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Trading is easy, isn’t it? (Part 2)

By Ernest Lim

Trading is easy, isn’t it? (Part 2)

In my previous article “Trading is easy, isn’t it? [20 Nov 16] (Part 1) click HERE”, I have discussed the importance of one’s psychology in trading. However, I have only given a general outline on risk management and trading system which are also very important topics. In this article, I will elaborate on risk management compiled from various trading books and will add in my thoughts under “→”.

Risk management – What it ACTUALLY means…

Risk management is a set of pre-defined guidelines which serious traders adhere so as to survive in the market over the long term. Risk management enables a trader to have a comfortable and known exposure to risk. It includes rules that define exit points, maximum loss per trade, maximum exposure and other key variables that affect your capital allocation.

Based on various statistics, risk management includes several aspects, viz. position sizing; predetermined stop loss and exit targets; loss management and abstinence from over trading.

1. Position sizing

a) Anti-martingale works better than martingale

This means how much capital we are going to put in each trade. Some people believe that trading is akin to gambling whereby gamblers will double their stake after losing trades. This form of management is called martingale. However, trading experts believe that anti-martingale (and not martingale) is the best risk management method suited for professional traders with a good track record in trading. In other words, we increase our position (i.e. our stakes) in trades when our equity (i.e. our capital) is rising. The rationale is that when we are making money, it is likely to be the result of a successful trading system and consequently, our psychology is better, thus we should capitalize by putting in more money and vice versa.

Anti-martingale risk management can be carried out in a myriad of ways such as equal dollar value model, fixed percentage mode, etc. However, I will not go into detail of the individual methods.

b) Adds to existing positions

Most experts believe that position sizing also refers to knowing when to add to positions that are already profitable, to maximize your returns. This is the difference between professional traders and amateur traders. Amateur traders want to open as many trades as possible, rather than increasing their positions on existing profitable ones.

At the inception of the trades, nobody knows which trades are successful. Once trades start to move well, professional traders will increase their positions according the signals given by their trading systems. For example, some traders may initiate a small position in stock A as it forms a potential reversal signal (e.g. it forms an inverted hammer with bullish divergence signals generated from other indicators). Next, the traders may increase their positions if there is price confirmation on the next day, such as a gap up, or a long white candlestick with heavy volume.

→ EL opinion: Notwithstanding the above, I hasten to add that for myself, it depends on the basis of my trades. If my basis is that the company may have potential catalysts in the next 3-6 months, I may add more positions into the company, even if my existing position is losing money i.e. I may average down.

2. Clear basis of entry

Personally, this is an extremely important point. I noted that some people may buy stocks in anticipation of certain specific events, such as a rumour on corporate action, or potential good set of results in the next 1-2 months. However, if the event does not happen, or if the event happens without any share price movement, they suddenly change their basis and validate their basis of entry with different reasons. However, unless they have unlimited funds, they will find that they eventually will end up with multiple “stuck” positions.

→ EL opinion: My basis of entry is clear. If it is based on one specific basis, such as the company is almost all time oversold, I will initiate opportunistic trades and capitalise on a potential “few bids of profits”. However, if my basis is on a combination of reasons such as strong industry dynamics, robust and growing order books, potential good set of upcoming results (not only one set of results), potential corporate action, under-researched, under-owned and under-valued company, I am likely to hold for some time, say 3-6 months.

3. Know what to avoid

I realise that most clients can monitor many different stocks at the same time. I have some interesting clients who will ask me at least 1-2 different stocks daily, either based on analyst reports, or from media, stock forum or from market rumours.

→ EL opinion: For myself, as previously mentioned, I adhere to two broad strategies. i) buy stocks with potential near term catalysts; ii) long or short stocks with wide analyst coverage which are near all-time overbought / oversold. I am fully aware of my own limitations hence I may disregard approximately 70-80% of what I hear from “hot tips” or “market rumours” etc.

4. Trade with the end in mind

Professional traders trade with the end in mind. This means that before they initiate a position, they will have a pre-determined stop loss, as well as, take profit levels. This is necessary because once we have open positions; our judgment will be naturally affected due to greed and fear.

Most traders would advise that once you have set your stop loss based on either chart reading or some other method, it is not wise to shift it, especially in a losing trade. This is because the stop loss is set so that one will have a clear idea on their potential loss and their risk to reward ratio in the executed trade. If we were to adjust the stop loss level, we would be exposing ourselves to greater loss and invalidate our earlier analysis.

→ For myself, if my basis is based on a series of potential events / catalysts, I may not cut loss on the stock especially if it drops on low volume.

5. Be wary of over trading

Overtrading can occur in two forms. The first situation is when one trades many times a day. The second situation is having too many open trading positions simultaneously.

Overtrading is a subjective issue. Overtrading for some one may be defined as having three or more open positions leading to sloppy judgement and losing trades. However, some traders can handle more than ten positions at any time and all are executed with astute judgement and skill. It is up to one to determine. A rule of thumb to indicate whether one is overtrading is when either one or more of the below situations happen:

  • Spending excessive amounts of time monitoring the market;
  • Your loved ones complain that you are not spending enough time with them;
  • Thinking of trading all the time;
  • Feeling lost during weekends;
  • Experiencing excessive stress and having difficulty sleeping;
  • Having a losing streak in a row.

It is best to identify whether one is over trading and nip it in the bud before this symptom of overtrading affects your daily life and ultimately your trading performance and your health.

→ For myself, due to my job as a stockbroker where I may need to monitor some private banking clients’ portfolios, attend results briefings, meetings with companies’ management, investor relation, analysts, funds, media, clients etc, I am aware of my own limitations. Thus, I do not have excessive short term stock positions. In addition, I do not do multiple intra-day or contra trades. In short, readers should be aware of their trading methodology and evaluate whether it suits their lifestyle and time constraints.

6. How to handle losses

Losses are a taboo to traders, aren’t them? However, although losses are a “No-No” word, we still have to address them. Have you ever heard amateur traders make the following complaints?

  • “It’s the market. The market moved against me.”
  • “I am just down on my luck to have a string of losses”
  • “It’s the dog next door which can’t stop barking and distracted me from executing a winning trade”
  • “My wife can’t stop nagging which causes me to execute a wrong trade!”

Before we can address the issue, it would be good to differentiate between avoidable and unavoidable losses. Avoidable losses occurred either through not closing a losing trade via a stop loss, or not initiating or exiting profitable trades according to our system due to fear or greed. Unavoidable losses are those losses which we cannot prevent despite our adherence to our rigorous trading system.

For avoidable losses, we will have to take responsibility to learn from these mistakes and do not repeat them. Taking a quote from Mr Winston Churchill, “all men make mistakes, but only wise men learn from their mistakes”. Whether we are wise men, depends on our approach to mistakes.

→ For myself, I always allocate a fixed sum of funds to invest / trade for the year in a separate bank account. Once I set aside the funds, I will not add or withdraw funds throughout the year. This segregation of fund allows me to view and manage my portfolio objectively. Over time, it gets easier to manage and to cut loss or take profit as I disassociate feelings with the funds. Having said that, I do a post mortem on my trades regularly, regardless whether they are profitable or loss-making.

Conclusion

After reading this article, I hope that all readers have a better understanding on risk management. It is indeed an integral part of your trading plan.

Stay tuned for the final article on trading system.

Disclaimer
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Ernest Lim
Ernest Lim

Ernest is an avid investor, trader cum remisier. He is a Chartered Financial Analyst® charterholder, as well as, a Chartered Accountant of Singapore. He has published articles on a wide range of topics on finance and investment on his blog http://ernest15percent.com/, ranging from market / sector outlook, technical analysis and fundamental analysis etc. His writeups and comments have been featured in various online and mainstream media such as Bloomberg, Business Times, Lianhe Zaobao, Sharesinvestment, Nextinsight etc.

He has worked at GIC Special Investment and was with Legacy Capital Group Pte Ltd, a boutique asset management and private equity firm, as an investment manager for high net worth clients, after which he went to work as an investment manager before embracing his lifelong passion as a remisier.