Chapter 5

In This Chapter

* Creating trading rules

* Knowing when to take the money and run

* Keeping losses under control

* Getting to know the stop-loss order

In technical trading, you use indicators that help you identify what the price is doing — trending, going sideways, making a peak or a bottom, and so on. Indicators give you useful information about price dynamics, but it’s up to you to build trading rules around them. Indicators are about price changes. Trading rules are about you and your money.

In this chapter, I talk about developing trading rules that match up with your indicator skills, your appetite for risk, and your choice of time frame. Special emphasis is on stop-loss rules — don’t leave home without one.

It’s when you sell that counts. Notice that the focus is on money, not on the security and not on the indicator. To trade is to plan the purchase and sale and to have an emergency exit plan if prices don’t develop according to the expectations that your indicators give you. This chapter covers the process of melding indicator-based trading with your own personal risk management.

Building Trading Rules

The technical trader seeks to plan the trade from entry to exit. This is the opposite of traditional investing, where you buy a security for an indefinite period of time and seldom establish in advance the level at which you will sell. But if you want to increase your capital stake or preserve capital, it’s when you sell that counts. You sell for one of two reasons — you met a profit target or a loss limit. In technical trading, making money is more important than having indicators that forecast perfectly.

Exits are harder than entries. Brokers say, “It’s easier to buy than to sell.” Nobody knows why this is so. On an entry you have hope and expectation — ideas and feelings — but on an exit, you have either a profit or a loss — cold, hard cash.

<Remember>

The paramount rule in technical trading is to control losses. You can pick so-so securities and apply so-so indicators to them, and if you’re trading systematically, you can still make a decent net gain if you only control losses. The process of successful technical trading rests on two pillars:

* Control losses.

* Take some money off the table once in a while and put it in a risk-free or low-risk investment, like a bond or a savings account.

These two ideas are so critical that the rest of the chapter is dedicated to them. First, though, I need to answer some common questions and clarify what a trading rule is and how it works.

Answering common questions about trading

<Tip>

The overall subject of money management is a big one and I can’t hope to cover more than some basics here. The first question is usually, “How much should I put into technical trading? Ten percent of my capital? Fifty percent?” No single correct answer exists. You have to decide this one on your own. However, take a look at the following list for answers to specific questions that I do have answers for:

* How many securities should I trade? As a general rule, you want more than one as a form of diversification (which reduces the risk of losing it all in a single crash) but less than twenty (which would require too much analysis even for a full-time trader). Three to five securities are about right, especially for a newcomer.

* Which securities? This is trickier.

* Diversification reduces risk, so pick securities whose price moves aren’t correlated. To pick two securities that move in the identical way is to get the identical return from trading them, and because you will have losing trades, you risk the doubling of losses.

* Pick securities whose moves you have the best chance of identifying, given the indicators you select. If you prefer slow-changing, lagging indicators like moving averages, you want to trade securities that are slow moving and highly trending. If you like trend-following, don’t pick a choppy, high-volatility security, which is better traded with different indicators.

* Use information or insight about certain securities or classes of securities. Farmers, knowledgeable about farm crops, trade wheat and corn futures. If you can read the mind of the Fed, trade bond futures. If you know about the computer industry, trade IBM, Cisco, and Dell. It can pay to supplement your technical work with the perspective that comes from fundamental knowledge.

* How do you allocate your capital among the securities you’re trading? You can divide it up equally, or you can allocate a higher percentage to the security getting the most winning trades over the past 30 or 90 days. You can also allocate more to the security that just gave you a loss. Counterintuitive as this may sound, it’s nonetheless one of the top approaches discussed by strategists.

Establishing your rules

To plan your trades, you need trading rules. A trading rule is the specific action you take when certain conditions are met. Trading rules are also called by the fancier names risk management and money management. At the most basic, a trading rule instructs you to buy or sell when an indicator meets a preset criterion (like the moving average crossover in the case in Chapter 4). Most indicators have a buy/sell trading rule already embedded in them, as I describe in each of the chapters about indicators (Chapters 6 through 17).

<Remember>

But technical trading is a mindset that goes beyond using indicators. The purpose of trading rules is to qualify the action signaled by indicators and to guide you when the market delivers a surprise instead of what you expect. Trading rules improve your trading performance by refining the buy/sell signals you get from indicators. Trading rules tend to be more complex and contain more conditions than indicators, such as “Buy after the first 45 minutes if x and y also occur.” Or, “Sell half the position when z occurs.”

Having an emergency plan

You can be the best indicator analyst in the world and still be a lousy trader. That’s because indicators are only indicators. They’re often wrong. Conditions change and contingencies arise, as described in Chapter 3.

Those of us in the technical trading business have heard the story dozens of times — the novice trader transformed $2,000 into $250,000 in his first six months. He then lost most of it, or even all of it, and has been trying for the past ten years to get the groove back. He labors mightily into the wee hours over complex formulas. He thinks the magic lies in designing the perfect indicator. He complains that the market is less trended these days.

But there is no magic and there is no perfect indicator. The market didn’t change its degree of trendedness, either. The trader is simply failing to acknowledge that he got lucky with the right indicator at the right time on the right security. He’s now using different indicators and overriding them willy-nilly. But of all the errors, the biggest was not having a plan to control his losses, which cost him $250,000.

<Remember>

You need an emergency plan to take care of these three problems:

* The indicator is wrong. One of the inherent challenges of using indicators is that you have to follow every buy/sell signal that your indicator generates if you expect to get the same or a similar gain/loss profile as you got in your back-test. One reason to create trading rules is to compensate for the possibility of indicators giving you false signals.

For example, you’re using an indicator that’s fairly sensitive to price changes, and it gives a lot of false signals. But you like the indicator because it gets you into a new move early. Instead of refining the indicator itself, you can modify the indicator-driven decision by specifying that the indicator has to be confirmed by a second indicator. See Chapter 16 for more on confirmation.

* The indicator isn’t wrong but you think it is. The urge to override an indicator signal is strong in the face of unexpected conditions and contingencies. Overriding is hard to do unemotionally — after all, your money is being lost. The point is to override an indicator the same way you developed the indicator in the first place — systematically.

If you’re overriding an indicator using fundamental judgment based on news, obviously you can’t back-test your decisions. You can, however, develop a list of overriding factors and conditions, and take action only when they’re present. At the least, the list limits your ability to override your indicators randomly. For example, you get a new indicator signal at the close on a Friday but you know that Monday is a national holiday and the market won’t reopen until Tuesday. Instead of automatically following the signal, spend the weekend going back over the price history to see if the price typically makes jumps before or after three-day weekends. In other words, using common sense and experience, you should question why an indicator is giving a new signal. And you should have a good reason, preferably based on research, to override it.

* Catastrophes do happen. To determine in advance what you will do under various conditions is especially critical when a price makes a very large and unexpected change. As noted in Chapter 3, large and unexpected changes are very common in markets, because the market is a group of people who sometimes fall into the grip of manias and panics. If you’re positioned the wrong way when a mania or a panic occurs, you need to get out of Dodge — fast.

Taking Money off the Table

When you have a gain in a trade, how much is enough? How do you know when to take profits? Unfortunately, few technical traders offer guidance on this topic or describe a take-profit rule. You never know at the beginning of a trend how long it’ll last or how far it’ll go. It’s therefore very difficult to choose a profit target. In practice, each individual trader develops his own technique. The optimum way to take profit is, in fact, one of the great unexplored frontiers of technical trading.

Relying on indicators

Instead of formulating take-profit rules, most technical traders rely on indicators to signal when a move has ended. The signal is the de facto take-profit rule. Lagging indicators always force you to leave a little profit on the table, because the indicator signals a late exit after the peak or bottom has already passed. Leading indicators can get your exit closer to the top, but at the risk of missing a breakout and new trend. (See Chapter 4 for a description of leading and lagging indicators.)

Using averages

You can use an average to exit. You look back over historical data, see that the indicators generated an average gain of x percent for the same period in the same security, and exit when you have reached that percentage gain. A related technique is to note that the market (the S&P 500 or NASDAQ, say) has returned an average x percent in each of the past five years, and when you reach that same level in your security, it’s time to go.

<Remember>

To base an exit on an average is to violate the principle that tells you to let your winners run. Perhaps this year the return on that indicator or that market will be double x. After all, the variation around an average can be very large. In general, exiting because an average was reached isn’t a good rule.

Securing satisfaction

Every trade has two components: what the price is doing and you. Say that a trade has given you a 50 percent return, or it has reached some specific dollar level, like $10,000. Are you justified in taking the profit? Yes, as long as you’re satisfied with the 50 percent or the $10,000 and won’t succumb to remorse over the lost opportunity if the trend keeps going. You may find that keeping yourself in check when this happens is surprisingly difficult to do. A lot of traders reinstate the same position. To exit only to get back in the same trade is obviously inefficient. You miss part of the move, you pay the bid-offer spread and commissions twice, and the only benefit is that you’re taking no risk while you’re temporarily out of the market.

Worse, to take a profit and then get back into the same trade shows that you don’t know why you’re trading. The purpose of trading is to make money, but to get back into the trade after making a satisfactory amount of money is to say that you’re not treating trading as a way to make money. Instead, you view it as a way to have fun, feel the excitement of the trade, and satisfy your ego (for having selected a winning trade).

Controlling Losses

Your level of risk seeking or risk aversion is personal. Therefore, nobody can design rules for you. You must do it for yourself. Ask yourself whether you’d faithfully follow every buy/sell signal generated by a given indicator when the back-test of the indicator predicts you will have some individual trades that entail a loss of 50 percent of your trading capital. No?

<Remember>

Well, how much of your trading capital are you prepared to lose? This isn’t an idle question. Put down the book and stare at the wall and think about it. Your answer is critical to whether you can succeed in technical trading. If you say you’ll accept no losses at all, forget technical trading. You will take losses in technical trading. If you say that you’re willing to lose 50 percent in a single trade — whoa, Nellie! That’s too much. Two losing trades and you would be out of business. The right amount to lose on any trade is somewhere between nothing and everything-in-two-trades. Here’s help in arriving at your personal number.

<Remember>

Experienced traders ask themselves, “How much will I lose today?” when they wake up every morning. In contrast, beginners find losses almost impossible to contemplate. And yet if you don’t control losses, it’s not a question of whether you go broke, but of when you go broke (as a famous trader named W.D. Gann wrote on the very first page of one of his books).

Selling out of a losing trade is the single hardest thing to do in trading. For one thing, it means that your indicator let you down. Maybe indicator-based trading is wrong. No! Indicators are valuable tools — they just can’t do the entire job alone. Accept that your indicators have shortcoming and that your job is to overcome those shortcomings by using money management rules.

A bigger problem is that your bruised ego. To sell a losing position means you failed. The standard response to a loss is denial. “It will come back!” you cry. In the long run, this may be true. But in the long run, you may be broke and unable to take advantage of the price coming back. Look again at the table in Figure 1-1, which shows the percentage gain that you need to recover a loss. To recover a 50 percent loss, you need to make a 100 percent gain.

Every top trader admits to taking bigger losses than they had planned. Many go out of business for a period of time, only to come back later with essentially the same indicators — and better ways to manage the trade. In fact, some investors say that the best time to place money with a professional trader is right after he has taken a fat loss — because then he’s a better trader. Note that such investors aren’t predicting he will be a better indicator analyst but a better trader.

The Stop-Loss Order

The stop-loss order is the tool you use for overcoming the unreliability of indicators (as well as your own emotional response to losses). A stop-loss order is an order you give your broker to get you out of a trade if it goes against you by some amount. If you’re a buyer, it’s a sell order. If you’re a seller, it’s a buy order. The stop-loss order is sometimes called a protective stop because it protects you from losing your entire stake.

Mental stops are hogwash

<Remember>

In keeping with the principle of planning the entire trade, you should enter your stop-loss order at the same time you enter the position. Why some traders don’t do this is a psychological mystery. It’s probably the triumph of hope of a spectacular gain (glorious wishful thinking) over the fear of a small loss (dreary reality check).

Many traders say they keep a mental stop in their heads, but this is a delusion. The trader is conning himself into thinking

* He’ll be watching the price every minute the market is open and will have the gumption to sell at a loss if the limit is reached.

* No catastrophic shock is going to happen while he has a position.

One of the main reasons to have a stop is to guard against catastrophic shocks; therefore it’s vanity to suppose a shock can’t happen on your watch. In practice, traders with mental stops sit hopelessly by as the trade goes further and further against them. They may pretend that they’re busy re-analyzing the situation, but analysis-paralysis is a rationalization.

Other traders say that the security they’re trading doesn’t lend itself to stop-loss orders, because it’s too volatile. Or they’re such big traders that the market would find out where their stops are and maliciously target them. The most pernicious of the excuses is that the trader routinely has his stop hit, only to see the price move back in the direction of his original position. This isn’t a reason to avoid using stop-losses. It’s a reason to reset the stop to a better level so this doesn’t happen or happens less often.

<Remember>

To pretend that you have a mental stop or to refuse to place stops is to avoid accepting the reality of trading — it’s a business, and setbacks happen in business. Setting a stop-loss is like buying insurance in case the store burns down. Not to take out insurance is to treat trading as a hobby and to view the amount at stake as play money that won’t be missed if you lose it rather than as risk capital. Every professional firm uses stop-loss orders — and fires the employee who breaks discipline.

Sorting out the types of stops

Technical traders have developed many stop-loss principles. Each concept is either a fixed trading rule or a self-adjusting one. Stops relate to indicators, money, or to time, and often these three don’t line up neatly to give you an easy decision. You have to choose the type of stop that works best for you.

The 2-percent stop rule

<Remember>

Probably the most famous stop-loss rule is the fixed 2-percent rule that was employed by a trading group named the Turtles. The 2-percent rule states that you should stop a loss when it reaches 2 percent of starting equity. If you’re trading risk capital of $10,000, you can afford to lose no more than $200 on any single trade if you expect to stay in business for a long period of time. The 2-percent rule is an example of a money stop, which names the amount of money you’re willing to lose in a single trade.

Two hundred dollars may sound like a tiny number to you, but in the context of active trading, it’s quite large. You need only 50 losing trades in a row to go broke. And 50 trades may sound like a lot of trades, but you’ll find that many valid indicators have you trading that often, depending on your time frame. If you’re trading 15-minute bars, you could have a lot more than 100 trades in a year.

Also, you may think it would be rare to have 50 consecutive losses in a single security, but if you’re trading several securities, 50 is no longer a large number. If you’re trading five securities, for example, you go broke after ten consecutive losses per security.

<Tip>

The fact that consecutive losses pile up more quickly when you trade a lot of securities is the chief reason that trading advisors usually recommend that you not trade more than five securities at a time — and that the securities not move in tandem.

Risk/reward money stops

The risk/reward ratio puts the amount of expected gain in direct relationship to the amount of expected loss. Say, for example, that you’re buying Blue Widget stock at $5 and your indicators tell you that the potential gain is $10, which means that the stock could go to $15. You could set your initial stop at $2.50, or 50 percent of your capital stake, for the chance to make $10. That gives you a risk/reward ratio of 10:2.5, or 4:1. (Strangely, the amount of the gain, the reward, is always placed first in the ratio, even though it comes second in the name.) The higher the risk/reward ratio, the more desirable the trade.

But consider the premise — that your ending capital will be triple your initial stake. You should always make a trade on a positive expectation of making a gain. But gee, expecting a 300 percent return is going a bit far, isn’t it? Well, it depends on your skills. If you consistently forecast and get 300 percent gains, time after time, good for you. You may be able to accept a higher initial stop-loss level than other mere mortals. The main reason to avoid aiming for gigantic gains is that the prospect of tripling your money carries an emotional wallop that even the coolest of minds has a hard time resisting.

<Warning>

Calculating the risk/reward ratio and using it to set a stop is dangerous. In the Blue Widget case above, you’re willing to lose 50 percent of your capital. If you lose, you can take only two such trades before you run out of money. Moreover, you can start out with a fixed risk/reward money stop but then change it to an adjustable stop as you modify your idea of how much the trade could potentially gain. Say the price falls from $5, your original entry, to $3.50. But your indicator is still telling you the potential high price is $15. If you buy more at $3.50 and the $15 is indeed reached, your gain is even bigger in percentage terms. This is how traders trick themselves into adding to losing positions, the blackest of cardinal sins in trading.

<Remember>

To apply the risk/reward ratio in a conservative and prudent manner, turn it upside down. Instead of calculating it with your best-case expected gain, use a realistic worst-case estimate of the gain. Your worst-case gain should be higher than your worst-case loss. For example, say you’re prepared to lose $2 for the chance to make $4. Your risk/reward ratio is 4:2, or 2:1. If you practice this exercise on every trade, the risk/reward ratio becomes a filter that winnows out trades that may be high probability but with excessive risk.

To analyze risk/reward ratios is a complex task requiring a knowledge of statistics and probability, and it’s beyond the scope of this chapter. But remember that in technical trading, the general rule is to take small losses and aim for bigger gains, not to take big losses and aim for gigantic gains.

Maximum adverse excursion

Maximum adverse excursion is a concept developed by John Sweeney. Using this method, you calculate the biggest change in the high-low range over a fixed period (say 30 days) that’s equivalent to your usual holding period. Actually, you need to calculate the maximum range from the entry levels you would’ve used. Because you know your entry rules, you can back-test to find the maximum range that was prevalent at each entry. The maximum adverse excursion is the statistically-determined worst-case loss that might occur during the course of your trade, although you may choose to adjust (tweak) the stop according to changes in the volatility of the range as they occur. For example, if the security never changes from high to low by more than $10 over the period, you would set your stop at $11. You should see a regular pattern between the maximum adverse excursion and your winning and losing trades over time. In fact, you can use the inverse of the adverse excursion, the maximum favorable excursion, to select trades in the first place. See Chapter 14 on volatility.

Trailing stops

Trailing stops use a dynamic process that follows the price: You raise the stop as the trade becomes more profitable. This means calling the broker or re-entering the stop electronically every day, depending on how you execute trades. The important point is that you keep the stop updated to protect gains and to guard against unacceptable losses. A trailing stop is set on a money basis — you maintain the loss you can tolerate at a constant dollar amount or percentage basis. You could, for example, say that you’re not willing to part with more than 20 percent of each day’s gain, so you’d raise the stop every day to include 80 percent of today’s again.

Some traders object to the trailing stop on the grounds that the normal average daily trading range will almost certainly encompass the trailing stop level on many occasions. A random event can cause a small spike, for example. Trailing stops are highly protective, but you risk being stopped out on an arbitrary price event that isn’t really related to the overall price trend.

Trailing stops are easily back-tested. Some securities are highly trending and lend themselves to trailing stops, and other securities are volatile and don’t. Of course, the trending security can also alternate periods of high and low volatility, so conducting a back-test can get a little tricky.

Indicator-based stops

Indicator-based stops depend on the price action and the indicators you use to capture it. Indicator stops can be either fixed or self-adjusting. I mention stops at various places throughout the book; here are some important ones:

* Last-three-days rule: The most basic of stop-loss rules is to exit the position if the price surpasses the lowest low (or highest high if you’re going short) of the preceding three days. This sounds a little corny. However, it jibes well with another piece of trading lore that says a trade should turn profitable right away if you’ve done the analysis right and you’re actually buying right after a low or selling right after a peak. If the price first rises for a day or two but can’t hold on to the gain, the upmove that you think you’ve identified is probably a false one. Consider the crowd dynamics (see Chapter 2) and how they play out on the price bar (covered in Chapter 6). You need a series of higher highs and higher lows to name an uptrend. If you get a lower low in the first three days, the probability is good that the trade is going south.

* Pattern stops: Pattern stops relate directly to market sentiment and are very handy. Most are of the fixed variety. I list a few below.

* The break of a support or resistance line is a powerful stop level, chiefly because so many other traders are drawing the same lines.

* The last notable high or low (the “historic” level; see Chapter 4) or the high/low of an important time period, like a year.

* You can infer stops from other pattern indicators, such as the center confirmation point of the W in a double bottom or the M in a double top (see Chapter 9). When the confirmation point is surpassed, the probability is high that the move continues in the expected direction. If you’re positioned the wrong way when the pattern appears, the pattern confirmation is also your stop level.

* Moving-average stop: You can also use a separate indicator that isn’t part of your buy/sell repertoire to set a stop, such as a moving average (see Chapter 10). You may not use a moving average because of its lagging nature, but it may serve well when it comes to getting out of a position that’s going against you. Many traders use the 10-day moving average as a warning to reduce a position, and the 20-day moving average as a stop. It’s interesting how often a retracement will penetrate a 10-day moving average but stop just short of crossing the 20-day. A moving-average stop is clearly of the self-adjusting variety.

Volatility stops are the most complex of the indicator-based, self-adjusting stops to figure out and to apply, but they’re also the most in tune with market action. Many variations are available. Here are the three of particular interest.

* Parabolic stop-and-reverse model: Invented by Welles Wilder, the parabolic concept is easy to illustrate and hard to describe. The principle is to create an indicator that rises by a factor of the average true range (see Chapter 7) as new highs are being recorded, so that the indicator accelerates as ever higher highs are met and decelerates as less high highs come in. In an uptrend, the indicator is plotted just below the price line. It diverges from the price line in a hot rally, and converges to the price line as the rally loses speed. See Figure 5-1. The parabolic stop is both self-adjusting and trailing; a rare combination.

* Average true range stop: This stop is set just beyond the maximum normal range limits. The average true range channel is described in Chapter 14. You take the average daily high-low range of the price bars, adjusted for gaps, and expand it by adding on a constant, like 25 percent of the range. Say your average daily trading range is $3. If the price goes more than 25 percent beyond the $3 high-low range, you consider it an extreme price and the signal to exit. The average true range stop has the virtue of being self-adjusting, but it also has the drawback of setting a stop that has nothing to do with your entry.

* Chandelier exit: This stop solves entry-level issue. Invented by Chuck LeBeau, the chandelier exit sets the stop at a level below the highest high or the highest close since your entry. You set the level as a function of the average true range. The logic is that you’re willing to lose only one range worth (or two or three) from the best price that occurred since you put on the trade. Like the parabolic stop, the chandelier is both self-adjusting and trailing.

<Remember>

Indicator stops usually entail taking a loss greater than the 2-percent benchmark rule. This hands you a hard decision. If you take the 2-percent rule, you have to live with the remorse of exiting trades only to see the price move your way later on. If you take an indicator rule that entails losses greater than 2 percent of your capital, but have a series of losing trades early in your trading career, you could lose a lot of money before you figure out how to adapt and apply indicators.

Time stops

Time stops acknowledge that when money is tied up in a trade that’s going nowhere, it could be put to better use in a different trade. Say you’re holding a position with the expectation (from your indicators) that it’ll rise or fall — but nothing happens. The price goes sideways. At some point, you lose patience and exit the position. This isn’t a lack of patience. After all, time is money. The money could be invested in a risk-free asset yielding some return, however small. Alternatively, the money could be put to work in a security that is moving. Professionals keep a list of tradable securities and rank them according to their trendedness and thus their ability to deliver a profit, mindful that the purpose of trading is to make money.

Clock and calendar stops

Clock and calendar stops pertain to a price event happening (or not happening) considering the time of day, week, month, or year. For example, who says the end of the calendar week must be the end of your analytical week? One calendar-based rule, for example, considers that Wednesday is the end of the analytical period. You’d stop out of a long trade if the price fails to deliver a higher close on Wednesday, because the move is weak.

Clock-based rules abound. Some technical traders advise against trading during the first hour in the U.S. stock market, because buy- or sell-on-open orders are being executed then (see Chapter 6). Others say that more gain can be had from the first hour than any other hour of the trading day if you can figure out which way the crowd is trading. As I describe in Chapter 16, one setup trader trick is to buy or sell the direction of an opening gap — and be done for the day an hour later. In foreign exchange, you often see prices retrace at the end of the European trading day — about 11 a.m. in New York — as traders there close positions. Not only is this a swell entry place when you’re sure you know the trend, but it’s also a benchmark for the U.S. trading day. If the price fails to close higher or lower than the European close, it means that American traders are having second thoughts about the trend.

<Tip>

Fortunately, if you’re a data hound, you can analyze all these clock and calendar effects via back-testing.

Adjusting Positions

Stops are the first line of defense against indicator failures and market catastrophes. The challenge in following indicators is that they’re wrong sometimes and don’t respond quickly to catastrophic shocks. But to exit a position is an extreme response when your uncertainty isn’t high. A stop is a blunt instrument when more delicacy may be called for.

Many indicators are black-and-white. You should either buy or sell. They lack nuance. Similarly, stops are a one-way proposition. It’s hardly ever appropriate to override a stop, but what if a nice uptrend is in place and you think your stop is wrong? Sometimes you know things (or think you know things) about the security or the market environment that can’t be reflected in the indicator or the stop. So, if you spot a situation that you think should trigger a stop — but it doesn’t — you have the choice of reducing your position instead of exiting.

Applying discretion is tricky, because you can’t back-test it. But if you can’t help having insights and you think your gut-feel is more often right than wrong, the solution is to systematize applying discretion. You do this by changing the amount of money you place on the price move, which is called position adjustment.

Reducing positions

The safest way to reduce the risk of loss is to reduce exposure to it. If you’ve bought on an indicator-based signal but you think you know of a fundamental reason why it’s not going to be a good trade, the two conflicting ideas may cancel each other out. Similarly, you may have a nicely trending security and get a surprise stop hit that you don’t trust, because you think you can identify the cause as an anomaly. Instead of being paralyzed or not trading at all, you have a few options:

* Delay following the indicator signal until the non-technical event risk is past.

* Stay in the trade but reduce the amount of money you allocate to it (and perhaps tighten the stop while you’re at it).

Some traders advise reducing (or exiting) positions ahead of known event risks, such as central bank meetings, earnings announcements, and national elections.

Adding to positions

You can add to a position when your existing position is highly profitable. Statisticians debate whether you should add to winning positions using unrealized profits from the existing trade, called pyramiding.

To pyramid is to use hypothetical profits to enlarge your position. Say you started with $1,000 and the trade has now generated another $1,000 in paper profits. Why not borrow against that extra $1,000 to buy some more of this high-performing security? The answer is that if a catastrophe strikes and the trade goes against you, your risk of loss can become huge — more than your original stake if your stop fails (or you didn’t place one). Be aware that if you engage in pyramiding, you’re taking a higher risk than if you don’t.

If you want to add to a position, the big question is how to determine the exact amount to add. Just as in determining the amount to allocate to trades in the first place, you can consider the risk/reward ratio — but this contains the wish or hope for the gain and is therefore subjective. You have better options:

* If you’re using a 2-percent stop rule, when the existing position has gained a profit that is greater than the 2 percent of starting capital you’ll lose if the stop is triggered, you add the amount of the surplus profit to the position with its own 2-percent stop. The problem, of course, is that it’s awkward to trade in odd lots, and odd lots don’t even exist in futures.

* For those using margin (where the trader puts down only a fraction of the value of the contract being traded), one rule of thumb is to add to the position when the existing trade has earned the cost of the minimum initial margin of the new position. If you’re trading on a 50 percent margin, you add to the position when the existing position has racked up enough paper gain to fund the new position.

This is an especially valuable rule in the futures market, in which the trader puts down only a small fraction of the value of the contract being traded. For example, to trade the Swiss franc, you have to have at least $1,823 deposited with your broker (as of this writing — the exchange changes the amount from time to time). You don’t want to add a second Swiss franc contract to your position until the first contract has a profit of $1,823. By then, you figure that the move is well in place. But remember, you have to have one stop-loss order on the first contract and a different one on the second trade.

<Warning>

Pyramiding without proper stops has probably caused more traders to go broke than any other cause.

Applying stops to adjusted positions

If you’re using an indicator stop and it signals that the price rise is over, doesn’t that mean you want to exit all positions at the same level as soon as possible? The answer from statisticians is maybe. It depends on whether you’re thinking in chart terms or money management terms. If you’re using a breakout concept to set your stop, for example, the price crossing a support line is a sell signal that would apply equally to all positions.

If you’re using a 2-percent or other rule (like the chandelier exit) that is calculated specifically with reference to your starting point, you exit each trade according to the rule. This has benefits and drawbacks. The benefit is that you’re still in the trade if the stop was triggered for one trade but the price retracement is only a minor, temporary one. You still have other positions left and if the price makes a big jump your way, you’re correctly positioned to take advantage of it. The drawback is that a well-set stop may really identify a change in overall price behavior (such as the average true range stop). If it’s a catastrophic price move, you may not get good execution of your stops and may end up losing more than the amount you planned.

More from the frontier of technical knowledge

Some technical traders say you can estimate the probability of each trade in advance, and therefore it’s not only safe but also wise to vary the amount of your position. In fact, you can probably improve on the expected results of your indicators. Other technical traders feel, usually with vehemence, that it isn’t possible to attach probabilities to specific trades. They say that you can attach probabilities to indicators and to overall rule-based approaches, including stops, but not to specific trades. They say that instead of varying position size, you should vary your stop-loss order.

If market conditions are choppy (high volatility), you might widen your stop even though your own particular security is behaving nicely. In this instance, you fear an overflow effect from the general market to your particular security. You may switch from a money-based trailing stop like the 2-percent rule to a volatility or pattern type of stop. Notice that to change the type of stop you use now entails yet another back-test.

<Warning>

When you see advertisements that describe a “high-probability trading strategy,” be sure to investigate how the author applies stops and whether position adjustment — with stops — was thoroughly back-tested. You also want to see how it worked in real time. Often the “strategy” is just an indicator without any accompanying trading rules that control losses.