Minimise frequency and quantum by putting stop losses in place. Exit trades on hitting the same.
Most traders seek foolproof methods of asset selection. But no such method exists. There is enough randomness in any efficient market to guarantee many losing trades, whatever the asset selection method.
The common sense way to handle this is to accept the risk of frequent losses and minimise the quantum of loss. This means setting stop losses. To set stops, the trader must ask a couple of key questions and act on them. One is, how much is he prepared to lose on a given trade? A second related question is, how often do such methods lose money?
If stops are placed on the basis of honest answers to those questions, almost any trading system may work. Losses can be controlled simply by exiting when a stop is hit. If winners are found, through luck or analysis, and profits on winners is maximised, good enough.
For example, say a trader has a 50 per cent strike rate and hopes to make 2 per cent return on his total trading capital every time he finds a winner. If he sets stops to restrict losses to 1 per cent of total capital per losing trade, the system will be successful.
This logic leads into the related areas of position-sizing and risk-equalisation. Both sound complicated but are easier to grasp in principle than many asset selection theories. Experienced traders, who play only one market, often take roughly equal positions on all trades. If they use disciplined stop losses, this may be enough to ensure that gains outweigh losses.
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But it doesn’t allow for the fact that different assets have different volatility. Even if the positions are the same size, the swings can be much more with a more volatile asset.
For example, while trading a volatile 2-beta stock and a stodgy 0.5-beta stock, the risk on the 2-beta stock is four times higher than the 0.5-beta stock.
Apart from uneven volatility, equal positioning is impossible when trading a large number of markets and contracts. Broadening the range of potential trades has the advantage of diversification and improves chances of finding suitable contracts. But different markets have different margin requirements and lot sizes.
This brings us to risk-equalisation, which is actually the guiding principle behind position-sizing. The trader ideally wants equal risk on every position. In the example given above, risk-equalisation implies that a position in the more volatile 2-beta asset should be only one-fourth as large as a position on the less volatile 0.5 beta asset.
However, even if understanding the concept is easy in principle, there are several ways to calculate likely risk and they all have error margins. The most common calculation is value-at-risk (VAR). VAR assumes returns are normally distributed and sets the trader’s likely maximum loss level at an average return of plus/minus two or three standard deviations (SD). The flaw is that asset-return distributions are not normal – moves can extend well beyond three SD.
Another cruder method multiplies the maximum swing session by two. That is, the trader finds the largest high-low range of an asset in a given time period and assumes he may lose twice that amount.
A third method is ‘average true range’ (ATR). The trader compares the differences between a session high-low, the difference between the session high and the close of the previous session, and the difference between previous close and this session low. He takes the largest absolute magnitude of these three, as the ‘true range’ (TR) and averages TR over a given period. The ATR or a multiple of ATR is assumed as maximum loss.
All these methods work reasonably as rules of thumb for risk equalisation. The unit risk value can be multiplied by lot size to estimate likely risk per contract. Any two assets can be compared this way for risk-equalisation. If a trader is prepared to set a stop at say, 2 per cent of total capital, he can calculate how large a position he can hold, once he knows risk per unit.
Working out a risk equalisation method is less intellectually demanding or stimulating than elegant asset selection methods. But it is a sounder way to manage trades, especially in choppy markets where trends switch rapidly.
One system I have seen demonstrated in the past two months is being long/short in alternate sessions in the 10 highest volume stock futures. The guys who use it, make money when they're on the right side of the trend. They cut off the losses when they're wrong. There's no magic to the asset selection. The positive returns are due to a disciplined focus on risk equalisation.