Money Management and Trading Tactics
posted under
Philosophy of Technical Analysis
by ceecabolos
INTRODUCTION
The previous chapters presented the major technical methods used to forecast and trade financial markets. In this chapter, we'll round out the trading process by adding to the task of market forecasting the crucial elements of trading tactics (or timing) and the often overlooked aspect of money management. No trading program can be complete without all three elements.
THE THREE ELEMENTS OF SUCCESSFUL TRADING
Any successful trading program must take into account three important factors: price forecasting, timing, and money management.
1. Price forecasting indicates which way a market is expected to trend. It is the crucial first step in the trading decision. The forecasting process determines whether the trader is bullish or bearish. It provides the answer to the basic question of whether to enter the market from the long or short side. If the price forecast is wrong, nothing else that follows will work.
2. Trading tactics, or timing, determines specific entry and exit points. Timing is especially crucial in futures trading. Because of the low margin requirements and the resulting high leverage, there isn't much room for error. It's quite possible to be correct on the direction of the market, but still lose money on a trade if the timing is off. Timing is almost entirely technical in nature. Therefore, even if the trader is fundamentally oriented, technical tools must be employed at this point to determine specific entry and exit points.
3. Money management covers the allocation of funds. It includes such areas as portfolio makeup, diversification, how much money to invest or risk in any one market, the use of stops, reward-to-risk ratios, what to do after periods of success or adversity, and whether to trade conservatively or aggressively.
The simplest way to summarize the three different elements is that price forecasting tells the trader what to do (buy or sell), timing helps decide when to do it, and money management determines how much to commit to the trade. The subject of price forecasting has been covered in the previous chapters. We'll deal with the other two aspects here. We'll discuss money management first because that subject should be taken into consideration when deciding on the appropriate trading tactics.
MONEY MANAGEMENT
After having spent many years in the research department of a major brokerage firm, I made the inevitable switch to managing money. I quickly discovered the major difference between recommending trading strategies to others and implementing them
Money Management and Trading Tactics 39S
myself. What surprised me was that the most difficult part of the transition had little to do with market strategies. The way I went about analyzing the markets and determining entry and exit points didn't change much. What did change was my perception of the importance of money management. I was amazed at the impact such things as the size of the account, the portfolio mix, and the amount of money committed to each trade could have on the final results.
Needless to say, I am a believer in the importance of money management. The industry is full of advisors and advisory services telling clients what to buy or sell and when to do it. Very little is said about how much of one's capital to commit to each trade.
Some traders believe that money management is the most important ingredient in a trading program, even more crucial than the trading approach itself. I'm not sure I'd go that far, but I don't think it's possible to survive for long without it. Money management deals with the question of survival. It tells the trader how to handle his or her money. Any good trader should win in the long run. Money management increases the odds that the trader will survive to reach the long run.
Some General Money Management Guidelines
Admittedly, the question of portfolio management can get very complicated, requiring the use of advanced statistical measures. We'll approach it here on a relatively simple level. The following are some general guidelines that can be helpful in allocating one's funds and in determining the size of one's trading commitments. These guidelines refer primarily to futures trading.
1. Total invested funds should be limited to 50% of total capital.
The balance is placed in Treasury Bills. This means that at any one time, no more than half of the trader's capital should be committed to the markets. The other half acts as a reserve during periods of adversity and drawdown. If, for example, the size of the account is $100,000, only $50,000 would be available for trading purposes.
2. Total commitment in any one market should be limited to 1015% of total equity. Therefore, in a $100,000 account, only $10,000 to $15,000 would be available for margin deposit in any one market. This should prevent the trader from placing too much capital in any one trade.
3. The total amount risked in any one market should be limited to 5% of total equity. This 5% refers to how much the trader is willing to lose if the trade doesn't work. This is an important consideration in deciding how many contracts to trade and how far away a protective stop should be placed. A $100,000 account, therefore, should not risk more than $5,000 on a single trade.
4. Total margin in any market group should be limited to 20-25% of total equity. The purpose of this criteria is to protect against getting too heavily involved in any one market group. Markets within groups tend to move together. Gold and silver are part of the precious metals group and usually trend in the same direction. Putting on full positions in each market in the same group would frustrate the principle of diversification. Market commitments in the same group should be controlled.
These guidelines are fairly standard in the futures industry, but can be modified to the trader's needs. Some traders are more aggressive than others and take bigger positions. Others are more conservative. The important consideration is that some form of diversification be employed that allows for preservation of capital and some measure of protection during losing periods. (Although these guidelines relate to futures trading, the general principles of money management and asset allocation can be applied to all forms of investing.)
Diversification Versus Concentration
While diversification is one way to limit risk exposure, it can be overdone. If a trader has trading commitments in too many markets at the same time, a few profitable trades may be diluted by a larger number of losing trades. A tradeoff exists and the proper
balance must be found. Some successful traders concentrate their trading in a handful of markets. That's fine as long as those markets are the ones that are trending at that time. The more negative correlation between the markets, the more diversification is achieved. Holding long positions in four foreign currency markets at the same time would not be a good example of diversification, since foreign currencies usually trend in the same direction against the U.S. dollar.
Using Protective Stops
I strongly recommend the use of protective stops. Stop placement, however, is an art. The trader must combine technical factors on the price chart with money management considerations. We'll show how this is done later in the chapter in the section on tactics. The trader must consider the volatility of the market. The more volatile the market is, the looser the stop that must be employed. Here again, a tradeoff exists. The trader wants the protective stop to be close enough so that losing trades are as small as possible. Protective stops placed too close, however, may result in unwanted liquidation on short term market swings (or "noise"). Protective stops placed too far away may avoid the noise factor, but will result in larger losses. The trick is to find the right middle ground.
REWARD TO RISK RATIOS
The best futures traders make money on only 40% of their trades. That's right. Most trades wind up being losers. How then do traders make money if they're wrong most of the time? Because futures contracts require so little margin, even a slight move in the wrong direction results in forced liquidation. Therefore, it may be necessary for a trader to probe a market several times before catching the move he or she is looking for.
This brings us to the question of reward-to-risk ratios. Because most trades are losers, the only way to come out ahead is to ensure that the dollar amount of the winning trades is greater
than that of the losing trades. To accomplish this, most traders use a reward-to-risk ratio. For each potential trade, a profit objective is determined. That profit objective (the reward) is then balanced against the potential loss if the trade goes wrong (the risk). A commonly used yardstick is a 3 to 1 reward-to-risk ratio. The profit potential must be at least three times the possible loss if a trade is to be considered.
"Letting profits run and cutting losses short" is one of the oldest maxims of trading. Large profits in trading are achieved by staying with persistent trends. Because only a relative handful of trades during the course of a year will generate large profits, it's necessary to maximize those few big winners. Letting profits run is the way that is done. The other side of the coin is to keep losing trades as small as possible. You'd be surprised how many traders do just the opposite.
TRADING MULTIPLE POSITIONS: TRENDING VERSUS
TRADING UNITS
Letting profits run isn't as easy as it sounds. Picture a situation where a market starts to trend, producing large profits in a relatively short period of time. Suddenly, the trend stalls, the oscillators show an overbought situation and there's some resistance visible on the chart. What to do? You believe the market has much higher potential, but you're worried about losing your paper profits if the market should fail. Do you take profits or ride out a possible correction?
One way to resolve that problem is to always trade in multiple units. Those units can be divided into trading and trending positions. The trending portion of the position is held for the long pull. Loose protective stops are employed and the market is given plenty of room to consolidate or correct itself. These are the positions that produce the largest profits in the long run.
The trading portion of the portfolio is earmarked for shorter term in-and-out trading. If the market reaches a first objective,
is near resistance and overbought, some profits could be taken or a tight protective stop utilized. The purpose is to lock up or protect profits. If the trend then resumes, any liquidated positions can be reinstated. It's best to avoid trading only one unit at a time. The increased flexibility that is achieved from trading multiple units makes a big difference in overall trading results.
WHAT TO DO AFTER PERIODS OF SUCCESS AND ADVERSITY
What does a trader do after a losing or a winning streak? Suppose your trading equity is down by 50%. Do you change your style of trading? If you've already lost half of your money, you now have to double what you have remaining just to get back to where you were in the first place. Do you get more selective choosing trades, or keep doing the same things you were doing before? If you become more conservative, it will be that much harder to win back your losses.
A more pleasant dilemma occurs after a winning streak. What do you do with your winnings? Suppose you've doubled your money. One alternative is to put your money to maximum use by doubling the size of your positions. If you do that, however, what will happen during the inevitable losing period that's sure to follow? Instead of giving back 50% of your winnings, you'll wind up giving it all back. So the answers to these two questions aren't as simple or obvious as they might first appear.
Every trader's track record is a series of peaks and troughs, much like a price chart. The trend of the equity chart should be pointing upward if the trader is making money on balance. The worst time to increase the size of one's commitments is after a winning streak. That's much like buying into an overbought market in an uptrend. The wiser thing to do (which goes against basic human nature) is to begin increasing one's commitments after a dip in equity. This increases the odds that the heavier commitments will be made near the equity troughs instead of the peaks.
TRADING TACTICS
Upon completion of the market analysis, the trader should know whether he or she wants to buy or sell the market. By this time, money management considerations should have dictated the level of involvement. The final step is the actual purchase or sale. This can be the most difficult part of the process. The final decision as to how and where to enter the market is based on a combination of technical factors, money management parameters, and the type of trading order to employ. Let's consider them in that order.
Using Technical Analysis in Timing
There's nothing really new in applying the technical principles discussed in previous chapters to the timing process. The only real difference is that timing covers the very short term. The time frame that concerns us here is measured in days, hours, and minutes as opposed to weeks and months. But the technical tools employed remain the same. Rather than going through all of the technical methods again, we'll limit our discussion to some general concepts.
1. Tactics on breakouts
2. The breaking of trendlines
3. The use of support and resistance
4. The use of percentage retracements 5. The use of gaps
Tactics on Breakouts: Anticipation or Reaction?
The trader is forever faced with the dilemma of taking a position in anticipation of a breakout, taking a position on the breakout itself, or waiting for the pullback or reaction after the breakout occurs. There are arguments in favor of each approach or all three combined. If the trader is trading several units, one unit can be taken in each instance. If the position is taken in antici‑
pation of an upside breakout, the payoff is a better (lower) price if the anticipated breakout takes place. The odds of making a bad trade, however, are increased. Waiting for the actual breakout increases the odds of success, but the penalty is a later (higher) entry price. Waiting for the pullback after the breakout is a sensible compromise, providing the pullback occurs. Unfortunately, many dynamic markets (usually the most profitable ones) don't always give the patient trader a second chance. The risk involved in waiting for the pullback is the increased chance of missing the market.
This situation is an example of how trading multiple positions simplifies the dilemma. The trader could take a small position in anticipation of the breakout, buy some more on the breakout, and add a little more on the corrective dip following the breakout.
The Breaking of Trendlines
This is one of the most useful early entry or exit signals. If the trader is looking to enter a new position on a technical sign of a trend change or a reason to exit an old position, the breaking of a tight trendline is often an excellent action signal. Other technical factors must, of course, always be considered. Trendlines can also be used for entry points when they act as support or resistance. Buying against a major up trendline or selling against a down trendline can be an effective timing strategy.
Using Support and Resistance
Support and resistance are the most effective chart tools to use for entry and exit points. The breaking of resistance can be a signal for a new long position. Protective stops can then be placed under the nearest support point. A closer protective stop could be placed just below the actual breakout point, which should now function as support. Rallies to resistance in a downtrend or declines to support in an uptrend can be used to initiate new positions or add to old profitable ones. For purposes of placing protective stops, support and resistance levels are most valuable.
Using Percentage Retracements
In an uptrend, pullbacks that retrace 40-60% of the prior advance can be utilized for new or additional long positions. Because we're talking primarily about timing, percentage retracements can be applied to very short term action. A 40% pullback after a bullish breakout, for example, might provide an excellent buying point. Bounces of 40-60% usually provide excellent shorting opportunities in downtrends. Percentage retracements can be used on intraday charts also.
Using Price Gaps
Price gaps on bar charts can be used effectively in the timing of purchases or sales. After an upmove, for example, underlying gaps usually function as support levels. Buy a dip to the upper end of the gap or a dip into the gap itself. A protective stop can be placed below the gap. In a bear move, sell a rally to the lower end of the gap or into the gap itself. A protective stop can be kept over the gap.
Combining Technical Concepts
The most effective way to use these technical concepts is to combine them. Remember that when we're discussing timing, the basic decision to buy or sell has already been made. All we're doing here is fine tuning the entry or exit point. If a buy signal has been given, the trader wants to get the best price possible. Suppose prices dip into the 40-60% buying zone, show a prominent support level in that zone, and/or have a potential support gap. Suppose further that a significant up trendline is nearby.
All of these factors used together would improve the timing of the trade. The idea is to buy near support, but to exit quickly if that support is broken. Violation of a tight down trendline drawn above the highs of a downside reaction could also be used as a buying signal. During a bounce in a downtrend, the breaking of a tight up trendline could be a shorting opportunity.
COMBINING TECHNICAL FACTORS AND MONEY MANAGEMENT
Besides using chart points, money management guidelines should play a role in how protective stops are set. Assuming an account size of $100,000, and using the 10% criteria for maximum commitment, only $10,000 is available for the trade. The maximum risk is 5%, or $5,000. Therefore, protective stops on the total position must be placed in such a way that no more than $5,000 would be lost if the trade doesn't work.
A closer protective stop would permit the taking of larger positions. A looser stop would reduce the size of the position. Some traders use only money management factors in determining where to place a protective stop. It's critically important, however, that the protective stop be placed over a valid resistance point for a short position or below a valid support point for a long position. The use of intraday charts can be especially effective in finding closer support or resistance levels that have some validity.
TYPES OF TRADING ORDERS
Choosing the right type of trading order is a necessary ingredient in the tactical process. We'll concern ourselves only with some of the more common types of orders: market, limit, stop, stop limit, and market-if-touched (M.I.T.).
1. The market order simply instructs your broker to buy or sell at the current market price. This is usually preferable in fast market conditions or when the trader wants to ensure that a position is taken and to protect against missing a potentially dynamic market move.
2. The limit order specifies a price that the trader is willing to pay or accept. A buy limit order is placed below the current market price and states the highest price the trader is willing to pay for a purchase. A sell limit order is placed over the current market price and is the lowest price the seller is
willing to accept. This type of resting order is used, for example, after a bullish breakout when the buyer wants to buy a downside reaction closer to support.
3. A stop order can be used to establish a new position, limit a loss on an existing position, or protect a profit. A stop order specifies a price at which an order is to be executed. A buy stop is placed over the market and a sell stop under the market (which is the opposite of the limit order). Once the stop price is hit, the order becomes a market order and is executed at the best price possible. On a long position, a sell stop is placed below the market to limit a loss. After the market moves higher, the stop can be raised to protect the profit (a trailing stop). A buy stop could be placed above resistance to initiate a long position on a bullish breakout. Since the stop order becomes a market order, the actual "fill" price may be beyond the stop price, especially in a fast market.
4. A stop limit order combines both a stop and a limit order. This type of order specifies both a stop price where the trade is activated and a limit price. Once the stop is elected, the order becomes a limit order. This type of order is useful when the trader wants to buy or sell a breakout, but wants to control the price paid or received.
5. The market-if-touched (M.I.T.) order is similar to a limit order, except that it becomes a market order when the limit price is touched. An M.I.T. order to buy would be placed under the market like a limit order. When the limit price is hit, the trade is made at the market. This type of trade has one major advantage over the limit order. The buy limit order placed under the market does not guarantee a fill even if the limit price is touched. Prices may bounce sharply from the limit price, leaving the order unfilled. An M.I.T. order is most useful when the trader wants to buy the dip, but doesn't want to risk missing the market after the limit price is hit.
Each of these orders is appropriate at certain times. Each has its own strong and weak points. Market orders guarantee a position, but may result in "chasing" the market. Limit orders provide more control and better prices, but risk missing the market. Stop limit orders also risk missing the market if prices gap beyond the limit price. Stop prices are strongly recommended to limit losses and protect profits. However, the use of a buy or sell stop to initiate new positions may result in bad fills. The market-if-touched order is particularly useful, but is not allowed on some exchanges. Familiarize yourself with the different types of orders and learn their strengths and weaknesses. Each of them has a place in your trading plan. Be sure to find out which types of orders are permitted on the various financial exchanges.
FROM DAILY CHARTS TO INTRADAY PRICE CHARTS
Because timing deals with very short term market action, intraday price charts are especially useful. Intraday charts are indispensable for day trading purposes, although that's not our focus here. We're mainly interested in how intraday activity can be used to aid the trader in the timing of purchases and sales once the basic decision to enter or exit a market has been made.It bears repeating that the trading process must begin with a long range view and then gradually work toward the shorter term. Analysis begins with monthly and weekly charts for long term perspective. Then the daily chart is consulted, which is the basis for the actual trading decision. The intraday chart is the last one viewed for even greater precision. The long term chart gives a telescopic view of a market. The intraday chart allows more microscopic study. The technical principles already discussed are clearly visible on these very sensitive charts.
THE USE OF INTRADAY PIVOT POINTS
In order to achieve earlier entry with even tighter protective stops, some traders try to anticipate where a market will close by the use of pivot points. This technique combines seven key price levels with four time periods. The seven pivot points are the previous day's high, low, and close and the current day's open, high, low, and close. The four time periods are applied to the current trading day. They are the open, 30 minutes after the open, midday (about 12:30 New York time), and 35 minutes before the close.
These are average times and can be adjusted to the individual markets. The idea is to use pivot points only as a timing device when the trader believes a market is topping or bottoming. Buy or sell signals are given as the pivot points are broken during the day. The later in the day the signal is given, the stronger it is.
As an illustration of a buy signal, if the market opens above the previous day's close, but is below the previous day's high, a buy stop is placed above the previous day's high. If the buy stop is elected, a protective sell stop is placed below the current day's low. At 35 minutes before the close, if no position has been taken, a buy stop is placed above the current day's high, with a protective stop under today's open. No action is generally taken during the first 30 minutes of trading. As the day progresses, the pivot points are narrowed as are the protective stops. As a final requirement on a buy signal, prices must close above both the previous day's closing price and today's opening price.
SUMMARY OF MONEY MANAGEMENT AND TRADING GUIDELINES
The following list pulls together most of the more important elements of money management and trading.
1. Trade in the direction of the intermediate trend.
2. In uptrends, buy the dips; in downtrends, sell bounces.
3. Let profits run, cut losses short.
4. Use protective stops to limit losses.
5. Don't trade impulsively; have a plan.
6. Plan your work and work your plan.
7. Use money management principles.
8. Diversify, but don't overdo it.
9. Employ at least a 3 to 1 reward-to-risk ratio.
10. When pyramiding (adding positions), follow these guidelines.
a. Each successive layer should be smaller than before.
b. Add only to winning positions.
c. Never add to a losing position.
d. Adjust protective stops to the breakeven point. 11. Never meet a margin call; don't throw good money after bad.
12. Close out losing positions before the winning ones.
13. Except for very short term trading, make decisions away from the market, preferably when the markets are closed.
14. Work from the long term to the short term.
15. Use intraday charts to fine-tune entry and exit.
16. Master interday trading before trying intraday trading.
17. Try to ignore conventional wisdom; don't take anything said in the financial media too seriously.
18. Learn to be comfortable being in the minority. If you're right on the market, most people will disagree with you.
19. Technical analysis is a skill that improves with experience and study. Always be a student and keep learning.
20. Keep it simple; more complicated isn't always better.
APPLICATION TO STOCKS
The trading tactics that we've covered in this chapter (and the analytical tools in preceding chapters) also apply to the stock market, with some minor adjustments. While futures traders focus on short to intermediate trends, stock investors are more concerned with intermediate to longer term trends. Stock trading places less emphasis on the very short term and makes less use of intraday charts. But the general principles remain the same for analyzing and trading markets—whether they're in the futures pits of Chicago or on the floor of the New York Stock Exchange.
ASSET ALLOCATION
The money management guidelines presented in this chapter refer mainly to futures trading. However, many of the principles included in that discussion relate to the need for proper diversification in one's investment portfolio and touches on the subject of asset allocation. Asset allocation refers to how a person's portfolio is divided among stocks, bonds, and cash
(usually in the form of a money market fund or Treasury Bills). It can also refer to how much of one's portfolio should be allocated to foreign markets. Asset allocation also refers to how one's stockholdings are spread among the various market sectors and industry groups. And, more recently, it deals with how much of one's portfolio should be allocated to traditional commodity markets.
MANAGED ACCOUNTS AND MUTUAL FUNDS
Managed accounts have been available in the futures markets for several years and have provided a vehicle for those wishing to put some money into futures but lacked the expertise to do so themselves. Managed accounts have provided a sort of mutual fund approach to futures. Even though managed futures accounts invest in all futures markets—including currencies, commodities, bonds, and stock index futures—they still provide some measure of diversification from bonds and stocks. Part of the diversification is due to their practice of trading from both the long and the short side. Another part comes from the commodity portion itself. However, the ability to devote some of one's assets to commodities was made even easier during 1997.
Oppenheimer Real Assets, launched in March 1997, is the first mutual fund devoted exclusively to commodity investing. By investing in commodity-linked notes, the fund is able to fashion a commodity portfolio that tracks the Goldman Sachs Commodity Index, which includes 22 commodity markets. Since commodities often trend in opposite directions to bonds and stocks, they provide an excellent diversification vehicle. Proper diversification requires spreading one's assets among market groups or classes that have a low correlation to each other—in other words, they don't always trend in the same direction. Commodities certainly fit that criteria.
We point these things out for two reasons. One is to show that the areas of money management and asset allocation are very much intertwined. The second is to show that the markets them‑
selves are very much intertwined. In the next two chapters, you'll see how closely linked the futures and stock markets really are, and why it's important that stock investors keep informed of what's going on in the futures markets. Chapter 17 will introduce you to intermarket technical analysis.
MARKET PROFILE
We couldn't leave the subject of intraday charts without introducing one of the most innovative approaches to intraday trading called Market Profile. This trading technique was developed by J. Peter Steidlmayer, a former floor trader on the Chicago Board of Trade. Mr. Steidlmayer's approach has gained an enthusiastic following over the past decade, especially in the futures markets. Market Profile can, however, be applied to common stocks as well. It's not an easy approach to grasp. But those traders that have done so give it very high marks. Dennis Hynes, an expert in Market Profile trading, explains the approach in Appendix B.
The previous chapters presented the major technical methods used to forecast and trade financial markets. In this chapter, we'll round out the trading process by adding to the task of market forecasting the crucial elements of trading tactics (or timing) and the often overlooked aspect of money management. No trading program can be complete without all three elements.
THE THREE ELEMENTS OF SUCCESSFUL TRADING
Any successful trading program must take into account three important factors: price forecasting, timing, and money management.
1. Price forecasting indicates which way a market is expected to trend. It is the crucial first step in the trading decision. The forecasting process determines whether the trader is bullish or bearish. It provides the answer to the basic question of whether to enter the market from the long or short side. If the price forecast is wrong, nothing else that follows will work.
2. Trading tactics, or timing, determines specific entry and exit points. Timing is especially crucial in futures trading. Because of the low margin requirements and the resulting high leverage, there isn't much room for error. It's quite possible to be correct on the direction of the market, but still lose money on a trade if the timing is off. Timing is almost entirely technical in nature. Therefore, even if the trader is fundamentally oriented, technical tools must be employed at this point to determine specific entry and exit points.
3. Money management covers the allocation of funds. It includes such areas as portfolio makeup, diversification, how much money to invest or risk in any one market, the use of stops, reward-to-risk ratios, what to do after periods of success or adversity, and whether to trade conservatively or aggressively.
The simplest way to summarize the three different elements is that price forecasting tells the trader what to do (buy or sell), timing helps decide when to do it, and money management determines how much to commit to the trade. The subject of price forecasting has been covered in the previous chapters. We'll deal with the other two aspects here. We'll discuss money management first because that subject should be taken into consideration when deciding on the appropriate trading tactics.
MONEY MANAGEMENT
After having spent many years in the research department of a major brokerage firm, I made the inevitable switch to managing money. I quickly discovered the major difference between recommending trading strategies to others and implementing them
Money Management and Trading Tactics 39S
myself. What surprised me was that the most difficult part of the transition had little to do with market strategies. The way I went about analyzing the markets and determining entry and exit points didn't change much. What did change was my perception of the importance of money management. I was amazed at the impact such things as the size of the account, the portfolio mix, and the amount of money committed to each trade could have on the final results.
Needless to say, I am a believer in the importance of money management. The industry is full of advisors and advisory services telling clients what to buy or sell and when to do it. Very little is said about how much of one's capital to commit to each trade.
Some traders believe that money management is the most important ingredient in a trading program, even more crucial than the trading approach itself. I'm not sure I'd go that far, but I don't think it's possible to survive for long without it. Money management deals with the question of survival. It tells the trader how to handle his or her money. Any good trader should win in the long run. Money management increases the odds that the trader will survive to reach the long run.
Some General Money Management Guidelines
Admittedly, the question of portfolio management can get very complicated, requiring the use of advanced statistical measures. We'll approach it here on a relatively simple level. The following are some general guidelines that can be helpful in allocating one's funds and in determining the size of one's trading commitments. These guidelines refer primarily to futures trading.
1. Total invested funds should be limited to 50% of total capital.
The balance is placed in Treasury Bills. This means that at any one time, no more than half of the trader's capital should be committed to the markets. The other half acts as a reserve during periods of adversity and drawdown. If, for example, the size of the account is $100,000, only $50,000 would be available for trading purposes.
2. Total commitment in any one market should be limited to 1015% of total equity. Therefore, in a $100,000 account, only $10,000 to $15,000 would be available for margin deposit in any one market. This should prevent the trader from placing too much capital in any one trade.
3. The total amount risked in any one market should be limited to 5% of total equity. This 5% refers to how much the trader is willing to lose if the trade doesn't work. This is an important consideration in deciding how many contracts to trade and how far away a protective stop should be placed. A $100,000 account, therefore, should not risk more than $5,000 on a single trade.
4. Total margin in any market group should be limited to 20-25% of total equity. The purpose of this criteria is to protect against getting too heavily involved in any one market group. Markets within groups tend to move together. Gold and silver are part of the precious metals group and usually trend in the same direction. Putting on full positions in each market in the same group would frustrate the principle of diversification. Market commitments in the same group should be controlled.
These guidelines are fairly standard in the futures industry, but can be modified to the trader's needs. Some traders are more aggressive than others and take bigger positions. Others are more conservative. The important consideration is that some form of diversification be employed that allows for preservation of capital and some measure of protection during losing periods. (Although these guidelines relate to futures trading, the general principles of money management and asset allocation can be applied to all forms of investing.)
Diversification Versus Concentration
While diversification is one way to limit risk exposure, it can be overdone. If a trader has trading commitments in too many markets at the same time, a few profitable trades may be diluted by a larger number of losing trades. A tradeoff exists and the proper
balance must be found. Some successful traders concentrate their trading in a handful of markets. That's fine as long as those markets are the ones that are trending at that time. The more negative correlation between the markets, the more diversification is achieved. Holding long positions in four foreign currency markets at the same time would not be a good example of diversification, since foreign currencies usually trend in the same direction against the U.S. dollar.
Using Protective Stops
I strongly recommend the use of protective stops. Stop placement, however, is an art. The trader must combine technical factors on the price chart with money management considerations. We'll show how this is done later in the chapter in the section on tactics. The trader must consider the volatility of the market. The more volatile the market is, the looser the stop that must be employed. Here again, a tradeoff exists. The trader wants the protective stop to be close enough so that losing trades are as small as possible. Protective stops placed too close, however, may result in unwanted liquidation on short term market swings (or "noise"). Protective stops placed too far away may avoid the noise factor, but will result in larger losses. The trick is to find the right middle ground.
REWARD TO RISK RATIOS
The best futures traders make money on only 40% of their trades. That's right. Most trades wind up being losers. How then do traders make money if they're wrong most of the time? Because futures contracts require so little margin, even a slight move in the wrong direction results in forced liquidation. Therefore, it may be necessary for a trader to probe a market several times before catching the move he or she is looking for.
This brings us to the question of reward-to-risk ratios. Because most trades are losers, the only way to come out ahead is to ensure that the dollar amount of the winning trades is greater
than that of the losing trades. To accomplish this, most traders use a reward-to-risk ratio. For each potential trade, a profit objective is determined. That profit objective (the reward) is then balanced against the potential loss if the trade goes wrong (the risk). A commonly used yardstick is a 3 to 1 reward-to-risk ratio. The profit potential must be at least three times the possible loss if a trade is to be considered.
"Letting profits run and cutting losses short" is one of the oldest maxims of trading. Large profits in trading are achieved by staying with persistent trends. Because only a relative handful of trades during the course of a year will generate large profits, it's necessary to maximize those few big winners. Letting profits run is the way that is done. The other side of the coin is to keep losing trades as small as possible. You'd be surprised how many traders do just the opposite.
TRADING MULTIPLE POSITIONS: TRENDING VERSUS
TRADING UNITS
Letting profits run isn't as easy as it sounds. Picture a situation where a market starts to trend, producing large profits in a relatively short period of time. Suddenly, the trend stalls, the oscillators show an overbought situation and there's some resistance visible on the chart. What to do? You believe the market has much higher potential, but you're worried about losing your paper profits if the market should fail. Do you take profits or ride out a possible correction?
One way to resolve that problem is to always trade in multiple units. Those units can be divided into trading and trending positions. The trending portion of the position is held for the long pull. Loose protective stops are employed and the market is given plenty of room to consolidate or correct itself. These are the positions that produce the largest profits in the long run.
The trading portion of the portfolio is earmarked for shorter term in-and-out trading. If the market reaches a first objective,
is near resistance and overbought, some profits could be taken or a tight protective stop utilized. The purpose is to lock up or protect profits. If the trend then resumes, any liquidated positions can be reinstated. It's best to avoid trading only one unit at a time. The increased flexibility that is achieved from trading multiple units makes a big difference in overall trading results.
WHAT TO DO AFTER PERIODS OF SUCCESS AND ADVERSITY
What does a trader do after a losing or a winning streak? Suppose your trading equity is down by 50%. Do you change your style of trading? If you've already lost half of your money, you now have to double what you have remaining just to get back to where you were in the first place. Do you get more selective choosing trades, or keep doing the same things you were doing before? If you become more conservative, it will be that much harder to win back your losses.
A more pleasant dilemma occurs after a winning streak. What do you do with your winnings? Suppose you've doubled your money. One alternative is to put your money to maximum use by doubling the size of your positions. If you do that, however, what will happen during the inevitable losing period that's sure to follow? Instead of giving back 50% of your winnings, you'll wind up giving it all back. So the answers to these two questions aren't as simple or obvious as they might first appear.
Every trader's track record is a series of peaks and troughs, much like a price chart. The trend of the equity chart should be pointing upward if the trader is making money on balance. The worst time to increase the size of one's commitments is after a winning streak. That's much like buying into an overbought market in an uptrend. The wiser thing to do (which goes against basic human nature) is to begin increasing one's commitments after a dip in equity. This increases the odds that the heavier commitments will be made near the equity troughs instead of the peaks.
TRADING TACTICS
Upon completion of the market analysis, the trader should know whether he or she wants to buy or sell the market. By this time, money management considerations should have dictated the level of involvement. The final step is the actual purchase or sale. This can be the most difficult part of the process. The final decision as to how and where to enter the market is based on a combination of technical factors, money management parameters, and the type of trading order to employ. Let's consider them in that order.
Using Technical Analysis in Timing
There's nothing really new in applying the technical principles discussed in previous chapters to the timing process. The only real difference is that timing covers the very short term. The time frame that concerns us here is measured in days, hours, and minutes as opposed to weeks and months. But the technical tools employed remain the same. Rather than going through all of the technical methods again, we'll limit our discussion to some general concepts.
1. Tactics on breakouts
2. The breaking of trendlines
3. The use of support and resistance
4. The use of percentage retracements 5. The use of gaps
Tactics on Breakouts: Anticipation or Reaction?
The trader is forever faced with the dilemma of taking a position in anticipation of a breakout, taking a position on the breakout itself, or waiting for the pullback or reaction after the breakout occurs. There are arguments in favor of each approach or all three combined. If the trader is trading several units, one unit can be taken in each instance. If the position is taken in antici‑
pation of an upside breakout, the payoff is a better (lower) price if the anticipated breakout takes place. The odds of making a bad trade, however, are increased. Waiting for the actual breakout increases the odds of success, but the penalty is a later (higher) entry price. Waiting for the pullback after the breakout is a sensible compromise, providing the pullback occurs. Unfortunately, many dynamic markets (usually the most profitable ones) don't always give the patient trader a second chance. The risk involved in waiting for the pullback is the increased chance of missing the market.
This situation is an example of how trading multiple positions simplifies the dilemma. The trader could take a small position in anticipation of the breakout, buy some more on the breakout, and add a little more on the corrective dip following the breakout.
The Breaking of Trendlines
This is one of the most useful early entry or exit signals. If the trader is looking to enter a new position on a technical sign of a trend change or a reason to exit an old position, the breaking of a tight trendline is often an excellent action signal. Other technical factors must, of course, always be considered. Trendlines can also be used for entry points when they act as support or resistance. Buying against a major up trendline or selling against a down trendline can be an effective timing strategy.
Using Support and Resistance
Support and resistance are the most effective chart tools to use for entry and exit points. The breaking of resistance can be a signal for a new long position. Protective stops can then be placed under the nearest support point. A closer protective stop could be placed just below the actual breakout point, which should now function as support. Rallies to resistance in a downtrend or declines to support in an uptrend can be used to initiate new positions or add to old profitable ones. For purposes of placing protective stops, support and resistance levels are most valuable.
Using Percentage Retracements
In an uptrend, pullbacks that retrace 40-60% of the prior advance can be utilized for new or additional long positions. Because we're talking primarily about timing, percentage retracements can be applied to very short term action. A 40% pullback after a bullish breakout, for example, might provide an excellent buying point. Bounces of 40-60% usually provide excellent shorting opportunities in downtrends. Percentage retracements can be used on intraday charts also.
Using Price Gaps
Price gaps on bar charts can be used effectively in the timing of purchases or sales. After an upmove, for example, underlying gaps usually function as support levels. Buy a dip to the upper end of the gap or a dip into the gap itself. A protective stop can be placed below the gap. In a bear move, sell a rally to the lower end of the gap or into the gap itself. A protective stop can be kept over the gap.
Combining Technical Concepts
The most effective way to use these technical concepts is to combine them. Remember that when we're discussing timing, the basic decision to buy or sell has already been made. All we're doing here is fine tuning the entry or exit point. If a buy signal has been given, the trader wants to get the best price possible. Suppose prices dip into the 40-60% buying zone, show a prominent support level in that zone, and/or have a potential support gap. Suppose further that a significant up trendline is nearby.
All of these factors used together would improve the timing of the trade. The idea is to buy near support, but to exit quickly if that support is broken. Violation of a tight down trendline drawn above the highs of a downside reaction could also be used as a buying signal. During a bounce in a downtrend, the breaking of a tight up trendline could be a shorting opportunity.
COMBINING TECHNICAL FACTORS AND MONEY MANAGEMENT
Besides using chart points, money management guidelines should play a role in how protective stops are set. Assuming an account size of $100,000, and using the 10% criteria for maximum commitment, only $10,000 is available for the trade. The maximum risk is 5%, or $5,000. Therefore, protective stops on the total position must be placed in such a way that no more than $5,000 would be lost if the trade doesn't work.
A closer protective stop would permit the taking of larger positions. A looser stop would reduce the size of the position. Some traders use only money management factors in determining where to place a protective stop. It's critically important, however, that the protective stop be placed over a valid resistance point for a short position or below a valid support point for a long position. The use of intraday charts can be especially effective in finding closer support or resistance levels that have some validity.
TYPES OF TRADING ORDERS
Choosing the right type of trading order is a necessary ingredient in the tactical process. We'll concern ourselves only with some of the more common types of orders: market, limit, stop, stop limit, and market-if-touched (M.I.T.).
1. The market order simply instructs your broker to buy or sell at the current market price. This is usually preferable in fast market conditions or when the trader wants to ensure that a position is taken and to protect against missing a potentially dynamic market move.
2. The limit order specifies a price that the trader is willing to pay or accept. A buy limit order is placed below the current market price and states the highest price the trader is willing to pay for a purchase. A sell limit order is placed over the current market price and is the lowest price the seller is
willing to accept. This type of resting order is used, for example, after a bullish breakout when the buyer wants to buy a downside reaction closer to support.
3. A stop order can be used to establish a new position, limit a loss on an existing position, or protect a profit. A stop order specifies a price at which an order is to be executed. A buy stop is placed over the market and a sell stop under the market (which is the opposite of the limit order). Once the stop price is hit, the order becomes a market order and is executed at the best price possible. On a long position, a sell stop is placed below the market to limit a loss. After the market moves higher, the stop can be raised to protect the profit (a trailing stop). A buy stop could be placed above resistance to initiate a long position on a bullish breakout. Since the stop order becomes a market order, the actual "fill" price may be beyond the stop price, especially in a fast market.
4. A stop limit order combines both a stop and a limit order. This type of order specifies both a stop price where the trade is activated and a limit price. Once the stop is elected, the order becomes a limit order. This type of order is useful when the trader wants to buy or sell a breakout, but wants to control the price paid or received.
5. The market-if-touched (M.I.T.) order is similar to a limit order, except that it becomes a market order when the limit price is touched. An M.I.T. order to buy would be placed under the market like a limit order. When the limit price is hit, the trade is made at the market. This type of trade has one major advantage over the limit order. The buy limit order placed under the market does not guarantee a fill even if the limit price is touched. Prices may bounce sharply from the limit price, leaving the order unfilled. An M.I.T. order is most useful when the trader wants to buy the dip, but doesn't want to risk missing the market after the limit price is hit.
Each of these orders is appropriate at certain times. Each has its own strong and weak points. Market orders guarantee a position, but may result in "chasing" the market. Limit orders provide more control and better prices, but risk missing the market. Stop limit orders also risk missing the market if prices gap beyond the limit price. Stop prices are strongly recommended to limit losses and protect profits. However, the use of a buy or sell stop to initiate new positions may result in bad fills. The market-if-touched order is particularly useful, but is not allowed on some exchanges. Familiarize yourself with the different types of orders and learn their strengths and weaknesses. Each of them has a place in your trading plan. Be sure to find out which types of orders are permitted on the various financial exchanges.
FROM DAILY CHARTS TO INTRADAY PRICE CHARTS
Because timing deals with very short term market action, intraday price charts are especially useful. Intraday charts are indispensable for day trading purposes, although that's not our focus here. We're mainly interested in how intraday activity can be used to aid the trader in the timing of purchases and sales once the basic decision to enter or exit a market has been made.It bears repeating that the trading process must begin with a long range view and then gradually work toward the shorter term. Analysis begins with monthly and weekly charts for long term perspective. Then the daily chart is consulted, which is the basis for the actual trading decision. The intraday chart is the last one viewed for even greater precision. The long term chart gives a telescopic view of a market. The intraday chart allows more microscopic study. The technical principles already discussed are clearly visible on these very sensitive charts.
THE USE OF INTRADAY PIVOT POINTS
In order to achieve earlier entry with even tighter protective stops, some traders try to anticipate where a market will close by the use of pivot points. This technique combines seven key price levels with four time periods. The seven pivot points are the previous day's high, low, and close and the current day's open, high, low, and close. The four time periods are applied to the current trading day. They are the open, 30 minutes after the open, midday (about 12:30 New York time), and 35 minutes before the close.
These are average times and can be adjusted to the individual markets. The idea is to use pivot points only as a timing device when the trader believes a market is topping or bottoming. Buy or sell signals are given as the pivot points are broken during the day. The later in the day the signal is given, the stronger it is.
As an illustration of a buy signal, if the market opens above the previous day's close, but is below the previous day's high, a buy stop is placed above the previous day's high. If the buy stop is elected, a protective sell stop is placed below the current day's low. At 35 minutes before the close, if no position has been taken, a buy stop is placed above the current day's high, with a protective stop under today's open. No action is generally taken during the first 30 minutes of trading. As the day progresses, the pivot points are narrowed as are the protective stops. As a final requirement on a buy signal, prices must close above both the previous day's closing price and today's opening price.
SUMMARY OF MONEY MANAGEMENT AND TRADING GUIDELINES
The following list pulls together most of the more important elements of money management and trading.
1. Trade in the direction of the intermediate trend.
2. In uptrends, buy the dips; in downtrends, sell bounces.
3. Let profits run, cut losses short.
4. Use protective stops to limit losses.
5. Don't trade impulsively; have a plan.
6. Plan your work and work your plan.
7. Use money management principles.
8. Diversify, but don't overdo it.
9. Employ at least a 3 to 1 reward-to-risk ratio.
10. When pyramiding (adding positions), follow these guidelines.
a. Each successive layer should be smaller than before.
b. Add only to winning positions.
c. Never add to a losing position.
d. Adjust protective stops to the breakeven point. 11. Never meet a margin call; don't throw good money after bad.
12. Close out losing positions before the winning ones.
13. Except for very short term trading, make decisions away from the market, preferably when the markets are closed.
14. Work from the long term to the short term.
15. Use intraday charts to fine-tune entry and exit.
16. Master interday trading before trying intraday trading.
17. Try to ignore conventional wisdom; don't take anything said in the financial media too seriously.
18. Learn to be comfortable being in the minority. If you're right on the market, most people will disagree with you.
19. Technical analysis is a skill that improves with experience and study. Always be a student and keep learning.
20. Keep it simple; more complicated isn't always better.
APPLICATION TO STOCKS
The trading tactics that we've covered in this chapter (and the analytical tools in preceding chapters) also apply to the stock market, with some minor adjustments. While futures traders focus on short to intermediate trends, stock investors are more concerned with intermediate to longer term trends. Stock trading places less emphasis on the very short term and makes less use of intraday charts. But the general principles remain the same for analyzing and trading markets—whether they're in the futures pits of Chicago or on the floor of the New York Stock Exchange.
ASSET ALLOCATION
The money management guidelines presented in this chapter refer mainly to futures trading. However, many of the principles included in that discussion relate to the need for proper diversification in one's investment portfolio and touches on the subject of asset allocation. Asset allocation refers to how a person's portfolio is divided among stocks, bonds, and cash
(usually in the form of a money market fund or Treasury Bills). It can also refer to how much of one's portfolio should be allocated to foreign markets. Asset allocation also refers to how one's stockholdings are spread among the various market sectors and industry groups. And, more recently, it deals with how much of one's portfolio should be allocated to traditional commodity markets.
MANAGED ACCOUNTS AND MUTUAL FUNDS
Managed accounts have been available in the futures markets for several years and have provided a vehicle for those wishing to put some money into futures but lacked the expertise to do so themselves. Managed accounts have provided a sort of mutual fund approach to futures. Even though managed futures accounts invest in all futures markets—including currencies, commodities, bonds, and stock index futures—they still provide some measure of diversification from bonds and stocks. Part of the diversification is due to their practice of trading from both the long and the short side. Another part comes from the commodity portion itself. However, the ability to devote some of one's assets to commodities was made even easier during 1997.
Oppenheimer Real Assets, launched in March 1997, is the first mutual fund devoted exclusively to commodity investing. By investing in commodity-linked notes, the fund is able to fashion a commodity portfolio that tracks the Goldman Sachs Commodity Index, which includes 22 commodity markets. Since commodities often trend in opposite directions to bonds and stocks, they provide an excellent diversification vehicle. Proper diversification requires spreading one's assets among market groups or classes that have a low correlation to each other—in other words, they don't always trend in the same direction. Commodities certainly fit that criteria.
We point these things out for two reasons. One is to show that the areas of money management and asset allocation are very much intertwined. The second is to show that the markets them‑
selves are very much intertwined. In the next two chapters, you'll see how closely linked the futures and stock markets really are, and why it's important that stock investors keep informed of what's going on in the futures markets. Chapter 17 will introduce you to intermarket technical analysis.
MARKET PROFILE
We couldn't leave the subject of intraday charts without introducing one of the most innovative approaches to intraday trading called Market Profile. This trading technique was developed by J. Peter Steidlmayer, a former floor trader on the Chicago Board of Trade. Mr. Steidlmayer's approach has gained an enthusiastic following over the past decade, especially in the futures markets. Market Profile can, however, be applied to common stocks as well. It's not an easy approach to grasp. But those traders that have done so give it very high marks. Dennis Hynes, an expert in Market Profile trading, explains the approach in Appendix B.
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