This post is more for those new to trading who want to learn how to combine technical analysis, stock selection and account management than your experienced trader. This deals mainly with the risk aspect of trading, but also on stock selection rules and the technical indications that aren’t necessarily your usual TA patterns. I’ve been AFK for the past few days, so I’ve been doing my regular chart-trawling this afternoon looking for some interesting setups. A few charts have really caught my eye, for several different reasons. All of them were decent-probability trades; yet from the 4, 2 were/are going well while the other 2 would have really caught you with your pants down had you traded them.
This has again got me thinking about how important a good trading strategy and solid account & risk management rules are to a successful equity curve. I talk a lot about risk reward on this blog, and the spine of my trading strategy is based around risk aversion. My main rule is simply to only risk 1.75% of account balance per trade, which in turn dictates position sizing – which in turn then affects the amount of positions you have open. I especially like to find circumstances were the drawdown risk is actually significantly below 1.75%, of which I have traded many lately in the TSLR watchlist portfolio.
This links to the odds. Stats are very important to me as a trader as they are the most honest and transparent method of tracking performance and patterns in your trading. Not just odds though; risk. If you had bet the house without a stop (risk management) and picked one of the 2 that have done well, then great. If you bet the house without a stop, and picked one of the 2 that didn’t – and you would have had a 50% chance of doing so – then your account would have been heavily drawn down, and in one case almost wiped out. A 50/50 chance given the potential exposure there is not a wise long term strategy. Particularly when you consider the fact that a trader who trades without a stop is essentially willing to forfeit the entire equity held in that position. If there is no stop, then there is no target – so when does he cash out?
So here’s what I’m on about;
This trade was just so great for so many reasons. I was watching this one on Tuesday and put it on the fringe, but being AFK yesterday I didn’t expect this to rip like it did. ST double bottom off strong support area, bounce off long term support line, good accumulation breakout above support, gap up and gap close hammer on smaller volume.. etc etc. You can see that this was just such a great trade to take either at $40 or yesterday during the pullback. The RRR here is 15.25 which is ridiculously in your favour – even if you lost you would be happy with it. In terms of risk, you could have bet the house here and still have only be exposed to 2/3 of your per trade risk with a max position size with the best scenario increasing your balance by 1/5. Even at the current price on CLF, the closing ratio would have been 8.73.
On the flip side is ORLY. With good but not spectacular accumulation in the lead up to resistance at $40.50, a trader would be forgiven for opening a position on such a bullish candle and break above resistance towards the end of the trading day, particularly when the internals were generally trending up and increasing in strength towards the close. I can picture many newish traders taking this to the long side, but I would dodge these trades for 4 very important factors (to me). Firstly, I like to open positions on the day after the stock has closed above resistance or below support – which you wouldn’t have done here. Secondly, the bullish candle closed a gap and also closed off highs. The third is from a technical viewpoint – there is no discernible formation or pattern in this trade, and the move developed out of a choppy consolidation period. Lastly, earnings. I have discovered lately how much volatility is involved in earnings, these reversals are happening every where at the moment – I wouldn’t say to not trade earnings, as these are the main catalysts for movements – just practice good management and discretion when opening the day before the announcement!
Due to this gap, you have overstepped your risk at the open here by nearly $1.50 per share. One final note, because of the poor technical setup, the risk reward ratio was only 2.5. That alone, without the other 4 factors is enough to have avoided this trade.
Another setup here, this time to the short side. I really like this type of setup, the old retest former support/resistance for the first time. This trade looks simple, but there are a few things that could have caught out a trader taking either a short, or a long. For those contemplating the long, yesterdays retest of the gap from Tuesday and then the nice wick from that could have been reason enough to take a low risk punt to the long side – fair enough. For those looking short, there is the heavy volume day at resistance and the 50MA overhead in a stock which was hitting its third successive lower high – a bearish trend establishing itself.
This trade was nice because it offered something for both parties involved. The long side would have been stopped out at the open for their risk and nothing else, whereas the shorts would have had a good opportunity to at least close half as NTAP approached an S/R area at $30. The 6.66 ratio is more implied to the short side here, and I would be looking to add short at $31.70 if I were a scalper today. Again, anyone either way without a stop would be exposing heavy downside, particular longs who endured the pain of holding through that heavy sell-off this morning – why put yourself through that? Trading can be stressful enough.
This is the real killer in this post. Can you imagine waking up to a 67% loss in your account in the morning? Talk about demoralising. The worst thing about this trade for me is that there were 2 reasons to go long in XNPT 3 sessions before today. Support area wicking off the 50MA – maybe open a small position and see what happens? I can just picture some traders taking this and can’t imagine how they are feeling today! It gets worse, yesterdays high was the 4th test of the short term resistive trendline – which is an excellent reason to close the trade to the long side.
Gap downs like this can destroy accounts and ruin traders – and no risk management strategy can really cope with them except from supreme concentration on the trade. The trendline was a good reason to close, but for me there are 2 glaring reasons to have never even thought about this one. Firstly, pharmaceuticals/biotechs – any news can see these rip or implode, and as a risk averse trader, I don’t even like to contemplate holding these through any announcement or news on trials. Secondly, small volume – averaging less than 400k per day in a low price stock means that this shouldn’t be on your hitlist for dollar volume reason enough.
It’s probably easier for me to visualise this information so have a look.
The 1/4 equity per trade assumes a position size based on stop level and 1.75% of the 1/4 account position. The overall drawdown is 2.139 less than it would be at maximum acceptable exposure, which is actually very good. So either you can spread your risk and be strict on position sizes and account management OR you can have a 50/50 chance of making either an average profit of +$3100 or an average loss of -$18000. Which would you chose!?
A post-script bullet pointer to cover the main lessons here:
- Risk aversion is crucial in trading. Before you trade, develop a set of rules for reducing your downside. This includes overall account exposure, percentage risk per trade, “account closure drawdown” amount, limit on number of open trades and minimum risk reward ratios.
- Seek liquidity and stability in your stock selection. Small-cap, thinly traded Biotechs & Pharma can damage your account just as much as it can improve it, is 50/50 good enough for you?
- Multiple reasons to enter a low risk and high probability trade should always be acted upon without hesitation so long as everything lines up with your risk strategy.
- If you see a technical pattern that would make you take the opposite position to the one you have open, close the trade and consider reversing.
- Exercise caution when opening into earnings (consider half size)
- It is usually best to wait for the day after the breakout before opening a position.
- Keep a trading journal or blog to keep track of your trades, develop ideas or practice your strategies.
- Enjoy your trading.