Money-Management Risk Strategies

In addition to determining the optimal position size, optimal initial capital, and leverage, risk strategies include the timing and placement of exits.

Entry strategies carry no risk until executed. An entry can be made at any time, when the situation or setup is right, or not at all. Perhaps you would rather go to the beach. Because you must now watch your investment, you cannot go to the beach. Once entered into a position, however, an exit strategy is necessary because the position is now at risk. It is the most important action decision in any system.

Exit strategies are usually twofold: prevention of loss of capital or closing at a target profit or price. Prevention of capital loss can come after a loss, as in a protective stop, or after a profit, as in a trailing stop. There is always a trade-off between potential reward and potential risk. An exit stop placed too tightly to the trading price prevents a single large loss, but many small losses that are equally devastating can occur instead. An exit stop can also be too loose, resulting in a larger-than-necessary loss. It must be wide enough to avoid being triggered by random noise and intrinsic volatility of the issue but not sacrifice too many profitable trades. At other times, a profit may have accrued, and rather than a risk of loss, the question of stop placement or target exit is necessary. All these decisions, naturally, should be tested before the situation arises. There are advantages and disadvantages to all of them.

Slippage is a problem with stops. Any stop that suggests an exit in the direction of the short-term trend rarely will be executed at the same price as the system test suggests. A volatility stop, for example, often will occur when price volatility exceeds the estimated volatility, and a technical stop at a specific price, depending on where it is located within a price pattern, may occur along with many others and receive a poor execution. A target exit often receives a better execution and less slippage because the trend is directed into the target limit. However, it might not be executed at all if the price fails to reach the target, or the price might roar through the target and lose profit opportunity. There is no easy answer about slippage except that these potential problems should be addressed in the testing of a system.

1. Protective Stop

All entries must have a protective stop under all circumstances, and that stop must be inviolate. The protective stop is placed at the level of maximum limit of loss from entry, accounting for the maximum loss that the trader can allow on any one position on any one trade. It is often called a money-management stop because it prevents the complete loss of capital. It is determined by the level of risk that the trader is willing to take with his capital in any one position on any one trade. There are numerous methods of determining where the protective stop should be placed.

2. Hard Money or Dollar Stop

When we decide how much money we are willing to risk in a trade, we can place a protective hard money stop at a price level that reflects that potential loss and no more. In the earlier example of position size risk, we considered a stock trading at $50, with the maximum amount we wanted to risk at $500. We can buy 100 shares at $50 and place a sell stop at $45, or we can buy 200 shares at $50 and place a sell stop at $47.50. The same dollar risk appears to be present in each transaction. This is not accurate, however, because the odds of being triggered at $47.50 are higher than at $45. The consideration of where to place the stop, therefore, should be one based on the best price rather than on how many shares can be bought. Once the price is determined, the amount of shares to purchase can be adjusted accordingly. Let us say there is a large support level at $46. It would be wiser to use the $45 stop than the $47.50 stop, even though fewer shares are originally purchased, because the support level has a better chance of holding the stock from falling through $45 and triggering the stop. Furthermore, as technical traders, we know that if the support level at $46 is broken, we do not want to own the stock. At $47.50, we do not know anything about the stock prospects, and the market does not care.

3. Maximum Winning Adverse Excursion

The protective stop is placed to prevent loss if something goes wrong with the system. A method of determining when the system is going wrong is called the maximum adverse excursion method. Taking each winning trade in the system test or from the past real-time use of the system, one plots the frequency of adverse excursions. These are the amounts by which the value of the entered position in each trade goes against the initial value before it is closed at a profit. It is similar to a drawdown except limited to winning trades. If an entry is made and the trade eventually is a profitable one, the adverse excursion is the amount of money that the trade was in the hole before it turned profitable. Some profitable trades immediately profit. These are not a problem. Looking at those winning trades that do have initial problems, you will find that, over time, the excursion from entry value reaches a limit. If the system is trouble free, that price is the level beyond which a profitable trade should not go in the future. A price just beyond that level is where the protective stop should be placed. Losing trade adverse excursions are not considered because they will become a problem and will be stopped out at the protective stop. Once the maximum adverse excursion from winning trades is established, it also determines how many contracts or shares can be entered on the system entry signal. If the maximum adverse excursion for one contract is greater than the maximum limit of loss allowed by the trader, the position should not be taken. Otherwise, the number of shares or contracts can be determined by dividing the maximum adverse excursion by the margin required for the contract or the price of the shares. The maximum winning adverse excursion should be recalculated periodically to maintain consistent with any changes in the market or the system.

4. Trailing Stop

With the protective stop in place and inviolate, the market issue will either trigger that stop or will begin to profit. Once a certain amount of profit in the trade has occurred, the next problem for the system is to maximize the profit without giving up too much of what has been gained. A trailing stop is used most frequently to lock in the gain.

5. Breakeven Level and Breakeven Stop

A trailing stop often is not placed until a certain gain level is accumulated. This is called the breakeven level, the profit level at which a stop can be placed at the entry price to lock in a breakeven on the trade but not be triggered by noise. In the preceding example, we bought the stock at $50, and after a little erratic motion, the stock rose to $55. The ATR (Average True Range) is $1.50. If we had earlier set three times the ATR, or $4.50, as the break-even level, then when the stock reached $54.50 ($50 + $4.50), we would automatically raise the protective stop to a break-even stop at the entry price of $50. This eliminates the risk of any loss on the transaction from then on. At the same time as the break-even stop is placed, a trailing stop strategy is initiated.

Another method of handling the break-even level is to exit half the position when the profit has reached the break-even level. The break-even stop is then raised to the entry price. This method locks in a profit, keeps a portion of the position open, and cannot lose capital once it is entered. The potential for profit is reduced, but a smaller profit has already been stashed, and the risk of loss is zero on the remaining portion. A trailing stop strategy then is applied to the remaining position.

6. Technical Point Versus Money Point

The decision about a trailing stop usually centers on whether to use a technical point or a money point. A money point stop is similar to a hard money stop described previously, only in this case it defines the amount that the trade should not lose from its maximum profit level. If $500 is the money point stop, the stop-price level changes with the value change in the market issue, such that if a correction of more than $500 occurs from the maximum unrealized profit, the system will exit the trade. A technical stop is one placed at a price that represents a technical level beyond which it is obvious that the trade is reversing direction. It is sometimes called a critical threshold stop (Katz and McCormick, 1998) because breaking the specified stop level is critical to the trade. Technical points often are used more in investment and swing trading trailing stops. Money point stops are used more in short-term trading, where price action is often more erratic. The market itself does not accommodate a money point stop because that level is unrelated to the market price and is a matter of the personal risk decision of the trader, but the market does respect the technical stop if properly placed.

7. Volatility Stop

We discussed volatility stops in Chapter 13, “Breakouts, Stops, and Retracements.” A trailing stop is placed at a certain level based on the historical volatility of the issue. As such, the stop price will adjust to changes in volatility; it will loosen when volatility increases and tighten when volatility decreases. It is commonly used for this reason.

8. Maximum Winning Favorable

A maximum winning favorable excursion, as opposed to the adverse used in establishing stops, also can be used to establish a trailing stop. The maximum favorable excursion is the highest amount that a profitable trade reaches before it is exited. It is similar to a target. A fraction of this calculation is added to the entry price, and the fraction is increased over time.

9. Trend Line

A trend line stop can be used because a trend line follows the price action. As a technical point stop, it has advantages in that a bunching of orders at a critical level, such as a support or resistance zone, usually is not seen along a trend line, such that when triggered, the execution of the exit will be less influenced by competing orders.

10. Adaptive

Special formulas, such as Wilder’s parabolic, can be used. These formulas follow the price trend and adjust to market conditions along the way. They and volatility stops also are called adaptive stops, and their details can be complicated.

11. Other Kinds of Stops

We have just considered a number of protective and trailing stop strategies, which are generally based on price action. Other exit strategies may be employed, such as those based on a particular technical signal or those based on time.

11.1. Signal

One obvious stop is the signal stop. This occurs when the system gives a signal to enter a position in the opposite direction from the existing position. It is part of a stop-and-reverse system.

11.2. Time

Because of the multidimensional aspect of time and reward versus risk, a time stop often is used in short­term trading when time, cost of money, and opportunity cost are important. This stop is placed to exit the position a certain time after the entry. If a profit has not been gained within the time specified, the odds of it not occurring in the future increase, and the position is best closed to avoid further risk. A variation of the time stop is to reduce the position size as certain time passes. This reduces the risk but leaves room for some further gain. Time stops are also used in swing trading where the trade horizon is only a few days.

11.3. Targets

In our look at point-and-figure charts and, in some instances, at bar chart patterns, a price target often is established. Exiting at a target can be an exit strategy. In short-term trading, money targets are often used: “If I make $500 on this trade, I’m out.” Targets can be tested as long as the target calculation method is easily quantified. At a target, especially a longer-term target, position size may be reduced or trailing stops tightened using technical barriers, a money stop, or volatility adjustment. In addition, once a target is reached, the system might have a reentry signal that enters the position again if the target is exceeded by a certain amount or the trend continues. Finally, a combination of target and time stop can adjust the target prices as time moves along. This reduces the possibility of the added risk with time affecting profits. All target limits should be accompanied by a trailing stop to avoid losing any profits already gained in case a target is not reached.

11.4. Execution

Execution risk strategies are useful in short-term trading where profit margin often is related to executed prices and slippage. Entry execution in most instances is related to when the system gives a signal. A breakout system often has competition at the breakout level, for example. Exit execution, on the other hand, can be controlled through experiment. A short-term system must establish, when the system is not a stop-and-reverse, the time at which a better exit can be obtained. Should the trade exit on the close for the day, the opening of the next day, or at some time between when volatility usually declines? The opening is usually emotional and can be either an advantage or a disadvantage. The closing is used in most systems because it is the most rational and eliminates overnight risk.

Another means of executing an entry or exit is scaling. This is done more by institutions, which have large positions they need to accumulate or distribute, but it can equally be useful for the smaller-sized trader or investor, who can accommodate more than one standard position size. Scaling is the entering or exiting a position over time in small pieces. The initial execution accomplishes part of the goal of the system, and over time, entries may be added at more advantageous prices. If they do not, at least a small position has been entered.

Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.