Last time we discussed the theory of climbing back out of a dip having avoided the bulk of the drawdown that might have otherwise been experienced.  During the recovery the aim is to increase size quickly in order to further capitalise on our change of fortune.  This was the simple model we were working from:

This time I want to discuss some of the practical difficulties we have to face when translating this theory into reality.

The main problem we have is that the simple clean curve we see in theory is a very crude approximation for the noisy line that we will actually experience in real life.  The second problem is that we need to be able to identify when the bottom of the dip has actually been formed in order for us to be able to move from reducing size to increasing size.  If we can find a way to deal with these two factors, we can come surprisingly close to matching our theoretical model.

Identifying your bottom!

Let’s deal with identifying the bottom first as this is the first thing that we have to concern ourselves with in practice.  In our model you should recall that during our first recovery month we are trading exactly the unit size as dictated by our capital preservation plan in the previous month.  In other words we don’t have to worry about whether we have turned the corner or not during the month in which we actually do turn the corner.  We simply know when this has happened by virtue of having a profitable month.

Next we have to deal with the noise issue.  What if our profitable month was just a blip, just a bit of noise on a continuing downward path?  That’s a serious concern in the real world that we have to be prepared to deal with if necessary and here is how to do it.

When you had your first profitable month you were trading with a tiny monthly risk of just 1.05% of capital, having cut back from a starting point of 8% at the previous equity high.  The line in the sand is the equity low made at the close of the previous month and this must be defended at all costs.

The rule is simple – as you pull away from this line it becomes increasingly safe to increase trade size.  However should you head back down towards it again you have to be prepared to cut size again were you to reach that equity low again.  At the equity low, you immediately reset your trade size to whatever you were using during the 1.05% month, and reapply your capital preservation plan from that point going further down below that line.  The safety net provided by the capital preservation plan takes precedence over everything else.

Increasing size

OK, so that deals with the worst possible outcome, which in reality is not bad at all.  So let’s now consider how we operate once we do pull away from that equity low.  Our objective is to double our size each month as we climb back out of the hole, until our original unit size is reached, equating to 8% monthly risk in this example.

So after the first profitable month (the 1.05% month), you could just move straight up to 2.11% which is next step up on the theoretical model.  However this is where our practical noise problem has to be considered.  In simple terms you have a month’s worth of profit under your belt so far and this is the buffer between where you start the next month and that line in the sand.  If you double your unit size in one hit, you effectively halve the size of that buffer.

Is that what you really want to do in practice?  Probably not.  As you pull further and further away from the line in the sand, in becomes easier and easier to increase size and the additional risk becomes proportionately less.  But in these early stages of recovery we need to be more guarded in practice than in theory.  So here’s what we can do…

Split the month into 4 or 5 weeks and increase a little bit after each profitable week.  This is a tactic that will effectively preserve that buffer you have whilst achieving the goal of increasing size.  So for example if your previous size was say 6 contracts, don’t go straight up to 12 on the first day of the month, but maybe go to 8. As long as your first week at 8 contracts ends in profit go up to 10 for week 2.  If your first week wasn’t profitable be pleased that you were trading 8 lots and not 12s and stick at 8 for the next week.

If week 1 was positive, go up to 10 in week 2.  If week 3 is positive move up to 12 and maintain that for the remainder of the month.  At the end of the month you ended at the desired size but avoided risking your buffer unduly.  So yes in practice doing this costs you a few more days than in the noise free theoretical model.  But so what?  You just endured a 6 month drawdown and pulling away from that line in the sand as smoothly as possible is far more valuable than a few extra days in the overall scheme of things.

Now you have 2 months of buffer profits under your belt and you are well on your way to recovery.  Until you make new equity highs always keep that line in the sand in place and be prepared to act accordingly.

Disclaimer, risk warning and copyright notice apply to all articles published on this site.

Copyright © Simon Townshend Ltd 2010, all rights reserved

The markets appear to have stabilised after a most challenging period.  For the first time in quite some while we seem to be seeing a period of more normal volatility.  That is not to say that conditions are perfect as clearly they aren’t.  However most markets are at least tradable once again.  So we are in with a fighting chance of fulfilling our objectives.

I have spoken at length in the past about managing your equity curve when entering a period of drawdown.  There is no doubt that recent months will have lead the majority of traders into some sort of drawdown.  Now things are starting to look a little brighter, it is time to think about how we manage our way back out of a drawdown.

To some traders, myself included, managing your way into and back out of a drawdown can be one of the most powerful tools in the armoury, so this is a subject worthy of significant personal study.  In this first article I want to cover the core principles of this technique and then next time I will expand upon this and discuss how we put the theory into practice.

Going Into The Hole

Let’s start at the beginning, with your capital preservation plan.  The purpose of this is to ensure you retain the majority of your capital – however long and however bad a drawdown period you have to endure.  Everyone has his or her own version of this, but I am going to use the simple model I gave you in Golden Rule #3.  In this we have (a) a maximum allowable loss limit per month and (b) loss levels at which we cut our unit size by 1/3^rd each time a drawdown level is reached:

The main point here is that even with a somewhat conservative rate of cutting back the unit size, you still have 80% of your capital at the end of an astonishingly bad period.  You would also carry on cutting back if it went on further.  If you never recovered at all you would still have ¾ of your capital intact by the time you retired!  So don’t underestimate the importance of this.

Climbing Back Out

Once the tide has turned you then start to build your size back up.  However if you reinstate size more aggressively you can accelerate the recovery back to equity highs by taking fuller advantage of the upturn.

In the following model I show the effect of the same capital preservation plan which risks a maximum monthly loss of 8% initially and reducing by 1/3^rd when going down.  When climbing back out this plan doubles the unit size after each successive profitable month, until full size is restored.  In this way it takes 6 months of reducing from full size down to a very small unit size, but only 3 months to build back up to full size which is then maintained in the final 3 months.  The result is the red line.

In contrast the blue line shows the impact of sticking with a fixed unit size throughout but still using a maximum monthly loss limit – so this line is a simple 8% loss each month on the way down and a fixed 8% monthly gain when going back up.

So after 6 bad months and 6 good months the linear plan gets right back to where it started, after enduring a gut wrenching 48% drawdown and with no certainty that it couldn’t actually continue going down to zero if the second six months also turned out to be losers!

Whereas our planned and managed approach not only recovers fully but even generates a 10% profit on what is a very bad year.  But most important of all its drawdown is a much more tolerable 22%, plus the mathematical certainty that it actually cannot fall very much lower than that were the second six months to also be complete losers.

I don’t know about you, but I know exactly which one I prefer!  Yes there are several practical difficulties in implementing this, which prevent a simple theory working perfectly in real life.  But we can come surprisingly close with the right tactical approach and that is what I will cover next time.

Disclaimer, risk warning and copyright notice apply to all articles published on this site.

Copyright © Simon Townshend Ltd 2010, all rights reserved

I have the pleasure of having met hundreds of traders, the majority of whom are full time professionals.  I have regular dialog with several dozen traders as well.  Guess how many have been telling me lately that they are having a great year?

Zero!  Not one single person has said to me “hey Simon I am doing well at the moment”.  Isn’t that strange out of all of these traders?  I have had people say to me:

• “The market just doesn’t move, so I cant make money” – true earlier this year there was no opportunity whatsoever, at least none with a worthwhile risk/reward profile.
• “The markets are moving randomly on news and manipulation, so my normal signals aren’t working” – also true nothing works when a sudden shock spontaneously rewrites the supply/demand dynamic.
• “My strategy is broken, I need to throw it away and start building a new one” – wrong, don’t do it!  Living through freak times does call for modified daily behaviour, but don’t discard the tools that have served you well over many years throughout normal times.

Several people have asked me what I am doing to survive until things settle down to a higher degree of normality, so here are the three things at the top of my list:

Protect your capital

The first and absolute top priority is to protect the bulk of your capital.  How this is best achieved may vary from person to person, but whatever you do you must ensure you emerge from the rough times with your capital largely intact.  It is pointless waiting for better times when you can be profitable once again if you are effectively blown out of the game or nursing a drawdown that is too big to be quickly recovered from when the time is right.

Keep trading

The second point is that you must keep going.  That may sound at odds with the previous point.  But if you cut back on the number of trades you take and the size of those trades, you can actually continue indefinitely without doing any significant damage to your capital.  If necessary move onto a simulator or just paper trade.  But you must keep trading, for several reasons – it keeps you in touch with the market, it keeps you active and alert, it helps you practise and hone your execution skills.  Most of all it means you will be there when the silliness subsides.

That doesn’t mean you need to keep up the same long hours or to trade every day of the month.  Let’s face it you are not going to make money working 60 hours a week, working half time means you are simply going to not make money half as much – if you see what I mean!  There is nothing wrong with taking time off as long as you keep trading sufficiently long each week to still be in the game.  After all you wouldn’t want to be taking time off when things improve, so why not make the most of the tough times?

I used to think the solution to tough times was to put more time and effort in.  It was a natural way to think for those of us brought up to work harder and harder until we succeed.  But I was wrong!  If the market isn’t going to pay you it isn’t going to pay you and that’s all there is to know.

Do something positive

My third priority is finding something constructive to do in the business that keeps you positive.  Work on something that is within your control and not that of a crazy market.  It doesn’t really matter what you choose as long as you do something that is of value and something that you can feel a sense of achievement over.

I recently applied myself to taking overhead costs out of the business.  Fixed costs are a drag on any business and trading is no exception although mercifully our fixed costs are more limited that most businesses.  I was pleased to find savings amounting to 18% of our annual spend that I was able to eliminate.  That is quite a few thousand dollars a year.  But it is not the money that matters so much, although clearly it is better to have it than not.  What really matters is applying yourself to doing something constructive that you can feel proud of achieving at the end of the exercise.  It is certainly no replacement for getting your trading back into a profitable groove, but it is something that you have absolute control over and that no crazy market can derail you from.

So that’s my simple formula to weather the storm – protect your capital, keep trading and find something positive to do.

Disclaimer, risk warning and copyright notice apply to all articles published on this site.

Copyright © Simon Townshend Ltd 2010, all rights reserved

If your answer to this question is “because I have to use a stop”, then that is the right answer.  But it is not the answer I am looking for.

As far as I am concerned a protective stop can be used to serve two very different purposes.  It is important to know which of these purposes is the reason for using the stop.  Without knowing this it is impossible to select the optimum place to put that stop.

The two uses for a protective stop are:

• As an emergency exit
• To close all or part of a position

I am not talking semantics here – these are very different propositions for very different circumstances.

The Emergency Exit

Here a stop is placed a fair distance from the current market price at a position that the market should not even get near if the hypothesis for the trade was to remain valid.  This is your classic “get the heck out of here” type of order.  The trade has failed and you are on the wrong side of the market, so you take your loss and move on to the next opportunity.

Such an exit may be used in any and all markets, even the thinner markets where you may experience a few ticks of slippage.  That doesn’t matter for a couple of reasons – Firstly you need to get out as the probability is that losses will accelerate from this point.  Secondly such stops don’t get activated very often so a few ticks of slippage won’t make any difference to your overall performance.

Closing a Position

In this case a stop order is used to close out all or part of a position.  The stop is very tight to the market and is actively used as part of your trade management approach.  It is often a trailing stop as well – progressively reducing risk and then locking more and more profit in.  Here you are on the right side of the market, but seeking to ensure you capture the bulk of an open profit in the event of the current move ending.

This exit may only be used in deep liquid markets, where slippage is unlikely.  Such an exit will be activated regularly so slippage is important and if used in markets prone to slippage the impact on your bottom line can be considerable.

Conclusion

So whilst it is easy to think of all stops being equal, they really aren’t.  They are very different.  Unless you are clear which one you are using it is impossible to place it in the ideal location.  As you can see the two types of stop are almost total opposites.  By definition this polarisation means that there must be an area in between in which you never place a stop.  There is and it is a big wide area too.  So if you find yourself placing a stop in this vague middle ground, you know it is the wrong place and that you have not thought through where the right place is!  There is no room for:

• “I’ll give this one a bit more room” when you know it should be much tighter
• “I’ll give this less room to reduce my risk” when you know you should give the market room to breath

In both of these cases the purpose of the stop has been overlooked and both trades will suffer in the long run – the first one will dilute profits by giving up bigger losses and/or locking in smaller profits, the second will dilute profits by decreasing the percentage of winning trades by getting tagged in the noise too frequently.

How I Use Stops

In my work I use stops in exactly the two ways described above and each time I place the order I know its objective.

In short term trading in liquid markets, such as the S&P and Euro my stops are used as managed exits.  I only allow any trade just a few ticks of initial risk – either the trade works or it doesn’t so I am not going to give up much on the losing trades.  As the trade starts moving I will tighten the stop.  When my first profit target is achieved the stop on the balance is at breakeven already.  When my second target is achieved the stop on the remaining 1/3^rd locks in a few ticks.  On that final piece I keep tightening and tightening and I am quite happy if my final exit is achieved with that trailing stop.

My second program is swing trading in 30+ markets, some of which can be relatively thin especially at night.  Here I use an emergency stop which is a long way from the current price.  If something dramatic changes I want to be taken out.  I must have that stop in place just in case of emergency as I also do not watch these markets intra-day, nor when I am asleep either!  However when a multi-day swing trade fails to perform I try to manage the exit by working limit orders to scratch the trade or to accept a smaller loss.  It is extremely rare to be stopped out of these trades with a full sized loss as the stop is there to cater for emergencies only.

So on your next trade as you place your protective stop, just check with yourself “exactly why am I placing this stop?”  Without absolute certainty in your answer, the chances are the stop is in the wrong place.

Disclaimer, risk warning and copyright notice apply to all articles published on this site.

Copyright © Simon Townshend Ltd 2010, all rights reserved