case, there is little value in hedging.

That said, for some traders hedging is a useful tool to define and limit position risk. If you are a part-time trader holding long-term positions, there may be a benefit in hedging, as long as the cost is not too high relative to your portfolio.

Hedging can also be done for your portfolio as a whole.