Advanced Trade Management
In this article we take a more detailed look at more advanced money and trade management strategies.
The term “Trade Management” refers to methods and manipulations which can be followed before and after a trade has been made to ensure a protection from undesirable movements of the tradable and at the same time to guarantee that if the position finally proved to be right, the profit will compensate the risk taken. There are two concepts of trade management mentioned in the literature: the use of trailing stop and the reward-to-risk ratio (also known as Profit/Loss ratio) .
In respect to the trailing stop, in the case of a long position, the trader sets an initial stop loss level which is raised as long as the price of the tradable rises. In other words, the price “trails” the stop loss level upward. Similarly, in the case of a short position, an initial stop loss level declines as long as the price of the tradable declines. That is, the price “trails” the stop loss level downward.
As far as the Profit/Loss ratio is concerned, the trader determines an initial stop loss level before entering a trade and calculates the loss he will take if the stop is reached. He then moves on and calculates the expected profit from the trade. Finally, he calculates the Profit/Loss ratio and discards the trade if this ratio is less than an amount, otherwise he moves on and makes the trade.
In the present article I will introduce and discuss three subtle but important enhancements to the above concepts of trade management:
- The use of two intraday stop-loss levels.
- The use of a threshold (CE level) which will be used to trigger the change of the original expectations from the position.
- The use of dynamic Reward/Risk ratios.
Using Two Intraday Stop-Loss Levels
Almost all traders have faced the frustrating situation where a stop loss level is penetrated during a day just to force him to exit a trade and immediately after that the market starts moving in the favor of the original position. In many of these cases, as soon as the stop loss level is penetrated, the rigid trader immediately gets out of his position usually placing at-the-market orders for the full position.
A solution for this problem is to use two stop loss levels. When the first level is penetrated, a stop loss order is activated and a portion of the original position is immediately liquidated and protected from further losses. In the sequence, if the market reverses and moves in the favor of the original position then the remaining portion of the position will produce profits. If, on the other hand, the situation gets worse and the second level is penetrated, a second stop loss order will be activated and the remaining portion of the position will be liquidated.
The use of two stop loss levels is equivalent to the use of one stop loss level. More precisely, if you use a first stop loss level L1 assigned with a portion p% of your position and a second stop loss level L2 assigned with the remaining (100-p)% of your position then it is like using a single stop loss level L where:
L = p%.L1+(100- p)%.L2 (Equation 1).
L , by its definition, always lies between L1 and L2.
Equation 1 can be rewritten as:
(Equation 2). For objectivity reasons and for minimizing “wishful thinking” it is advised that you first determine the L, L1 and L2 levels and then using Equation 2 calculate the portion p% of the position that must be liquidated after the penetration of the L1 level.
Using a CE Level
In his book “Market Wizards” (see ), Jack D. Schwager cited an interesting though controversial opinion from Tom Baldwin: “Don’t get out of a losing trade too hastily; instead, wait and choose your time”. This opinion does contradict the basic tenet of trading to “cut losses quickly” unless the trading management rules themselves incorporate the case where a position will be considered undesirable but not unaffordable. This is exactly the purpose of a CE level.
A CE level (Change-of-Expectation level) is a price level which when penetrated it triggers the change of the original expectations of a position. Its purpose is to inform the trader that its original position is not so good as it was originally expected and he must exit his position but not necessarily immediately. In other words, it is a form of stop loss level offering the trader a period of grace to find a good exit point.
It is advised that the CE level is based upon the closing prices. That is, wait for the closing price to penetrate the CE level before considering the penetration valid. This is due to the sentiment attached in the closing prices for a great portion of market participants. As the closing price is the most mentioned after the market is closed, it is quite likely that in the next trading session you will get the desirable pullback to make a gracious exit.
Using Dynamic Reward/Risk Ratios
As already mentioned, the initial Reward/Risk ratio (simply RR) is the ratio of the expected profit (reward) from a trade P to the potential loss L from the trade as determined by the stop loss (risk taken). In his book “Technical Analysis of The Financial Markets” (see ), John J. Murphy proposes the avoidance of trades when their RR is less than 3 so, the number of false trades must be more than three times the number of the correct ones to actually reduce the total value of a portfolio. What is not generally known however is that the RR ratio must be continually calculated as prices move.