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Around the mid 2000's, I was drinking espresso in the lobby of the vice consulate of Italy in Denver, CO. That was what my friend called his living room — his wife’s diplomatic work was done from the house. Legally, I left the United States and entered Italian sovereign territory when I visited him. We were discussing momentum indicators and the importance of trends. He believed the long-term trend was the most important characteristic of a stock. Nothing too controversial, to be sure. It’s what he said next that really surprised me. He said: “Short-term stock price changes are like flipping a coin.” Is This As Absurd As It Sounds About half the time, a flipped coin will come up heads and the other half it will come up tails. It...
Every successful trader learns to manage risk so they can avoid large losses like those that have crippled many Wall Street firms. In this article, we'll show how traders manage risk, identify the lessons we can learn from JPMorgan, and detail a way that technicians can duplicate the value at risk (VAR) metric that many large firms use to help add insight to their potential losses. In what has become a fairly regular event and taking a past example from a few years ago, a Wall Street firm announced in May 2012 a multibillion-dollar trading loss. JPMorgan told analysts and investors in early May that year that a hedge trade they had made would lead to a loss of at least $2 billion. CEO Jamie Dimon said that the firm "screwed up" and a...
Most people who are interested in learning how to become profitable traders need only spend a few minutes online before reading such phrases as "plan your trade; trade your plan" and "keep your losses to a minimum." For new traders, these tidbits of information can seem more like a distraction than any actionable advice. New traders often just want to know how to set up their charts so they can hurry up and make money. To be successful in trading, one needs to understand the importance of and adhere to a set of tried-and-true rules that have guided all types of traders, with a variety of trading account sizes. Each rule alone is important, but when they work together the effects are strong. Trading with these rules can greatly...
It is not a mystery that in the financial markets there are two distinct groups, those that make money a large portion of the time (banks and institutions) and, on the other side, those who don’t (the general trading and investing public). These folks tend to struggle to keep up with market returns at best; or end up washing out and losing all their money at worst. On Wall Street, the cohort that makes money consistently is referred to as the smart money and the aforementioned latter group is referred to as, let’s just say, not so smart money. To be fair, the vast majority of retail traders and investors, through no fault of their own, just don’t know how financial markets really work. They’ve bought into what all the trading books...
Risk tolerance is a topic that is often discussed, but rarely defined. It is not unusual to read a trade recommendation discussing alternatives or options based on different risk tolerances. But how does an individual investor determine his or her risk tolerance? How can understanding this concept help investors in diversifying their portfolios? Read on as we delve into this concept. Risk Tolerance by Time frame An often seen cliché is that of what we'll refer to as "age-based" risk tolerance. It is conventional wisdom that a younger investor has a long-term time horizon in terms of the need for investments and can take more risk. Following this logic, an older individual has a short investment horizon, especially once that individual...
Are you a risk taker? When you're an individual trader in the stock market, one of the few safety devices you have is the risk/reward calculation. Risk v Reward Sadly, retail investors might end up losing a lot of money when they try to invest their own money. There are many reasons for this, but one of those comes from the inability of individual investors to manage risk. Risk/reward is a common term in financial vernacular, but what does it mean? Simply put, investing money into the markets has a high degree of risk, and you should be compensated if you're going to take that risk. If somebody you marginally trust asks for a $50 loan and offers to pay you $60 in two weeks, it might not be worth the risk, but what if they offered to...
One of the most enduring sayings on Wall Street is "Cut your losses short and let your winners run." Sage advice, but many investors still appear to do the opposite, selling stocks after a small gain only to watch them head higher, or holding a stock with a small loss, only to see it worsen. No one will deliberately buy a stock they believe will go down in price and be worth less than what they paid for it. However, buying stocks that drop in value is inherent to investing. The objective, therefore, is not to avoid losses, but to minimize the losses. Realizing a capital loss before it gets out of hand separates successful investors from the rest. In this article, we'll help you stand out from the crowd and show you how to identify when...
Risk management is an essential but often overlooked prerequisite to successful active trading. After all, a trader who has generated substantial profits over his or her lifetime can lose it all in just one or two bad trades if proper risk management isn't employed. This article will discuss some simple strategies that can be used to protect your trading profits. Planning Your Trades As Chinese military general Sun Tzu's famously said: "Every battle is won before it is fought." The phrase implies that planning and strategy - not the battles - win wars. Similarly, successful traders commonly quote the phrase: "Plan the trade and trade the plan." Just like in war, planning ahead can often mean the difference between success and failure...
A common perception among the general retail investing and trading public is that in order to garner large profits, you must take on big risk. So where does this view come from? Who perpetuates it? And is it necessarily true that low risk trading isn’t possible? Can Low Risk Trading Result in High Profit? This view comes from the fact that most people perceive volatility and leverage as high risk. Therefore, if one engages in the markets during periods of high volatility using a leveraged product, the odds are very low (high risk,) but the profits can be huge if things work out. This is the common perception. In essence, the belief is that because most people are risk-averse they should settle for only mediocre returns as higher...
One of the key components of successful trading or investing, is the ability to trade around a CORE position. The “core” position as we say, is the main position of the investment or the primary amount of shares or contracts that you wish to have on during the majority of the time you are in a particular trade. Sadly, most people have no understanding of how to apply such a concept, and they plow into a trade or investment in just one single entry. Giving yourself one entry or at best two, has very limiting implications, but what is even more limiting is the idea of holding just 1 or 2 lots for the entire move. It is true that a majority of market players approach the market in this fashion. They enter once or twice at best and they...
Any investment portfolio is bound to take some lumps in a volatile market place like that experienced by most investors in the last 14 months. During an economic market cycle, market pullbacks and corrections are commonplace and naturally occurring parts of normal market growth. Even so, they can be difficult to stomach and send investors reeling for less volatile asset classes. When the volatility pendulum swings, investors can stay too long in the way of a poorly performing investment. Riding upward growth is euphoric for most investors but the contrary is disproportionately crushing to the psyche while plundering the pocketbook. How do you stop the madness when you're holding and you should be letting go? No matter which type of...
Most of us would prefer not to relive 2015 it is my guess. Equity markets weren't very friendly with treacherous volatility towards the end of the year. Moving sideways from about June on, markets sneaked slight gains but most investors felt the burn of "nothing to show" for the year. China fears of slowed global growth and the increasing stockpiles of crude oil put a lot of downward pressure on the growth in equity markets around the world. The Federal Reserve finally gave us hope in a Federal Funds Rate increase of 0.25% in December. Monetary policy baffles me. Central banks are seemingly more influenced by "sunshine or doom and gloom" trading headwinds than actual economic data. When the smoke cleared, the NASDAQ was up 5.73%, the...
In almost all instances, the root cause of a financial crisis is an asset bubble. But how does this bubble form, what finally causes it to pop and how can investors profit before it goes bust? In order for a market to attain the excessive valuations necessary to prompt a crisis, a prolonged period of price appreciation combined with a large number of new entrants to the market is usually necessary. Crisis in the Making The combination of price appreciation and an increase in new entrants to the market are defining characteristics of market bubbles. Investors should remember that many bubbles are based on attractive fundamentals, which explain why money flows into the market in the first place. However, at some point, so much money...
"To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework." Warren E. Buffett (Preface to "The Intelligent Investor" by Benjamin Graham) Any veteran market player will tell you that it's vital to have a plan of attack. Formulating the plan is not particularly difficult, but sticking to it, especially when all other indicators seem to be against you, can be. This article will show why a plan is crucial, including what can happen without one, what to consider when formulating one as well as the investment vehicle options that best suit you...
If anyone has forgotten how volatile financial markets can be, the beginning of 2016 has certainly served as a stark reminder. In turbulent times it is even more important than usual to have a robust risk management system, and one that can adapt to changing levels of volatility. Most traders are aware that there will always be losers, no matter how accurate the trade selection methodology. But what some don’t consider is the probability of a devastating string of losses. Consider these statistics from hedge fund manager Larry Hite. Assuming 50% of your trades are winners, over a series of ten trades you can expect at some point to have three losers in a row; over a series of 100 trades the expected run of sequential losses rises to...
Shorting covered calls is a very popular option trading strategy that involves shorting a call option and taking a long position in underlying stock. On the upside, there is limited capped profit to the trader with limited and proportionate loss on the downside. Experienced traders apply this strategy with the right timing and careful selection of the expiry and moneyness of call options The risks in selling covered calls There's a common misconception that any option that is shorted, the potential for loss is unlimited. The same is thought of short covered calls, but this is not true. In fact, the maximum risk in a short covered call position is limited and can be managed efficiently - with the proper timing of the trade and selecting...
I hadn’t made any significant changes to my strategy for over ten years, but last year was different – I stopped using a stop-loss. Shock! Horror! Trading suicide? Or is there another way to control risk? Let me explain. I trade potential trend continuation after retracement on UK equities mainly drawn from FTSE100. When the market is rising the equities that trigger will generally be in a good up trend, strong and outperforming the FTSE100 index. Conversely, when the market is falling they will generally be in a good down trend, weak and under performing the index. I’ve always had problems with my stop-losses on two counts. Firstly, that all too familiar and frustrating experience of price taking out my stop and then shooting off in...
For this article I would like to illustrate three particular scenarios which deal with various aspects of risk management. In addition to the required and necessary skill-sets involved in consistent speculative trading, maintaining a constant and disciplined approach to capital preservation is ultimately the number one objective for any professional in the field. Failure to adhere to these risk management principles will typically result in ongoing frustration and concern for any individual aspiring to attain market success. In the classroom learning environment, I always advise my students to maintain a risk parameter of between 1% and 2% of their account balance. Therefore, should they be working with let's say a $10,000 trading...
It is the job of every serious-minded Forex trader out there to keep abreast of the latest news and events, which could potentially have an effect on their day-to-day trading activities. This month is a big month for the world of Forex trading in that we have seen brand new legislation enforced which will no doubt ripple across the activities of all Forex traders participating or looking to participate in the markets over the course of the future. This ruling has been met with praise by some and scorn with others, yet needless to say, it is here to stay and we should all be aware of its appearance moving forward. The ruling I am talking about is the introduction of the latest Commodity Futures Trading Commission (CFTC) Compliance rule...
As a trader you must have three pieces working in synch. Your equipment, your trading tools, and your mind. The Art of War by Sun Tzu is a book that has been applied to every facet of human experience. While originally meant to be a book that taught war strategies the lessons it imparts can and will change your life. Students of the market are constantly battling between the emotions of fear and greed. The Art of War can help you cut a path between these two emotions and lead you to a mental place that will constantly help you put your best foot forward. In this series I will address various poor trading habits by excerpting and interpreting various passages. While my interpretations are not meant to be definitive by any stretch of the...
Many beginning and intermediate level traders may benefit from learning a new approach to risk management which I intend to discuss in this article. There are two types of trader that this may apply to and the first, (Trader A), is the one who enters a trade with a stop set at a fixed distance away from their entry and it is always the same distance regardless of the market or instrument being traded. Trader A places a stop entirely based on a fixed monetary risk and when the amount of money that they have set aside for the trade has departed their account they close the trade. The second trader, (Trader B), places a stop that can vary in distance from their entry and is based on “Technical” reasons as to why the trade is no longer...
Traders spend most of their time researching setups for trade entry, using fundamental analysis, chart patterns, signals from technical indicators, or some combination of these. Yes, no doubt about it, finding entries is vitally important, because the entry is the foundation upon which a trade is built. However, if finding good entries is the most difficult thing, finding good exits is the most emotionally challenging part of the trading process! Winning or losing, deciding on the exact time to close your trade can drive you nuts. Common exits occur when traders get stopped out at a stop loss level, close the trade into high volume spikes, or attain predefined targets. All trades should have a stop loss in place. Some traders hold a...
Paper trading is widely discussed regarding its merits, and whether it is of value to a trader as they try to make the transition to real money trader. One viewpoint is that since paper trading is not real, the profits are meaningless, and are no indication of real money profitability. An opposite viewpoint would state that paper trading is an important step in the trader's learning progression, and regardless of whether it is real, if the trader cannot "properly" paper trade, then they will not be able to real money trade. I began trading in early 1995, with the intentions of becoming an options trader; my first trading education was through an oex options teaching service. Besides options training, the service included "tape"...
Introduction In this article we'll take a look at two related practices that are widely used by traders called Backtesting and Data Mining. These are techniques that are powerful and valuable if we use them correctly, however traders often misuse them. Therefore, we'll also explore two common pitfalls of these techniques, known as the multiple hypothesis problem and overfitting and how to overcome these pitfalls. Backtesting Backtesting is just the process of using historical data to test the performance of some trading strategy. Backtesting generally starts with a strategy that we would like to test, for instance buying GBP/USD when it crosses above the 20-day moving average and selling when it crosses below that average. Now we could...
What Is The Risk Of Ruin? Please excuse me if I start off a little technical in this article. There is nothing complicated about the risk of ruin concept but it does require a quick calculation. Simply stated, the risk of ruin is the percentage probability that a trader's account balance will reach zero. This will either result in the trader ceasing to speculate on the financial markets, or having to stump up another chunk of capital in an attempt to make back the first tranche before making net profits. Having a solid trading strategy which is applied with discipline is clearly crucial, however understanding your probability of success or failure given certain actions must be more so. By using the risk of ruin formula a trader can...
Why do people trade? For most, their primary motivation is to make money. Sure, there are secondary reasons however they all stem from the undeniable urge to make money. Ironically, this would have to be the main reason why people fail. With most of our trading decisions, it is only natural that we focus on making money because this is the main reason we consider trading in the first place. Whilst I concede the idea of making money is important, it is not as important as protecting the money that you have to trade with. I think Paul Tudor Jones says it best when he said, "Don't focus on making money, focus on protecting what you have." Stephen Waugh is a former Australian cricketer and was the captain of the Australian Test...
Introduction The importance of well-placed stop orders to a FOREX trader cannot be over emphasized. The margin percentage required in a typical FOREX account is so small that a fully leveraged trader could easily lose a substantial amount of their net worth from a single position if it moves too far in the wrong direction. The name of the game is risk control and the key tool for protecting your account from substantial losses is the stop order. That being said however, I do know some traders who claim never to place stops. Usually the rationale for this is that their trades are very short term (on the order of just a few minutes) and they are watching the market during the entire trade, finger twitching on the exit trigger ready to...
Risk management isn't just about having your 'stop-loss' in place. So what else is it about? Any trader who knows his salt will tell you that Risk Management is the single most important aspect in trading, regardless of style or technical strategy. Yet, most traders are really not able to define what "Risk Management" really is. Let's pause for a moment, and think: can we define, in one brief sentence, what Risk Management is? "Loss control" would probably be the best broad definition, but to me this is a little more precise: In the business of trading the financial markets, Risk Management is the constant modulation of Risk Exposure to a constantly changing market. What is this exactly? Most participants will relegate their entire...
In this article we take a more detailed look at more advanced money and trade management strategies. Introduction 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...
The rules that should be 'Utterley Simple Rules of Trading' but which we all seems to find 'Utterley Difficult!' The world of investing/treading, even at the very highest levels, where we are supposed to believe that wisdom prevails and profits abound, is littered with the wreckage of wealth that has hit the various myriad rocks that exist just beneath the tranquil surface of the global economy. It matters not what level of supposed wisdom, or education, that the money managers or individuals in question have. We can make a list of wondrously large financial failures that have come to flounder upon these rocks for the very same reasons. Let us, for a bit, have a moment of collective silence for Long Term Capital Management; for...
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