Smart Trader

Q: I have a question I feel is unanswered in your book, Trade Your Way….

Once you find a trading system with a positive expectancy, what are a few ways to gauge how real that expectancy is? Obviously you will go on bad runs, but when is it significant enough to realize that your expectancy has changed?

Thank you for your work. —Sam

A: It’s in my book the Definitive Guide to Position Sizing. You’ll find that there are a minimum of six market types:

Up quiet
Up volatile
Sideways quiet
Sideways volatile
Down quiet
Down volatile

The expectancy (and System Quality Number™) of any system will differ significantly with respect to market type.

In addition, you can get a mean (expectancy) and standard deviation of your R-multiple distributions.

Anything more than two standard deviations from the expectancy (especially if it’s localized to market type) is probably an abnormality. — Van

Q: I found the comments about extreme volatility in your latest newsletter very interesting. I knew about the high volatility link to bear markets from reading (although I don’t recall exactly where) and that is why I asked a question on your forum some years back about what kind of trading system works in bear markets. It was highly discussed, but as I recall no one challenged or answered my comments that trend following systems fail in bear markets.

Anyways, I was particularly interested in your comments about the best strategies to trade under those conditions. Do you have any more information on where you learned that information so I can do some further research on the topic? — Richard

A: The systems that work best in high volatility environments are day trading systems that capitalize on volatility and option methods that capture volatility.

Long term trend following (shorting) generally doesn’t work unless you are willing to tolerate huge drawdowns. — Van

Q: Dear Van, I wish to thank you for your most enjoyable commentary on market types. I found the email to be very informative. I am new to currency trading and currently studying as much as I can so that I can develop an edge towards the market before I engage with real time trading.

My interest in currencies began after reading a book called Hot Commodities by Jim Rogers. I recently heard him say on Bloomberg TV that the US dollar is a “flawed currency.”

I have a lot of respect for Mr. Rogers, yet found myself scratching my head at this comment. I would be extremely grateful if you, or someone in your team could be kind enough to clarify this for me.

Best Regards, James

A: I totally understand Roger’s comment. What I don’t understand is how the dollar continues as a world reserve currency.

1) The US is a bankrupt country and there is a report at the St. Louis Federal Reserve site which state this.

2) Our debt is parabolic with no end in sight.

3) Only two things keep the US alive: a. Other countries are willing to buy our debt. b. The US Dollar is still the world’s reserve currency.

Keep in mind that my comments on the dollar are long term…as are Jimmy Rogers’. This probably has no impact on short term currency trading strategies.

Van

Question: I have the book Trade Your Way to Financial Freedom, and am trying to use the concepts as part of a trading business plan that I am putting together.

I can’t figure out how to apply expectancy in the percent volatility position sizing model. Can you please clarify?

Answer: Expectancy is the average reward-to-risk ratio for a set of trades. Expectancy tells you how well those trades performed and how well you might expect similar trades to perform in the future—regardless of the position size for those trades. You want to trade only positive expectancy systems and you also want to keep track of a system’s expectancy.

Position sizing tells you how much to risk on a trade in dollars and also the likely result in dollars. You don’t need an expectancy figure to apply the percent volatility position sizing model. However, to come up with a percent volatility position size you will need the average true range (ATR) for the instrument you would like to trade.

Reader Question: After reading (in 3 days) “Trade Your Way to Financial Freedom” I am stumped by a seeming contradiction. After analyzing personal account trades over the past 6 months, it seems clear I need to be much, much bigger in my trades. However, the trades are already 10% positions in my IRA. When I calculate the position size suggested by your formula in the book, my position sizes should be 25%….yet throughout the book, I am reminded to keep position sizes at 1% of equity. The book was extremely useful but I continue to scratch my head about this topic. Regards, J.L.

A: You are mixing up position size and initial risk. The 1% you are referring to is the initial risk amount. That’s the amount of money you are willing to risk or lose on a trade often expressed in terms of percent of equity. Position sizing is the total dollar amount of a trade or total shares, which is also often stated as a percent of equity. Additionally, your risk amount or 1R should generally not exceed 1% of your equity and any single position size should generally not exceed 20% of your equity.

Use the CPR Method written about in the book and calculate your risk first to determine your position size for a trade. If you had a $100,000 account and were willing to lose $1,000 on a trade, you would risk 1% of your equity. $1,000 is your 1R. Say you liked a stock at $10 with an $8 stop price. You would buy 500 shares ($1,000/$2 per share risk = 500 shares). In this case your position size would be $5,000 which in equity terms is a 5% position. Now say you wanted to buy another stock at $10 because you believe it just hit a major bottom at $9.80. You set your stop price for the trade at $9.75 and you would calculate a 4,000 share position ($1,000/$.25=4,000 shares). This $40,000 position is 40% of your equity. Even though your 1R is at an acceptable 1% of equity, this big of a position exposes an unacceptable share of your equity to market risk or price shocks. Imagine if you had taken on a position this big on the afternoon of Monday, September 10, 2001 or on the eve of some other market moving event. With that much equity exposed in the market in a single position, you could take a hit from which it would be hard to recover. You need to manage both the initial risk amount and the position size.

In your IRA account, it sounds like you have a real life example closer to the second scenario mentioned above where the optimum position size for trades might be larger than your equity allows. This can and does happen— even in leveraged accounts. There are several things you can do about this situation, but the best alternatives really depend on your objectives.

Dr. Tharp is out of the country for the next few weeks, but we’ll continue to post some questions that come up in his absence.

Question: I am concerned about the information you provided in a recent newsletter regarding the rate at which ETFs are being shut down. I’ve been trying to find the answer to the question you raised, “What happens if you own an ETF that gets closed?” Have you found an answer? I’ve been unable to so far.

Answer (from Ken Long): Once it is announced that an ETF will close, there is a period of time (3-4 weeks) that it is still traded. This is currently the case with the Ameristock Treasury bond ETFs, which will cease trading today.

In this time period, investors can buy or sell shares as they normally would. On the day that the ETF closes, all trading stops. The provider then has a period of time (about 2 weeks) to sell the underlying securities within the ETF.

The proceeds are then distributed to the owner of record. The owner will get the value of the securities from when they were sold, not when the ETF stopped trading. So, if you’re holding the ETF when it closes, you’re running the risk that the underlying securities could go down (or up) in value in that time frame.

If you want to know the value you are getting from your ETF, it might be better to sell the shares before the ETF stops trading. Otherwise, you’re left cooling your heels and won’t know what you’re going to get until the securities are sold and proceeds are distributed. It’s up to your risk tolerance.

But the closing of an ETF is an orderly process, and investors are given plenty of warning so they can plan accordingly.

Q: What is the scope of one’s asset base that one should include in the position sizing and risk management analysis? Presumably, folks have longer term investments that are the bulk of the monies they will need in retirement, medium term investments that one can take some medium level of risk, and shorter term (maybe even day trades) investments (many a small percent of one’s overall asset base) that one will subject to greater risk.

Should all these components be included in the position sizing and risk management analysis, or should we have different strategies for managing these different components of one’s asset base?

A: Each account should be subject to some form of position sizing depending upon the objectives of the account. But don’t lump all the funds together. Treat the equity for each account separately.

Reader Question: I really appreciate your work and your email letters. I have a question that perhaps others would also like to have answered.

As background information, I see the big picture on markets and the economy much as you do. I am an intuitive trader as opposed to a system trader and I mainly trade ETFs, both long and short. My goal is to attain a certain percentage gain each month.

What should I do when my goal has been reached? Should I stop trading until the beginning of the next month, cut my risk and just trade smaller or go for even bigger gains?

It seems a shame to risk losing when I have already hit my target but it seems a shame as well to just skip other trading opportunities.

I have been an “investor” for many years but a “trader” for only a few months. Thanks.

Van’s Answer: I don’t see any statement about your objectives. You need to really dig into your objectives and then you can answer the question yourself.

How painful would it be to give back some of those profits? Say 10%? Or 25%?

How painful would it be to give back all of those profits?

You must weigh that against the joy of making bigger profits…say making double your monthly goal.

When you understand your objectives, then you’ll have the answer for yourself.

For example, if the pain of giving back any profits is immense… then stop trading when you meet your goal

If you are willing to give back a certain percentage of them, then trade at a risk level that makes it nearly impossible to give back more than that level of profits.

All of this is in the Definitive Guide to Position Sizing, but thanks for the question because once again it allows me to emphasize the importance of knowing your objectives.

Van: Last week following my article on the ETF GLD, I asked Ken Long, our resident ETF expert, “Does investing in GLD actually affect the price of gold?”

Ken: GLD is kind of in the same category of ETNs (Exchange Traded Notes*) which are promissory notes of the investment house that is guaranteeing performance of the instrument. There are quite a few of those out there that I don’t include in my ETF database for analysis at all for the very reason that there is an extra degree of risk that’s unsettling. GLD isn’t an ETN but it’s true that no one can validate the holdings of the contracts they hold.

With regards to my own personal trading styles and systems, I consider my ETF2 trading system to be a short term system. If I were a fundamentalist with a macro economic opinion and was looking to hedge with gold long term, I wouldn’t use GLD; I’d pay the extra premium to own bullion outright or consider coins.

The worries about GLD have been floating around since day one of the ETF, being fielded, for example in the goldbug groups on Yahoo where the conspiracy theorists argue that it’s really part of a shell game being played to manipulate the price of gold lower. The problem with “conspiracy theorists” is that once in awhile they are right.

There is an argument that can also be made about what your belief in the real value of an ounce of gold in your hand in your possession is worth as well. It’s really a function of the strength of the social contract that respects the ownership of private property, and the willingness of someone else to accept a chunk of shiny metal in exchange for something else. So, the onion skin sets of beliefs about the reality and value of trading instruments is pretty precarious the closer you look at it. That said, I concur that GLD in particular, when compared to other more “normal” ETFs has special risks that are political and controversial in nature.

GLD right now trades about 1.6B dollars a day in dollar volume; my sense is that it follows the spot price rather than pushing the spot price around. The gold contracts are trading something like $20B a day right now.

There are some flat out sound heuristics already available for action: no more than 10% of portfolio position in any single ETF; no use of ETNs whatsoever; maintain short term trading outlook; and after some research, perhaps exclude ETFs that trigger some kinds of alarms like GLD.

Q: I have just read the 2nd edition of “Trade your Way” and I still don’t understand how maximum adverse excursion is determined. Is this an estimate of what earlier trades have done? How can you determine the MAE upon entering a trade when that trade obviously has no history? The way I read the explanation made it sound as if it was the maximum intraday excursion—does this change from day to day or what?

A: When the trade is over look at the maximum excursion against you. If the trade was always profitable, then it is zero, but when it becomes a loss, it is an adversion excurion. The maximum (expressed as an R-multiple) is the MAE.

Say you enter into a trade at 10 with a stop at 8. You never get stopped out and you eventually sell at a profit of $5. However, during the first two weeks of the trade, the price got as low at $8.50. Your MAE is $1.5. And since R = $2, the MAE is 0.75R.