The two main issues in investing are always a sound profitable strategy and risk management.
A. The Strategy
Our trading strategy is sound. The back-test has proven it and the real life trading since September 2013 tends to confirm the results of the back-tests. The Portfolio Management statistics show that since September 9, 2013 the portfolio has gained almost 20% compared with 9.6% for the S&P500.
One poster wrote that using TNA as an instrument would have produced even better returns. Indeed, during the same period, TNA would have produced +33.5%.
The main difference is risk management. With TNA lies the risk of volatility and a wrong market direction. Do not forget that to gain 33% since September 9, 2013, TNA went through three pull-backs of 10% to 15%. How would you have managed such pull-backs? Selling? If so, when would you have bought back?
This comparison is just to introduce the principles of risk management.
B. Risk Management
The main question is: How much portfolio value are you ready to lose on any single trade?
Usually, this number is between 0.5% and 1%.
The second question is: How many consecutive positions can you manage? If the response is 10 positions and the maximum loss in the portfolio for each trade is 0.5%, then you need a maximum 5% stop loss on each position.
For our portfolio, we decided to limit ourselves to 5 positions. Hence, 5% is the maximum admissible loss per trade.
The ZLC case study
The ZLC case was discussed in real time in the link below, but let's review it again to see how we could have better managed it.
http://www.effectivevolume.com/showthread.php?6901-ZLC
We entered the position at 16.10 and were stopped out at 15.39 for a loss of 4.41%
ZLC is a volatile stock with a 5D ATR (Average True Range) higher than 7%. Most stocks have an ATR lower than 5%. This means that the stock is more volatile than others and hence tight stops are difficult to manage. In our case, even a 4.41% stop loss was hit. This shows that the stop was too tight. In order for us to increase our stop, we should have taken a smaller position.
The real question though is what is the safest stop to use. We saw earlier that 5% is the maximum stop that we can use to limit the loss on the portfolio.
For ZLC, a stop of 15.39 had a 36.3% chance of being hit within 5 days.
To lower the probability to 10%, the stop level should have been set at 14.51, which is a stop loss of 9.5%. Such a high risk would have forced us to cut the position size in half.
How do we calculate such a probability? This is extremely tricky and highly hypothesis dependent. It is mainly what we call a conditional probability. The stricter the condition, the smaller the sample and the less reliable the results.
The main issue is volatility. The higher the 5D volatility, the higher the probability of hitting a fixed 5% stop loss level. We can see this in the table below. Indeed, the columns "ATR" and "Max Loss" have a correlation value of 0.90.
Let's study this table of potential trades for Monday.
The last three lines represent the stocks that are in the current portfolio.
All the others represent new trade ideas.
Long Candidates Target Price: This shows my entry price target for Monday
ATR: This shows the 5D Average True Range. It is a measure of the volatility.
Probability to hit target entry: This shows the probability that on Monday, the target price will be hit. This is a critical value. If a stock is extended from the target entry price, I would not even consider watching it.
Stop level for a max 10% 5D Stop hit probability: This shows the stop that I would need to use in order to limit to 10% the probability to hit the stop within 5 days.
Max Loss: This shows the maximum loss in percentage terms that such a stop loss level requires
Position Size: This shows the position size required in order to limit the maximum loss to 5% within the 10% probability to hit the stop.
5D Probability to hit a 5% stop level: This shows the probability to hit a 5% stop loss level in the next 5 days. Note that the three cells in red represent the probability to hit the real stops entered on the ongoing trades. We can see that SUNE and SCTY stops will probably not be hit in the next 5 days, but the CPB stop could well be hit faster than expected.
If we eliminate existing positions and sort the Table by a decreasing level of probability to reach the target entry price, we can easily eliminate the stocks that have a probability lower than 10% to reach their Buy level. This leaves us with the Table below. Since we have two positions to fill and since the total of the table is higher than 200%, this means that the two positions will probably be filled on Monday.
Below is the present portfolio Table.
Note that the high probability that CPB will hit its stop is simply due to the fact that CPB has had two large downtrends in the past, which naturally have increased the statistics of weakness attracting more weakness. However, we are now in a cup and handle pattern, and if we break below the low part of the handle, the trade should be closed.
The X and TCBI EV patterns are shown below.
Below are the technicals for ZLC. Still, the long trades are interesting here. It is not because we have been stopped out that we should not re-enter on Monday. ZLC did not make the list of leading stocks, but if the general market bounces, it could be interesting.
If the 20DMF and the markets are weak on Monday, no new long trade will be entered.