By Jason Pearce

The Art of the Exit

In a prior post, we discussed different ways for a trader to exit positions.  Professional traders assign a lot more importance to their exit strategies than they do to their entry strategies.  They know that it’s the exit that has the biggest impact on whether your trade made or lost money.

We addressed getting out of losing trades and getting out of winning trades.  First, we talked about using stop loss placements in order to limit the initial risk on a trade.

Measuring the Average True Range (ATR) to create a volatility-based stop loss and using price support and resistance were two of the solutions we covered.

Next, we talked about some exit strategies for taking profits in a winning trade.

Using market volatility to determine how much of a move you could expect from the market and then liquidating when the target is reached was one exit idea we touched on.

Taking profits at price support or price resistance was another.

We even discussed the use of an overbought/oversold oscillator for knowing when to bank profits on a winning trade.

Now we’re going to look at a few more ideas.

More Metrics

Another strategy for exiting a profitable trade is to use projections based off the market’s price structure. There are different ways to approach this.

Elliott Wave Theory is popular with many market technicians.  I am not going to dive into a discussion of the details here, but the theory makes specific wave counts in a market and provides criteria of how far each wave should go.

Therefore, someone who uses Elliott Wave could simply liquidate a position whenever the price expectations for the different wave criteria are met.

Fibonacci extensions are another technical analysis tool that can be used to set price targets.

One of the best Fibonacci traders I know enters a market when it makes a pullback to a Fibonacci .382 retracement of a trend and then takes profits when it rallies to one or all of three different price targets.

The first price target is when the market has rallied off the pullback low by .618 (62%) of the size of the rally that preceded it.  This is a Fibonacci contraction target.

For example, a market rallies 150 points off a low and then pulls back.  Once it starts to recover, the target would be about 92.7 points (150 * .618) from the pullback low.

The second price target is symmetrical.  A position is liquidated when the rally off a pullback low is the same size as the rally that preceded it.

In this case, the price symmetry target would be 150 points off the pullback low just like the initial 150-point rally.

The third and final price target is a move that is 62% larger than the initial rally that preceded the pullback.  This is a Fibonacci expansion target.

So if the market makes a pullback after the initial 150-point rally, the price extension target for the new rally would be 242.7 points (150 * 1.618) off the pullback low.

Let It Ride

There’s another camp out there that believes that profit targets are not the right way to extract profits from the market.

This group says you should simply stick with the position until there’s a change in the trend.

Bill Eckhardt, Richard Dennis’ trading partner and co-creator of the successful Turtle trading experiment in the 1980s, said, “One common adage on this subject that is completely wrongheaded is: you can’t go broke taking profits. That’s precisely how many traders do go broke. While amateurs go broke by taking large losses, professionals go broke by taking small profits.”

The thought behind this philosophy is that, when you’ve stumbled into a trade that’s working, the right course of action is usually to do nothing and allow the profits accumulate.  That’s because you have absolutely no idea how for the trend will go.

Markets often move well beyond predictions and expectations and one big move can pay for tons of small losers…but you’ve got to be in for the whole ride in order to benefit from it.

Although it sounds simple, it’s psychologically hard to do.

One reason for that is because of the fear that a winning trade could reverse and all the profits evaporate.  Something about how ”a bird in hand is worth two in the bush” comes to mind.

Not Completely Passive

There’s a Wall Street saying “Cut your losses and let your profits run.”

The part about letting the profits run does not mean you just sit back and let the market runaway for a while, reverse trend, and then come all the way back to where it started.

This method requires a trader to be passive as long as the market moves in their favor…

But once the market starts to give back some of the winnings, then the trader becomes active.

The strategy is simply about progressively “trailing” a stop loss order behind the market and waiting for it to finally reverse before the positions are liquidated.

As long as the market is running away, you stay in the trade and let it continue.  But once it stumbles or reverses, you take the money and run.

Setting Trails

In a prior post on pyramiding, we discussed a couple of ideas for trailing the stop orders to exit a position.  You can go back and read the post for the nitty-gritty of it, but here’s a quick overview.

First, a trader can use the market volatility, preferably a multiple of the Average True Range (ATR), to set the trailing stop level.

The ATR idea is used to keep the stop loss order far enough away from the market to not get hit by random noise, yet still trail off the highest point in the move (or the lowest point in a down trend) to keep locking in more and more profits as the market moves favorably.

The market’s price structure works well for trailing protective stops, too.

If you are trading the long side of an uptrend, the assumption is that the market will continue making higher highs and higher lows.  Therefore, the protective sell stop orders should be moving higher as well.

After a market makes a pullback and then returns to or surpasses the prior high of the move, the protective sell stop could be raised to just below the pullback low.  If the uptrend is still intact, this should be a higher low and should not be breached.

This cycle of ratcheting the stop loss orders higher and higher after each pullback and recovery should continue on indefinitely until the position is finally stopped out.

Moving Averages Are Moving Exits

Don’t forget about the benefits of moving averages.  Not only are they useful for signaling an entry for a market, they work just as well for signaling an exit for a market.

Suppose a market is in an uptrend and is staying consistently above a particular moving average.

You would simply exit once the market closes back under that moving average.

The 50-day moving average and the 200-day moving average are both popular ones to use.  Recall that even Paul Tudor Jones uses the 200-day MA as one of his metrics to determine if he wants to be in a market or not.

Nothing is fool-proof, of course.

Using the 200-day MA for a trailing stop would have knocked you out of the stock market the day after the BREXIT vote in June of 2016, only to see the market turn right around the very next day and start a run to new record highs.

Of course, using the 200-day MA as a trailing stop level would have fortunately kept you in the market during all the uncertainty around last year’s US Presidential election.

If you want to explore this idea further, read the post I wrote that shows my methodology for selecting the best moving averages to use.

Battle of the Bands

Price envelopes like Donchian bands can also be used for trailing stop placements.  This is where the market breaks out above or below the high or low of the last X number of days.

It is reliant on both price and time.

Even if a market hits a price congestion zone and gets stuck there for a while, the stop level set by Donchian bands may still continue to tighten.  This would serve to reduce risk/lock in more profits even when the market seems to be spinning its wheels.

Recall that Richard Dennis’ group of Turtle traders used this price envelope methodology for both entering a market and exiting a market.

History shows that it worked out pretty well for them.

The Trend Is Your Friend

All of these different trailing stop techniques work well in a trending market.

It makes sense because the market is continuing to reach mostly higher highs and set mostly higher lows.  So if you’re giving the market enough elbow room during the short-term corrective or reactive phases, the protective stops should go untouched.

But once the trend pauses or ends…

That’s when the wheels can come off the wagon.  Stop loss orders start to get hit and positions are exited.

If new entry signals are triggered and the market does not follow through, the new protective stops are hit as well and additional losses are doled out.

Welcome to the post-trend life.

It’s a choppy environment out there.  If you don’t have a method for trading ranges, this is when you should take a break and go from being a speculator to being a spectator.

While it is true that the trend is your friend, it’s not known for being a loyal friend.  The day will come when that friend will bail on you.  It’s like Ed Seykota says, “The trend is your friend except at the end where it bends.”

Free Trade

Another technique used to manage a trade is to exit half or at least part of a position once the market has moved favorably and then move the protective stop order on the remaining contracts or shares to breakeven for the rest of the position.

This idea is a combo of both the profit target strategy and the trailing stop strategy.

The objective here is to allow a trader to eliminate the risk on a trade as quickly as possible, yet still have a position to continue making profits from an ongoing trend.

The position then becomes a free trade of sorts.  Some may liken it to the concept of playing with the house’s money because you have taken your original money off the table and no longer have your initial stake at risk.

One of the benefits to this strategy is that it is psychologically rewarding to bag some profits on a trade.  This may both boost confidence and cause a trader to be more patient with the remainder of the position.

One way to determine if the free trade exit strategy could be beneficial to your trading methodology is to back test it against the exit strategy that you are currently using.

If you find that a lot of your losing trades initially had an open profit at some point, what would have happened if you’d initiated this strategy and turned a large position of the losers into breakeven or even small winners?

Before you get too excited, though, remember that this exit strategy also intrinsically means that every single big winning trade you previously had with your original exit strategy would have had the position size reduced –possibly by as much as half– early on.  This would significantly reduce the size of the trades that were previously the big winners.

All things being equal, you have to weigh the results to see if implementing this this exit strategy is worth it.

Did it increase or decrease your bottom line?

Did your batting average go up or down?

Were the trading equity drawdown streaks bigger or smaller, longer or shorter?

You also have to prioritize which of the metrics matter the most to you personally.  It is not a black and white topic.  Some traders are going to be more concerned with the smoothest returns, some traders are going to be more concerned with the biggest returns.

Like every aspect of trading, developing an exit strategy is a custom-fit endeavor.

Option Hedge: The Downside

Another idea to explore is buying options as a hedge against your position in lieu of using a traditional trailing stop loss order as the market moves in your favor.

If you are long the market, you will be buying put options for protection; if you are short the market, you will be buying call options for protection.

There is an immediate downside to this strategy, though.

When you buy an option, you have to pay a premium for it.  This can make a noticeable dent in your profits because you first have to recover that cost of the option via your market position.

That means your breakeven level on the trade was just moved further away from you.

For instance, suppose you are long shares of AAPL in mid-August at a price of $161.

Instead of putting in a sell stop order to liquidate if the position goes against you, perhaps you want to buy some three-month put options with a strike price of $155 to hedge the position.  Currently, the cost or premium is around $5.25 per share.

That means your stock position in AAPL would have to make at least $5.25 and hit $166.25 by the time the option expires just to cover the cost of the hedge.

That represents a three percent gain –annualized at a 12% gain- that will not get booked as a profit.  Instead, you’ll be using that gain on the stock to pay off your option premium.

Option Hedge: The Upside

On the other hand, there are at least two benefits to using options to manage your risk.

First, you have an absolute guarantee on what your risk is.  The difference between the entry price of your position and the strike price of the option plus the option premium is the most that you can possibly lose on the trade.

Using the same example of being long AAPL at $161 and holding a $155 strike put option that costs a premium of $5.25 yields a maximum risk of $11.25 on the position ($161 – $155 + $5.25 = $11.25).

On paper, that’s the equivalent trade risk of being long at $161 with a sell stop order placed seven percent lower at $149.75.

However…

What if AAPL moved against you be a few percentage points and then gapped seven, eight, or even ten percent lower the next day?

The slippage on the sell stop orders could be significantly more than you accounted for, resulting in a bigger-than-expected loss on the trade.

But the loss on the trade with the put option hedge does not increase.

While it’s true that the stock loss is bigger than anticipated, the gain on the put option is correspondingly bigger and offsets the loss side of the trade.

Suddenly, the risk profile of the two strategies is not exactly similar.

A second benefit to this strategy is that using options instead of stop loss orders might help preserve both financial and psychological capital in a trade campaign.

Unlike a traditional sell stop, the option will give you staying power to hold the entire position until option expiration.

If the market plunges and the put option goes deep into the money, you have the luxury of seeing if there’s a potential reversal before option expiration.  You are not forced to liquidate.

This does not happen with the stop loss.  A stop loss triggers your liquidation immediately.  If you want back in, you’ll have to reenter and risk more money.

If you happen to be in a winning trade, you can trail the hedge by simply liquidating the put options and buy new put options with higher strikes as the trend progresses.  This is the equivalent to trailing a protective stop loss order.

I know enough about the Greeks that I don’t immediately think we’re talking about the fraternity on Animal House instead of the different factors for option pricing when they are being discussed.

However, I certainly don’t claim to be the all-knowing option expert on all the various ways to use them.  What I discussed here was one simple way to use options for protection.

If you do want to go down the rabbit hole and delve deeper into a more complete and comprehensive study on the subject of options, I highly recommend that you snatch up a copy of Tony Saliba’s book Managing Expectations.  He’s one of the best option traders in the world with both the track record and the net worth to prove it.

Exit Diversification

Everyone knows about the benefits of diversification in your investment portfolio.

Some traders have also heard about the benefits of diversification in your trading systems as well.

Well, I submit the idea that there may be some benefits to be had by diversification in your exit strategies, too.

I mentioned earlier that a trader could use both profit targets and trailing stops.  But you can drill down even further and use different kinds of profit targets together and different kinds of trailing stops together.

Perhaps you want to cash out of part of your position when a market tags a Bollinger Band and also take a little off the table when a Fibonacci expansion target is reached.

Then maybe you can trail the stops on the rest of the position via a couple of different moving averages like the 50-day and 200-day and also use a trailing volatility stop like 2 or 3 times the 20-day ATR.

The combinations of what you can do here are endless.

Personalize It

This post and the previous one covered several different ways to exit a trade, from stop losses to profit-taking.

I decided to go wide on the topic instead of deep in order to expose you to a myriad of methods that could be useful for getting out of trades.

One strategy is not necessarily better than the other on its own merit; however, some of them may be a better fit for you than others.  Invest the time and test some of these ideas out to discover which strategy or strategies best apply to your trading goals.

But don’t forget that the simple strategies can also be quite potent on their own!

If you find that just one of these exit strategies delivers the results you want, don’t worry about trying to incorporate several different types into your trading if you’re not so inclined.

The most important thing here is that you find a proven exit plan and stick to it.

Want to read a great trading plan? Get Tony Saliba’s new options trading book – FREE

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More Articles by Jason Pearce:

Building Pyramids for Asymmetric Trading Gains Part 2

Building Pyramids for Asymmetric Trading Gains Part I

How Much Leverage is Appropriate in Your Account?

US Dollar: The New Bear Market?

Equities: US Against the World

Profiting From Failure: The Wash & Rinse Trade, Part II

Profiting From Failure: The Wash & Rinse Trade, Part I

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

 

 

 

 

By Jason Pearce

Exit Stage Right

So many traders spend the bulk of their time thinking about how to enter a trade, to the point of even obsessing over it.

Which fool-proof indicator will put them into the trade of the year?

What magical chart patterns are the keys to the kingdom of untold wealth?

How can one be positioned to rake in millions of dollars from the markets over the next few weeks?

For those seeking the Holy Grail on when to get into a trade, there’s a plethora of different books, websites, newsletters, trading gurus, etc. out there that are willing to accommodate paying customers.

But here’s the thing: It’s the novice traders who spend all their time and energy on finding that perfect entry signal.  Professional traders don’t spend too much energy trying to perfect their entries.

After all, they know it’s not where you enter the market that determines your profit or loss on a trade; it’s where you exit the market.

Professional traders have a Stoic attitude towards the market.  They believe that you cannot control the market; the only thing you can control is how you respond to the market.  That means deciding when and where to get out after you get in.

To that end, let’s discuss a few methods that traders can use to exit a market.

Kill the Losers

The winning trades take care of themselves, but the losing trades have to constantly be managed.  You can’t turn your back on them for a minute.  As a matter of fact, a good synonym for a professional trader would be a risk manager.

Victor Sperandeo said that “the single most important reason that people lose money in the financial markets, is that they don’t cut their losses short.”

Before a trader even puts a position on, they need to figure out what the largest acceptable loss would be.

This is accomplished by determining where you to get out of a trade if it doesn’t work out as expected and placing the stop loss at that level, then implementing the correct position-sizing rule.

Once the position is entered, the trader’s primary job is to make sure that they stick to the initial exit plan.

After that, they can start to look for opportunities to reduce the risk on the trade through trailing stops, profit targets, rolling option hedges, etc.

Bad Stop Placement

There are a few ways to determine where to place the initial stop loss to bail you of a losing trade.  One method that’s a popular rookie mistake is setting a dollar amount stop on a trade.

I’ve seen new commodity traders come in and buy a cocoa futures contract and say “place my sell stop $500 below my entry price”, which is the equivalent of 50 ticks on a 10-ton cocoa contract.

They then gets knocked out with a $500 loss before lunch…

And the market recovers by the close and proceeds to go even higher the next day!

The problem is that the $500 stop completely ignores the market’s current behavior.

What if cocoa is flip-flopping in a trading range of $800 a day for the last couple of weeks?  Then that $500 stop loss acts more like an open invitation than an open order and has a high-probability loss of being filled.

A Better Way

A better way to determine the dollar amount for the risk-per-contract on a trade would be to measure the market’s volatility and use something bigger than that.

This method is not a guarantee, but it greatly lowers the probability of getting the stop hit by a silly random daily swing.

Suppose cocoa has had an average trading range of $800 a day for the last couple of weeks.  The trader could use a protective stop of two to three times that amount instead of an arbitrary $500 dollar amount stop.  In that case, the stop order would be $1,600 to $2,400 away from the entry price.

The Average True Range (ATR) comes in handy for measuring the volatility.  It takes into account the difference between the daily highs and lows and, in the instance where the market has made a gap move, it measures from the prior day’s close to account for the gap.

To accommodate the wider stop and keep the risk size on the trade consistent, a trader simply buys less cocoa contracts.

Instead of buying five cocoa contracts and placing the sell stop $500 below the entry price, the trader might buy only one cocoa contract and place the sell stop $2,400 (three times the ATR) below the entry price.

Support/Resistance

Volatility is not the only way to set an initial stop loss.  It can also be something as simple as placing sell stops just below price support at a prior low.  Conversely, you would place protective buy stop orders on a short position above price resistance at a prior high.

In the case of a breakout move, initial protective stop orders can be set at the place where the breakout would be invalidated.

For instance, Nvidia Corporation (NVDA) had a couple of price peaks that marked price resistance back in December 2016 and February 2017 at $119.93 and $120.92.

If a trader bought on the breakout above these old highs in early May when the price reached $121.82, he could consider setting the initial stop loss order just under the $119.00 level.

The day that the breakout to $121.82 occurred, NVDA established the low for the day at $114.02.  So perhaps a smarter approach for setting the sell stop order would be to place it just below $114.02 to give it more breathing room.

You need to keep in mind that you are not going to be the only trading setting their stops just beyond support or resistance.  Everyone’s looking at the exact same chart as you.

That means the stops can sometimes get run and then market turns right back around.

So what do you do?  Decide to not place a stop and just cross your fingers?

That’s certainly a bad idea.  You’d be jumping out of the frying pan and into the fire.  It only takes one really bad trade without a protective stop to wipe out your account.

There are a couple of possibilities for remedying this situation.

First, be prepared in advance to reenter the trade if you get stopped out and the market reverses.

I encourage you to create your rules for this reentry strategy in advance.  You don’t want to be left on the sidelines and making an emotional decision in the heat of battle.

Second, consider setting the stop order beyond support or resistance by an amount that is meaningful.  Perhaps something that’s at least bigger than the 20-day ATR.  It could even be a multiple of it.  That way, it will take more than just a random daily fluctuation to trigger your protective stops.

Going Out On Top

We’ve talked about a couple of ideas on where to exit a losing trade.  But what about exiting a winning trade?  That’s the next order of business.

To simplify it, there are really only two ways to exit a winning trade: Cashing out as soon as the market hits a pre-determined target or liquidating the position when the winner starts to give up some ground and moves against you.

I do want to point out that a trader can also use a combination of the two styles.  Remember, trading doesn’t have to be a binary outcome where you are either “all in” or “all out”.

Many traders combine different levels of exposure and position sizes, so why not combine different exit criteria, too?  Trading is not like the Yankees vs the Red Sox where you have to choose a side!

Profit Targets

Some traders know where they want to take profits as soon as they get into a trade.  Therefore, they will place limit orders to liquidate their position at a profit target if the market reaches it.

The advantage to this idea is that, if the market does meet your objective, you are not going to sit around and give back the profits that you’ve made on the trade.

A perfectly executed trade with this strategy is the one where the market reaches your maximum expectation so you can ring a bell and cash out at the top.  You don’t care where the market goes after that; all you care about is that it hit your target.

Do It Right

There are different ways to set profit targets.  First, let’s address what you should not do.

For the same reason that it doesn’t make sense to use a set dollar amount for setting a protective stop, it also makes no sense to use an arbitrarily set dollar amount for a profit target.

After all, if the cocoa market is normally making advances of $1,500, then why in the world would you want to cash at as soon as you have an arbitrary profit of something like $500?!

You’re almost guaranteed to leave a lot of money on the table when you trade this way.

The solution for the profit objective is the same as the solution for the protective stop: set the price objective based on the market’s volatility or exit when it reaches resistance/support at an old high or low.

If your market research shows that cocoa is making advances of $1,500, then selling out with a profit of just under $1,500 is congruent with what the market is doing.  A successful trader tries to stay in sync with the market.

This also means that if the price volatility dies down and cocoa is only swinging around and making advances of $900, the profit targets would be scaled back from just under $1,500 to something a little less than $900.  Otherwise, you may not get any of your profit objectives hit.

Markets are fluid so you must be ready to adapt and change with them.

Play the Range

This concept of trading the range is pretty obvious, so we won’t spend too much time on it.  Simply put, the objective is to buy when a market nears the lower end of the range and sell when the market nears the upper end of the range.

This applies to both the entry and the exit on a trade.

Since markets seem to trade in congestion at least twice as often as they trade in a trending environment, don’t overlook this concept because of its simplicity.

I’ve seen range traders bag respectable amount of profits in trading ranges when the Buy & Hold crowd and the trend followers were either treading water or getting whipsawed.  There’s definitely merit to this strategy.

That being said, you need to make sure that you have rules that tell you when a market is no longer in a trading range.

Once Elvis has left the building, so to speak, you need to abandon the market or have a different strategy to implement.  Range trading is a mean reversion strategy.  You better know how to tell when a market is in reversion mode and when it’s not (i.e. a trending market).

Harvesting Trend Profits

When the markets are in a trending mode, profit targets can still be implemented.  But the difference between taking profits in a trading range and taking profits in a trending environment is that range-bound profit objectives should more or less be at similar levels while profit objectives in a market that’s trending should be at progressively higher levels in an uptrend and progressively lower levels in a down trend.

Bollinger Bands can be useful for setting profit objectives in a trending market.  The Bollinger Bands plot a standard deviation (2 standard deviations is the popular choice) of a market above and below a market’s designated moving average.

When a market touches a Bollinger Band, it’s considered to be at a short-term extreme.  Think of it as being similar to a rubber band that’s been stretched where the market should either snap back or else breakout.

To use this tool as a profit target, a trader would be long in a market that’s trending higher and then sell the position if/when it tags the upper Bollinger Band.

Once the market has pulled back some and perhaps tagged support at the moving average, the position would be reentered.

The inverse applies for a short position, of course.  The trade would be liquidated if/when the market drops to the lower Bollinger Band and then re-shorted on a bounce back up to the moving average.

The drawback to using this Bollinger Band idea for bagging profits in a trending market is that there’s a good chance that a trader would miss out on some serious profits if the situation turns into a parabolic move.

You need to either be OK with being on the sidelines when things go parabolic or you need to develop some rules to get back in if it occurs.

Indicator Extremes

Another useful strategy for determining profit objectives is to use an overbought/oversold oscillator.  Presuming that a trader is positioned with the market trend, profits would be taken whenever the oscillator reaches and extreme reading.

Popular tools for measuring when a market is in overbought/oversold territory include the Relative Strength Index (RSI), Williams Percent R (%R), and the Directional Movement Index (DMI).

Just as the different types of moving averages (simple, exponential, displaced, etc.) generally end up showing the same thing on a chart, it seems that the different overbought/oversold oscillators usually end up in the same territory as well.

Also just like moving averages, overbought/oversold oscillators should be applicable on multiple timeframes.  This is what makes it a robust tool that works just as well for the day trader as it does for the long-term trend follower.

Study the different nuances of each to see which makes the most sense to you.  In the meantime, let’s look at an example of how one could be applied.

Williams % R

Long time trader and systems developer Larry Williams created this indicator that shows where a market’s closing price is relative to the price range between the high and low of a set time period.

In other words, the %R will show you if the market is in the upper end, lower end, or mid-part of the price range of the last X number of days, weeks, months, etc., indicating if it’s overbought, oversold, or neither.

The %R shows a range of 0 to -100.  You can Google the math for the formula if you want it, but the important thing is to know that a market is considered to be overbought whenever the indicator reaches a level of -10 or higher and it is considered to be oversold whenever the indicator drops to a level of -90 or lower.

So how would a trader use it to take profits?

You exit a long position as soon as the %R hits the overbought level of -10 or higher and exit a short position as soon as the %R hits the oversold level of -90 or lower.

Once a profit has been booked, the trader can monitor the market and watch for a reentry setup to get back in after the %R is out of the overbought/oversold territory.

Beware: markets can hit oversold or overbought and stay that way for quite some time, especially when they’re in a fast moving environment.  Exiting a long position when an oscillator hits overbought will then leave you on the sidelines while the market continues to run.

American financier Bernard Baruch once said, “I made my money by selling too soon.”

It obviously worked out OK for him…but can you live with getting out of a trade too early?

More to Come

We’ve covered a few ideas for exiting both losing and profitable trades.  There are a lot more ways to skin the cat, though.

In the next post, we will discuss even more ideas that traders could incorporate into their exit strategies.

Make sure you put at least as much time –if not more- into designing your exits as you do your entries.  It’s where you get out of a position that determines if you’ve made or lost money on the trade.

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More Articles by Jason Pearce:

Building Pyramids for Asymmetric Trading Gains Part 2

Building Pyramids for Asymmetric Trading Gains Part I

How Much Leverage is Appropriate in Your Account?

US Dollar: The New Bear Market?

Equities: US Against the World

Profiting From Failure: The Wash & Rinse Trade, Part II

Profiting From Failure: The Wash & Rinse Trade, Part I

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

By Jason Pearce

Full Court Press

In a prior post, we discussed the topic of pyramiding.  This is where you take advantage of a winning trade by continually adding more and contracts or shares as a market trends in your favor.  The objective is to increase the size of your winning trades without a substantial increase in the risk on the trade.

First, we discussed an aggressive strategy of adding futures contracts just as soon as the open profits on a trade provide enough financing to do so.

Most traders initially learn about pyramiding this way.  As a matter of fact, I can recall a trading book that I read as a teenager that taught how to turn a $5,000 grubstake into $250,000 by simply following this easy path to “unlimited riches” while working a mere 15-20 minutes a day.

This is the absolute worst possible way to go about it.  It nearly always ends in tears.  The post explains why and shows a vivid example.

Next, a more sensible method was demonstrated.  This pyramiding method relies on the market’s price structure to determine where and when to pyramid a position.  There’s a delicate balance between pursuing profits and managing risks.  If you want to trade like a professional, this is the way to go.

In this post, we are going to touch on a couple of the more lesser-known pyramiding techniques.  These ideas will give you more options to work with.  This allows you to find and customize the pyramiding method that best suits your personal trading style.

Turtles, Pyramids, and Volatility

In full disclosure, what I know about Richard Dennis’ famous group of Turtles is only second-hand and third-hand knowledge.  When the Turtles were busy building their trading fortunes in the early 80s, I was busy doing my schoolwork, riding a BMX bike, and listening to my Def Leppard and Van Halen cassette tapes.

That being said, several of Dennis’ protégés have shared the secret sauce of the trading system that he taught them.  I feel like there’s enough information out there now that I can relay and comment on it.

The Turtles used volatility to determine their position sizes.  More fitting to out topic of discussion, they also used volatility to determine where they would add to their positions (i.e. pyramid).

They measured market volatility via the Average True Range (ATR), which is a tool that many professional traders still utilize today.  Specifically, they used the 20-day exponential moving average of the True Range as their volatility yardstick.

Once the Turtles bought a market on a breakout above a 20 or 55-day high, they would place their initial protective stops and then place order to buy more contracts at progressively higher prices.  These pyramid orders were designed to ramp the position size up as quickly as possible.

The 20-day ATR that they measured volatility with was referred to as “N”.  To pyramid, the Turtles would add to their long positions in intervals of ½ N higher as the market moved up.  So if the 20-day ATR of a particular market is 160 points, then ½ N is 80 points.

Importantly, the intervals were based on the actual fill prices.  So they would buy another round of contracts 80 points (½ N) higher than the last fill price.

The amount of entry points that a Turtle could take on one particular market was limited to four.  So after the initial breakout purchase was made (entry point #1), the position could be pyramided up to three more times at entry points #2, #3, and #4.

The protective sell stop for the contracts bought on the initial breakout was set at 2N below the entry price.  Also, the protective sell stop for each pyramided position was set at 2N below the entry price.  The thinking behind this is that the stop would be out of the way of random market swings since it’s double the average volatility of the last one month of trading (there’s typically twenty trading days in one month).

For example, if the 20-day ATR of a particular market is 160 points, then 2N is 320 points.  So the initial protective sell stop was place 320 points (2N) below the entry fill price.

Most of the time, when a new entry point was made, the protective sell stops on all units were raised to 2N below the most recent entry price as well.  The Turtles had a couple alternatives to this, but this was the standard method they used.

So there you have it: the pyramiding technique used by one of most famous and profitable trading group in the world.

Turtle Troubles

Before you take this Turtle pyramiding idea and apply it to your trading, there are a couple of potential drawbacks you should take into account.

First, recognize that the risk on the trade actually increases as more contracts are added.  Risk does not stay static or decrease the way that it does with the methodology we discussed in the prior post on using price structure to pyramid.

Suppose the 20-day ATR for gold is $13.00 and you went long a single 100/oz. futures contract at $1,240.00.  With the Turtle method, the initial protective sell stop would be set 2N or $26.00 below the entry price at $1,214.00.  This sets the initial risk at $2,600 on the trade.

If gold rallies ½ N higher ($6.50) you would purchase a second contract at $1,246.50.  The initial protective sell stop for this first pyramided contract would be set 2N ($26.00) below the entry price at $1,220.50.  Additionally, the protective sell stop for the initial purchase would also be raised to $1,220.50.

Here’s the rub: The risk on the pyramided contract is initially $2,600.  The risk on the initial contract, although reduced, is still $1,950.  So the total risk on the trade has now increased to $4,550.

Once you’ve extrapolated this out to the Turtle’s maximum position size of four entry points on the trade (the initial entry and three more pyramided entries), the total trade risk has jumped to $6,500.

That’s two and a half times the initial risk on the trade.

See the problem here?

Like I said, this is a potential drawback.  It doesn’t have to definitely be one.

If you know beforehand that the trade risk will increase as the pyramid is built, you could elect to initiate the trade with just a fraction of your maximum risk-per-trade.  Then as more contracts are added via the pyramid rules, your trade risk gets closer to your maximum risk-per-trade levels and finally reaches it when the last entry point is triggered.

In other words, you put a toe in the water and build up to your targeted maximum risk-per-trade as the market proves itself.  There’s certainly nothing wrong with a strategy of scaling into a position.  Many smart and successful traders do this.

A second potential drawback to this strategy is that the initial entry order and all three of the pyramid buy orders can get elected and filled all on the same day.

Worse yet, they could all be entered and then liquidated on the very same day!

If you’ve been trading for even a short length of time, you may have seen or even been caught in one of those “long bar” market spikes on the charts where prices rocket higher.  These sorts of moves happen on the downside as well.

As a matter of fact, the downside spikes seem to be more severe.  Anyone remember the Flash Crash?

One way you could offset this risk is to modify the pyramiding rules and limit it to one entry point per session.  That way, you will never be full loaded and then knocked right back out all in one fell swoop.

However, there is a potential downside to implementing a time limit rule like this.  If a market spike happens to be the start of a parabolic runaway move, you could miss significant chunks of the move and/or not get all the contracts you want.

There’s a tradeoff with everything in life, though.  You have to determine what is best for your own emotional makeup and capital risk.

Climbing Ladders

Now I’m going to show you a different twist on how to pyramid by incorporating both price structure and volatility.  I call this strategy a price interval ladder.  This is a method I’ve used many times, particularly with spread trade positions where I only track the closing prices, to build small positions into large positions.

You need to know up front that this pyramiding strategy is not something that I feel is compatible with a day trading or swing trading system.  (Why in the world are you day trading anyway?!)  This strategy is to be used in a campaign trade where you want to ride the trend for as long and as far as it will carry you.

In a nutshell, price interval ladders are evenly-spaced price points that are set in a market where contracts will be entered at progressively higher levels as the market advances.  Think of it as climbing a ladder and each higher price point interval is like a rung on that ladder.

The same set points of these price intervals are also where the protective sell stop levels will be trailed “up the ladder” until the market finally reverses trend and all contracts are liquidated.

Although the price interval ladders are based on price structure, it’s a different application than where we discussed trailing protective stops and adding after the market reactions against the trend.

Instead, we will measure the sizes of the countertrend moves in a trend.  Then the entry and exit points are set in price intervals that are larger than the size of the preceding countertrend moves.

The objective in spacing the intervals is to make them wide enough to be able to withstand any countertrend moves that are similar in size to what has already been occurring.

High-Tech Ladder

Let’s look at the NASDAQ 100 futures contract for an example of how a price interval ladder could have been applied during this run over the last few months.

In September and October of 2016, the NASDAQ 100 futures market prodded and poked at the 4,900 level a couple of times and stayed stuck in a trading range.

The election happened on November 8th and stock futures went absolutely nuts.  First it plunged to multi-month lows and then it rocketed back up to the highest level in several days.  The pullback from the preceding high in the all-session high was as much as 361 points.

At the end of the month, volatility had settled down.  The NASDAQ 100 had once again neared the 4,900 level and backed off one more time.

This time, the pullback was about 196.25 points in size.  This was larger than the 147-point pullback that the market experienced off the early October high, but not too different from the 207.75-point pullback that the market experienced off the August high.

In mid-December, the NASDAQ 100 finally cleared the 4,900 barrier.  With a breakout above the trading range and new all-time highs, anyone who looks at charts has to be bullish.  Therefore, let’s assume that a trader will want to get long.

We’ll be patient and wait for a bit of a pullback before jumping in.

The pullback finally occurred at the end of December when the market retraced 144.50 points from the December 27 record high of 4994.50.  Therefore, we can put in an order to buy a breakout to 5005.

Now let’s build a price interval ladder!

Due to the unusual volatility surrounding the election, we are going to disregard the pullback that occurred at that time.

With that in mind, the pullbacks that preceded the breakout ranged in size from 144.50 points to 207.75 points.  Therefore, we are going to set an interval ladder of 210 points to trade the NASDAQ 100.

This means that once the buy stop order at 5005 is filled, a protective sell stop will be placed at 4795.  Also, additional buy stop orders will be placed every 210 points higher at 5215, 5425, 5635, 5845, etc.

Every time a buy stop order is filled, the protective sell stop orders for all contracts will be placed 210 points lower than the most recent entry, which is one “rung” lower on the price interval ladder.  This process will carry on until the entire position is liquidated either by a sell stop getting triggered or a profit objective being met.

Here’s how this strategy would have worked out in 2017:

January 6, 2017 – NASDAQ 100 rallies to 5005 and fills buy stop order.  A protective sell stop order is placed 210 points lower at 4795 and a buy stop order to buy more is placed 210 points higher at 5215.

February 9, 2017 – NASDAQ 100 rallies to 5215 and fills buy stop order.  A protective sell stop order is placed 210 points lower at 5005 for both long contracts and a buy stop order to buy more is placed 210 points higher at 5425.

March 15, 2017 – NASDAQ 100 rallies to 5425 and fills buy stop order.  A protective sell stop order is placed 210 points lower at 5215 for all three long contracts and a buy stop order to buy more is placed 210 points higher at 5635.

May 1, 2017 – NASDAQ 100 rallies to 5635 and fills buy stop order.  A protective sell stop order is placed 210 points lower at 5425 for all four long contracts and a buy stop order to buy more is placed 210 points higher at 5845.

June 2, 2017 – NASDAQ 100 rallies to 5845 and fills buy stop order.  A protective sell stop order is placed 210 points lower at 5635 for all five long contracts and a buy stop order to buy more is placed 210 points higher at 6055.

June 12, 2017 – NASDAQ 100 declines to 5635 and elects the protective sell stop orders for all five contracts.  The trade results in a profit of 1,050 points, which is a 5-to-1 return on the initial risk.

The beauty of measuring the sizes of the countertrend moves in a particular trend is that it is relative to the current market conditions.  It works just as easily in currencies…and crude oil…and grains…and bonds…and any other market you can think of.  This is a robust strategy.

Ladder Modifications

Once you get the hang of this price interval ladder strategy, there are a couple of ways that a trader could build a better mousetrap and modify it.

First, the trailing exit stop or “lower rung” on the ladder can be trailed as the market makes new highs for the move without having to wait for the higher pyramid entry orders to get elected first.

Since the size of the countertrend moves off the highs were measured and the price intervals were placed in increments that are larger than the typical reaction, this is a smart trailing stop strategy that works to reduce risk at a faster pace.

Another modification is to update the size of the price intervals based on the most recent couple of countertrend moves.  If the pullbacks are getting bigger, the wider price intervals will provide more breathing room.

Conversely, if the pullbacks are getting smaller, the tightening price intervals will reflect that and reduce the risk on the trade.  This can have the positive effect of increasing the reward-to-risk ratio on a trade.

Know Your Limits

Do some noodling on these pyramiding ideas and figure out what sort of strategy makes the most sense to you and what gels with your own trading system/methodology.  Once you’ve decided on what you’re going to do, though, you’re homework isn’t complete.

You will still need to determine just how big you’re willing to build your pyramids.

Even though you’re trailing the protective stops as you pyramid a winning position, you still need to set a limit on how big you will go.  This is because there is no iron-clad guarantee that your protective stops will be executed and filled at the exact price of your order.  Price slippage –especially after a big run- tends to be the norm.

I’ve seen a reversal in the silver market only take twenty minutes to destroy one-third of a profit on a trade that took weeks of pyramiding to build…and that wasn’t even the final top for the market!  Traders beware.

Nasty slippage is not even the worst thing that can happen.

If a market suddenly makes a limit move against you, there’s no guarantee that your stop order will even be executed at all!  You could be stuck in a lock limit situation for days at a time.

This lock limit scenario is a worst case scenario.  It rarely happens.

But the fact that it’s possible means that you have to build it into your contingency plan.

It only takes one of those to put a trader out of business if the leverage is too high.  You’ve heard the story of what happened to those geniuses who ran Long Term Capital Management, haven’t you?  It was the leverage that killed ‘em, not their being wrong about the market.

So if you’re going to build pyramids, make sure they aren’t big enough to crush you when they occasionally topple over.

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More Articles by Jason Pearce:

Building Pyramids for Asymmetric Trading Gains Part I

How Much Leverage is Appropriate in Your Account?

US Dollar: The New Bear Market?

Equities: US Against the World

Profiting From Failure: The Wash & Rinse Trade, Part II

Profiting From Failure: The Wash & Rinse Trade, Part I

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

 

By Jason Pearce

Reward vs Risk

George Soros once said, “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”

His comments address the subject of the reward-to-risk ratio on a trade.  If the payoff of a winning trade is multiple times larger than the risk and subsequent loss on a losing trade, then you can net out a profit even if you have a lot more losing trades than winning trades.

This is why Paul Tudor Jones only takes a trade where he expects to get a minimum of a 5:1 reward-to-risk ratio.

Jones said, “Five to one means I’m risking one dollar to make five.  What five to one does is allow you to have a hit ratio of 20%.  I can actually be a complete imbecile.  I can be wrong 80% of the time, and I’m still not going to lose.”

Simple Math

To calculate the reward-to-risk ratio on a trade, you have to know where the position is being entered, where the initial protective stop is being placed, and where you expect the market to go if the trade is successful.

The difference between the entry price and the initial protective stop tells you the risk on the trade.

The difference between the entry price and the minimum price you expect it to get to if you’re right is the potential reward on the trade.

Just divide the potential reward amount by the initial risk amount and, voilà, you will get the targeted reward-to-risk ratio for the trade.

Building the Great Pyramids

Now that you know how to determine the reward-to-risk ratio on the trade, I want to discuss a strategy that one can use to potentially increase the reward side of that ratio for any given trade.

Unlike in poker, where you have to up the ante and increase the amount of money you must risk in order to stay at the table, this strategy can allow a trader to keep the initial risk size the same –in some cases, even lower the amount of risk on the trade- and capture even more of the upside of a winning trade.

What I’m talking about here is building a pyramid.  No, this is not some new MLM scheme like your dead-beat cousin Eddie is trying to get you to sign up for.  This is a legit way to ramp up your profits on a winning trade.

Pyramiding a position simply means that you continue to add more and more contracts or shares as the market moves in your favor.  You increase your position size as the trend proves itself and your profits grow.

No Averaging Down

It is important to understand that pyramiding a position is not like the traditional strategy of dollar cost averaging where you continue to add a predetermined amount to your investment in time increments like the guy who socks away $500 each month into his mutual fund portfolio.

It’s certainly not where you average down on a position and buy more and more shares of a sinking stock, either.

Quite the opposite.

In pyramiding, you only add to your position when you’re in a trending market that is moving in your favor.

Furthermore, when more contracts or shares are added, the protective stop orders for all the previously acquired contracts should be moving up as well in order to reduce/eliminate the risk on these contracts.  At least, that’s the right way to do it.  Otherwise, all you are doing is taking bigger risks with bigger positions.

From my point of view, adding more contracts without trailing the stops on the other positions is not pyramiding; it’s simply engaging in bad risk management.

Rookie Pyramid-Builder Mistake

Unfortunately, a lot of new commodity traders first learn about pyramiding with the worst application possible.  This is a financial nuclear meltdown just waiting to happen.

The novice trader might read a get-rich-quick trading book or talk to some sleazy broker that teaches them to buy a futures contract and add more just as soon as it has a big enough open profit to cover the margin for another contract.

This sort of pyramiding is the most aggressive way to apply the strategy…and the most incorrect way to do it!  So let’s go ahead and talk about this misapplication first and put it to rest.  Knowing what not to do is just as important for your trading success as knowing what to do.

Recipe for Disaster

The margin for a 5,000 bushel wheat futures contract is currently around $1,500.  This represents a price swing of 30 cents (5,000 bushels * 30 cents = $1,500).

Suppose a trader has $50k in his account and he buys a September wheat contract on a breakout at $5.40.  He could put in a buy stop order to buy another one when it rallies 30 cents to $5.70 as the initial contract purchased at $5.40 would show an open profit of $1,500 and provide the financing for an additional contract.

This all seems harmless at first.  A single contract with fifty grand to back it and one more contract when the market moves in the right direction.  But watch how crazy and how fast this can escalate…

The trader can place an order to buy another contract just 15 cents higher at $5.85 instead of 30 cents higher at $6.00.  This is because an additional 15-cent gain on two contracts is $1,500.

Or the trader could elect to be a little more patient and instead put in an order to buy two futures contracts at $6.00 instead of one at $5.85.

If the trader were to use the latter and more “conservative” choice, he could simply put in buy stop orders to double up every time the wheat market moves an additional 30 cents higher.

Let’s suppose our wheat trader gets “lucky” and catches a weather market in the grains where the market just shoots to the moon and makes hardly any pullbacks along the way.  That’s the sort of trade that fortunes are made of.  What happens if wheat rockets north of $8-per-bushel like it did in the summer of 2010?

The trader would have purchased one contract at $5.40, one additional contract at $5.70, two contracts at $6.00, four contracts at $6.30, eight contracts at $6.60, sixteen contracts at $6.90, thirty-two contracts at $7.20, sixty-four contracts at $7.50, and (gasp!) one hundred and twenty-eight contracts at $7.80.

That’s a total of two hundred and fifty-six wheat contracts that the trader is holding, folks.  I hope they’re not gluten-intolerant…

Oh, and when wheat touches eight dollars the account would be sitting on an open profit of $638,500.  What trader doesn’t dream of that?!

Jenga!

This nearly thirteen-fold increase in account size, brought about by an aggressive pyramiding strategy, is the siren song that lures the novice traders into the markets.  They only pay attention to the profit potential and hope to match Soros’ net worth with just a few trades with their $50k trading stake.

Here’s what they are not taking into account.  With two hundred and fifty-six wheat contracts on, every one-cent move in the price of wheat creates a profit or loss of $12,800 on their trading account and a mere ten-cent hiccup would rip an astronomical $128,000 from their account.

Notice what happened when wheat finally cracked the eight dollar mark in August of 2010: It rocketed to $8.41…and then promptly fell apart, like a high-stakes game of Jenga gone bad.

Wheat closed ‘limit down’ at a price of $7.25 3/4 that day.

From the day’s high to the close, this huge pyramided position dropped in value by $1,475,200.  (That’s nearly one and a half million dollars, just in case the commas aren’t registering in your brain.)

By the way, once wheat traded to $7.46 1/4 the account value hit zero.

By the day’s close of $7.25 3/4, the account was in a deficit to the tune of $261,900.  The trader is completely on the hook for this amount.

And that’s assuming he could have gotten out at the limit price.  If it was locked limit, the trader would have exited in the next trading session at an even worse price when the market gapped lower.

What?!

Although this is what the September wheat contract actually did in the summer of 2010, the pyramided trade is a theoretical example.  However, I can testify to the fact that scenarios like this can and do happen with alarming frequency.  I watched a trader run $20k into $100k in a matter of weeks and then crash it into a deficit of $20k in a matter of days.  It was accomplished during a good old-fashioned weather market in soybeans.

I also know of a mailman with a $50k net worth who ran a $25k account up to nearly $500,000…and then down into a deficit of nearly $1 million by aggressively pyramiding in the silver market this same way.

With a net worth of just $50k, it’s quite a burden to owe a clearing firm $1 million.

I could go on, but you should get the point by now.  This sort of aggressive pyramiding scheme that increases your account exponentially on the way up will decrease it even faster on the way down.  Don’t even think about it!

Trade Smart

A smarter and better way to build a pyramid is to wait for new entry setups to materialize in a market that you already have a position in.  In other words, you trade the market’s price structure.  This is not about calculating how much it takes to finance the next contract; it’s about waiting for the market to show you when and where to add to your position.

A very simple way to implement this is to trail the protective sell stops below each reaction low after a new high for the move is made.

You can also use the new high of the move as an entry signal for more contracts and place the protective sell stops below that same reaction low where the other stops are set.  That way, you’ve reduced you risk on all previously purchased contracts and you have a well-defined price structure pattern to add more.

The inverse works for short sales, of course.  After a market bounces and then hits a new low for the move, protective buy stops can be relocated to just above the bounce high and more contracts can be sold short.

There are two important rules you should adhere to:

First, only take new setups if the current position has an open profit.  You should never add to a position that’s currently a loser.  Even a breakeven trade has not earned the right to get bigger yet.

Second, wait until the initial protective stop has been moved enough to significantly reduce or even eliminate the initial risk on the trade.

That’s it.  Very simple to understand, very simple to and implement.  This is the KISS principle at its best.

Test Drive

As an example of pyramiding with market structure, let’s look at how this might have been applied to a short sale campaign trade in the July 2017 cocoa futures contract.  Keep in mind that one contract controls 10 metric tonnes of cocoa, so each tick ($1) is worth $10.

Also, let’s assume an account size of $100k where we’re behaving like reasonable traders and risking just one and a half percent (1.5%) of our equity per trade.  None of that crazy “pyramid-your-$10k-into-$1-million-in-two-months” garbage going on here.

We will cap the risk at $1,500 (that’s 1.5% of $100k) so that no losing trade or string of losers can ruin the account or take us out of the game.

Now, there are some who will say that you can’t make any real money when you’re risking such a small amount.  Like the saying goes, “No guts, no glory”, right?

Not when it comes to risk management and pyramiding.  Just watch and learn.

July cocoa made a double top last summer between the July and August highs of $3,077 and $3,069.   The lowest point between these two lows was the July 29th low of $2,800.  When this low was broken on September 9th, I think most technicians will agree that a short position could have been entered.

The initial protective buy stop order for this trade could be placed above the double top high of $3,077 or it could be placed above the bounce high that preceded the break at the September 7th six-session high of $2,907.

To keep things simple and low risk, let’s assume a short sale was initiated at $2,790 (ten ticks below the July 29th low) and the initial protective buy stop order was placed at $2,917 (ten ticks above the September 7th high).  This sets the initial risk on the trade at $1,270 per contract, which is a bit under our $1,500 risk target.

So here’s a price structure pyramiding plan that could have been implemented:

1 Once cocoa has bounced to at least a five-session high (this would be a one-week high since there are five trading days in a week) and then drops to a new low for the move, lower the protective buy stop for all contracts to ten ticks above the bounce high.

2 *After the protective buy stops on the prior contracts have been lowered, short another cocoa contract ten ticks below the most recent low for the move and place the initial protective buy stop ten ticks above the bounce high as well.

*There is a risk management contingency for the pyramided contracts: it can only be done as long as the total risk on all the prior positions are equal to or less than the initial risk on the trade and the new stop placement eliminates 50% or more of the open risk on the most recent contract added.

Here’s how the cocoa short sale campaign trade may have worked out:

September 19, 2016 – July cocoa rallies to a six-session high of $2,849.

September 29, 2016 – July cocoa drops to a one and a half year low of $2,693, breaking the prior low for the move at $2,729.  The protective stop on the initial short contract is lowered to $2,901 (ten ticks above the recent bounce high).  The risk is reduced to $1,110, which is not enough to allow for a new short contract.  Remember, the new protective stop placement has to cut at least half of the open risk on the most recent contract.

November 3, 2016 – July cocoa rallies to a nearly three-week high of $2,661.

November 4, 2016 – July cocoa drops to a three-year low of $2,539, breaking the prior low for the move at $2,585.  The protective stop on the initial short contract is lowered to $2,671 (ten ticks above the recent bounce high).  The initial contract entered at $2,790 now has a profit of +$1,190 locked in.

Also, a second contract is sold short at $2,575 (ten ticks below the most recent low for the move) and the initial protective buy stop for this contract is also set at $2,671 (ten ticks above the recent bounce high).  The initial risk on the second contract is $960.  Cumulatively, this locks in a net profit of +$230 on the entire trade.

November 21, 2016 – July cocoa rallies to a five-session high of $2,447.

December 2, 2016 – July cocoa drops to a new multi-year low of $2,334, breaking the prior low for the move at $2,363.  The protective stop on both short contracts is lowered to $2,457 (ten ticks above the recent bounce high).  The initial contract entered at $2,790 now has a profit of +$3,330 locked in and the second contract entered at $2,575 now has a profit of +$1,180 locked in.

Also, a third contract is sold short at $2,353 (ten ticks below the most recent low for the move) and the initial protective buy stop for this contract is also set at $2,457 (ten ticks above the recent bounce high).  The initial risk on the third contract is $1,040.  Cumulatively, this locks in a net profit of +$3,470 on the entire trade.

January 5, 2017 – July cocoa rallies to a six-session high of $2,244.

January 11, 2017 – July cocoa drops to a new multi-year low of $2,103, breaking the prior low for the move at $2,108.  The protective stop on all three short contracts is lowered to $2,280 (ten ticks above the recent bounce high).  The initial contract entered at $2,790 now has a profit of +$5,100 locked in, the second contract entered at $2,575 now has a profit of +$2,950 locked in, and the third contract entered at $2,353 now has a profit of +$730 locked in.

Note that a fourth contract was not sold short.  This is because the prior low for the move at $2,108 was not broken by at least ten ticks.

January 17, 2017 – July cocoa rallies to a six-session high of $2,240.

January 27, 2017 – July cocoa drops to a new multi-year low of $2,100, breaking the prior low for the move at $2,103.  The protective stop on all three short contracts is lowered to $2,257 (ten ticks above the recent bounce high).  The initial contract entered at $2,790 now has a profit of +$5,330 locked in, the second contract entered at $2,575 now has a profit of +$3,180 locked in, and the third contract entered at $2,353 now has a profit of +$960 locked in.

Once again, a fourth contract was not sold short because the prior low for the move at $2,103 was not broken by at least ten ticks.

January 30, 2017 – July cocoa drops to a new multi-year low of $2,088, breaking the prior low for the move at $2,103.  Therefore, a fourth contract is sold short at $2,093 (ten ticks below the most recent low for the move) and the initial protective buy stop for this contract is set at the same place as the others at $2,257 (ten ticks above the recent bounce high).  The initial risk on the fourth contract is $1,640.  Cumulatively, this locks in a net profit of +$7,830 on the entire trade.

February 16, 2017 – July cocoa rallies to a seven-session high of $2,060.

March 1, 2017 – July cocoa drops to a more than five-year low of $1,899, breaking the prior low for the move at $1,901.  The protective stop on all four short contracts is lowered to $2,075 (ten ticks above the recent bounce high).  The initial contract entered at $2,790 now has a profit of +$7,150 locked in, the second contract entered at $2,575 now has a profit of +$5,000 locked in, the third contract entered at $2,353 now has a profit of +$2,780 locked in, and the fourth contract entered at $2,093 now has a profit of +$180 locked in.

A fifth contract was not sold short.  This is because the prior low for the move at $1,901 was not broken by at least ten ticks.

March 2, 2017 – July cocoa drops to an eight and a half year low of $1,879, breaking the prior low for the move at $1,901.  Therefore, a fifth contract is sold short at $1,891 (ten ticks below the most recent low for the move) and the initial protective buy stop for this contract is set at the same place as the others at $2,075 (ten ticks above the recent bounce high).  The initial risk on the fifth contract is $1,840.  Cumulatively, this locks in a net profit of +$13,270 on the entire trade.

March 13, 2017 – July cocoa rallies to an eleven-session high of $2,023.

March 15, 2017 – July cocoa rallies to a multi-week high of $2,081.  This triggers the buy stop orders on all contracts at $2,075 and liquidates the entire position with a net profit of +$13,270 on the trade.

Price Structure Pyramid Performance

So how did this more conservative price structure pyramiding strategy affect the reward-to-risk ratio on the cocoa trade?

Well, the initial trade was entered at $2,790 with a risk of $1,270 per contract and the profit was +$7,150.  The profit was a little over five and a half times the initial risk, yielding a reward-to-risk of 5.6:1.

But…

The total profit on the trade was +$13,270 and the pyramiding and risk management rules made it so that the cumulative risk never exceeded the initial risk as more contracts were added.  That means the total trade risk was never more than the initial risk of $1,270.

So the +$13,270 profit was nearly ten and a half times the initial and maximum risk on the trade, yielding a reward-to-risk ratio of almost 10.5:1 in the $100k account.  That’s nearly double what the non-pyramided trade would have returned.

Consider the fact that the trade initially risked 1.27% and made a +13.27% return in six months without being hyper-aggressive.

Annualized, that’s a +26.54% return on the entire account with a single trade that risked about one and one-quarter of a percent.

Yes, Virginia, there really is a way to make good money on small risks!

Obviously, this cocoa pyramid trade is one of those best case scenarios.  They don’t all have this sort of outcome.  Most trades don’t.  But the example does show you the possibilities of what can happen when you take advantage of a sustained trend by pyramiding the smart way.

Many Ways to Win

In trading, there are many different paths to success.  Different timeframes, different setups, different entry signals, different kinds of systems, etc.

The same goes for pyramiding.

In this post, we discussed a wrong way to pyramid and one smart way to pyramid.

But this merely scratches the surface.

In the next post on the subject, we will discuss how volatility can be used for pyramiding.  I will also show you a different way to use price structure to build a pyramid.  Both of these pyramiding methods can be implemented in a systematic, rule-based manner.  So if you’re interested in learning how to potentially turning a single hit into a grand slam home run, stay tuned!

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More Articles by Jason Pearce:

How Much Leverage is Appropriate in Your Account?

US Dollar: The New Bear Market?

Equities: US Against the World

Profiting From Failure: The Wash & Rinse Trade, Part II

Profiting From Failure: The Wash & Rinse Trade, Part I

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

 

By Jason Pearce

The Two-Edged Sword

Archimedes made a great statement about the power of leverage when he said, “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”  That’s a great quote…until it gets misapplied to the arena of speculation.  Context is everything.

If you’re gonna talk about the advantage of using leverage in the financial markets, you would be irresponsible if you didn’t address a subject that’s intrinsically linked to it: risk.  If you want to learn the correct way to use leverage, you need to consider more than just the potential gains that leverage can bring.  You have to consider the potential losses.

The pros know that the winners take care of themselves.  It’s the losers that have to be managed.  The problem is, too much leverage can make the losing trades unmanageable even if you’re actively protecting yourself with stop orders.  Leverage is the how the markets provide a trader with more than enough rope to hang himself.

Leverage Levels

Currently, a stock brokerage firm will allow customers to trade with leverage of 2-to-1.  This is done by providing a margin loan to the trader.  If a trader has $100,000 on deposit, the brokerage firm will loan him up to $100,000 and allow him to buy $200,000 worth of equities.

So a stock trader with margin could double his money on a stock that increases in value by 50%…and just as easily wipe out his stake if the price of the stock was cut in half.

Many people believe that trading commodities is far riskier than trading stocks.  What?!  Trading corn is riskier than trading Tesla?!  This notion was likely brought about by the fact the available leverage for commodity trading is significantly higher than the leverage for stocks. So the belief is half right; commodity trading can be risker, but that’s because of the leverage available, not the instrument being traded.

That margin requirement to trade a futures contract is often around 5% of the value of the underlying contract.  For instance, the E-mini S&P 500 is currently worth around $120,000.  The initial margin requirement is $5,500, which is just 4.5% of the contract’s value.  This would allow a futures trader to potentially leverage his account at a level of 20-to-1 where $100,000 on deposit can control as much as $2 million worth of futures contracts.

At a level of 20-to-1, a fully margined commodity account would make a fortune on a modest price increase.  The other side of that coin is that the trader could also be completely wiped out on a 5% adverse move in price.

Forex trading reaches a whole different level of leverage…and insanity.  Those sleazy online “bucket shops” that are always trying to sucker the public into currency trading offer traders leverage of 50-to-1…and 100-to-1…and sometimes even 200-to-1.

Just think about that in dollar terms.  A $100,000 deposit in a forex account could control $5 million, $10 million, or even $20 million worth of currency.

At 100-to-1 leverage, it only takes a 1% change in price to double you money or lose it all.  What could possibly go wrong?

Too Much of a Good Thing

Just as leverage can amplify investment gains, it also amplifies invest losses.  This is why you never see professional traders and money managers taking full advantage of the leverage being offered.

It’s also why you’ve never heard of a professional trader racking up a month or even a year with a +1,000% return.  To knock it out of the park like that, you’d have to take way too much risk.

As a matter of fact, one professional trader I know gets very concerned if he makes too much money over a certain period of time!  His thinking is that he must be taking on too much risk or using too much leverage if the gains are accruing that quickly.

Professional traders make their trades based on probabilities.  But they manage risk based on possibilities.  If it’s possible for profits to snowball quickly, then it’s possible for losses to snowball quickly as well.  To keep a losing streak from turning into an avalanche you’ve got to put limits on the amount of leverage used.

Bond Bubble Blowup

C.S. Lewis wrote, “Experience: that most brutal of teachers. But you learn, my God do you learn.”  I’ve had the pleasure of having Professor Experience personally tutor me when I attended the University of Hard Knocks.  My major was in What Not to Do When Trading.

Let me first say that mean reversion works…eventually.  But if you’re going to make a bet on it and hold on, the trick is to make sure your position is small enough to survive the waiting period.  The more leverage involved, the less staying power you have.

When I was a wise old trader in my twenties, I picked a fight with the bond market.  Confidence and hubris was running high because I’d just come off of a couple of successful trade campaigns in the grain market and the Japanese yen.  And now that the Treasury market was running away to record highs, I put them in the crosshairs and went short.

T-bonds were around 124-00 at the time, which is a value of $124,000 per contract.  So initially, I went short one contract for every $20k in account equity and figured I could safely hold a contract with a $20k cushion and ride out the storm without needing a protective stop.  Based on the contract value, I was leveraged at 6-to-1.

T-bonds just kept ripping higher and posted a record string of daily gains.  Three weeks after I went short, I experienced an intraday drawdown of a little over $5,500 per contract.  Perversely, my losses were ratcheting higher by the day while the probabilities of a reversal also increased.

But don’t confuse probable with possible.

The six-figure open loss caused me emotional turmoil.  My $20k cushion shrank to $14,500 per contract.  I was down, but not out.  But I now had a bond contract value of $129,500 with a cushion of $14,500, raising the leverage to nearly 9-to-1.

Out of the Frying Pan

I called up another “professional” trader I knew in order to get his take on things.  He asked me about my conviction on the trade.  I told him I was still bearish and bonds just had to crash after a run-up like this!  Somehow, an old floor trader saying popped up: “When in trouble, double”.

So I did.  Seriously, I was already bleeding with a six-figure loss and then I proceeded to double my exposure by selling more contracts short at 128-24 ($128,750 value).  By doing so, my equity cushion was suddenly $15,250 for every two contracts.  Two contracts at that price are worth $257,500.  That spiked the leverage on the position to nearly 17-to-1.

As you would expect, Treasuries only accelerated from there.  The market posted daily gains and even some new all-time highs for several consecutive trading days.

When my trading accounts were just a stone’s throw away from a margin call, I finally tapped out.  I lost about $9k for each initial short contract and another $4,250 for each ‘add-on’ short contract.  My attempt at The Big Short wiped out two-thirds of my equity ($13,250 for every $20k), meaning a total loss of several hundred thousand dollars on the books.

Oh, and it gets even better…

As fate would have it, I covered all of those short positions just one day before the final record high was set!  Bonds tanked the very next day and started the multi-month decline I was anticipating…but without me in it.

There are a lot of lessons to learn from this story: Don’t bet the farm on one big trade, don’t fight the trend, don’t trade without protective stops (or at least options to hedge), don’t depend on the opinions of others, etc.

But one lesson I want to bring highlight right now is that of using too much leverage.

Had I stuck with the original (flawed) plan, which was a fully leveraged position of 6-to-1, I would have still had to endure a wicked drawdown.  But I would have never been forced to choose between liquidating or meeting a margin call.

By adding to a losing position and tripling my leverage to nearly 17-to-1, my protective buffer of equity was removed.  I had no more wiggle room when the trade went further against me and I had to get out.

Bottom line: the amount of leveraged used was the only difference between being able to weather a major drawdown until I could eventually get out with a profit or being forced out early with major losses.

Miscalculating Risk

I stated earlier that too much leverage can make the losing trades unmanageable.  A lot of times, this is due to the false sense of security that protective stops can bring.  You may think you know what your risk on a trade is, but sometimes you can be wrong.  Very wrong.

Suppose Sensible Sam is watching the soybean market and he thinks it’s about to take off.  He has $100,000 in his account and wants to risk three percent of his equity on a soybean trade.  That means he’ll have to put a protective stop order in the market to knock him out if the market moves against him by $3,000.

So Sensible Sam goes long three 5,000 bushel soybean futures contracts at $9.98 and places a protective sell stop at $9.78, which is twenty cents ($1,000 per contract) below his entry price.  Although he’s risking just three percent of his equity, Sensible Sam is moderately leveraged at about 1.5-to-1 because he has actually purchased $149,700 worth of soybeans ($9.98-per-bushel x 15,000 bushels = $149,700) with his $100k account.

Along comes Gunslinger Gary.  He’s also looking at the same soybean market and wants to get in on the action.  He’s been burned before by risking way too much of his equity, but he still wants to capitalize on the expected move in beans.

Gunslinger Gary has a brilliant idea: buy a ton of contracts and set a really tight protective stop.  Perhaps he is even going to follow Sensible Sam’s lead and risk just three percent of his $100,000 account…but that’s where the similarities stop.

Gunslinger Gary buys twenty 5,000 bushel soybean futures contracts at $9.98 and places a really tight protective sell stop at $9.95, which is just three cents ($150 per contract) below his entry price.  Theoretically, he’s only risking three percent of his equity.  However, trouble is brewing because Gunslinger Gary is leveraged at 10-to-1.  He has actually purchased $998,000 worth of soybeans ($9.98-per-bushel x 100,000 bushels = $998,000) with his $100k account.

Maybe Gunslinger Gary’s protective stop placement actually makes sense because he’s using intra-day charts to time a quick exit.  That’s not what I’m concerned about.  But we can’t escape the fact that he’s substantially more leverage than Sensible Sam.

Let’s forget about the best-case scenario where beans go ripping higher right after these guys get in.  Consider what happens if the market drops instead.

What if Gunslinger Gary’s protective stop is elected and he gets three-cent slippage on the fill?  He’ll lose $6k instead of $3k.  That’s double what he thought the risk was.

Or what if he manages to stay in the trade but an adverse crop report hammers the beans down 20 cents in the afterhours market where slippage is even greater or beans gap down in the morning (if he’s using pit-session stops only)?

In this scenario, Sam would also get knocked out of his three soybean contracts and suffer the $3k loss.  But good ol’ Gunslinger Gary would get murdered.  The 20-cent loss on his twenty soybean contracts would cost him a whopping $20,000.  That one trade would wipe out one-fifth of his account.

Although I used a hypothetical scenario to show the damage that leverage can inflict on a losing trade, don’t think for one moment that it’s not a plausible scenario.

Ask anyone who’s ever traded grains in the summer or had a position on when a crop report came out and you’ll hear tales about the market instantly moving limit.  Sometimes, the market will even move lock limit.  If you’re on the wrong side of that move, it means you can’t even get out at the market price!

Currently, the CME set the limit for soybeans at 70 cents ($3,500 per contract).  That limit amount can get raised by 50% in a heartbeat.

The takeaway here is that leverage is just as important –maybe even more so- than protective stop placements when calculating your true market risk.  Yes, you should have protective stops.  But you should also have leverage limits.  Leverage is like medicine: a little bit can help you…but too much will kill you!

Highly-Leveraged Is Relative

Most traders have heard the famous story about how George Soros “broke the Bank of England” by betting against the British pound back in 1992.

Soros’ right-hand man, Stanley Druckenmiller, was the one that pitched Soros the idea of shorting Sterling.  Druckenmiller said that Soros taught him to “go for the jugular” when you have a very strong conviction on a trade and to ride a profit with huge leverage.

Obviously, the plan worked.  They made over $1.5 billion on that trade.

Now, what many people don’t know is the size of that leverage on the trade.  Druckenmiller suggested to Soros that that they put 100% of the fund in the trade.  Soros disagreed.  He said they should have 200% in the trade.

Having 200% means leverage of 2-to-1.  That’s not 10-to-1 or 20-to-1 like a lot of novice commodity traders use and it’s certainly not 50-to-1 or 100-to-1 like the snake oil FX brokers tell the public they can use, either.

Druckenmiller said in one interview that the leverage at Quantum (Soros’s hedge fund) rarely exceeds 3-to-1 or 4-to-1.  So if one of the best traders in history doesn’t go beyond 4-to-1 leverage, why the heck would a lesser trader think that going 10-to-1 or more is a good idea?

Do keep in mind that just because they leveraged 2-to-1 does not mean that they were risking the entire amount.  Soros is known for taking a quick loss without regret if the market proves him wrong.

Market Wizard Wisdom

Larry Hite is one of the Market Wizards interviewed Jack Schwager’s famous book.  On the subject of leverage, he said that, “…if you leverage more than 3-to-1 that you are a loser. Because we found that if you did 3 to 1 you would have, even with perfect knowledge, you could go down a third.”

So here we’ve got yet another successful trader with several decades of performance to back his reputation, and he’s telling traders that the maximum leverage that they should consider is 3-to-1.

There are only two reasons I can think of that a person would use higher leverage than what the pros use: ignorance or greed.  And once you are made aware of the risk of using high leverage, you can no longer claim ignorance for your excuse.

Protect Yourself

Brokerage firms want you to use the available leverage.  The more you trade, the more commissions they make.  Don’t think for a minute that they’re going to step in and tell you that you’re taking too much risk.

Sure, the brokerage firms will issue margin calls.  But that’s not about protecting you; it’s about protecting them.  Brokerage firms don’t mind if you are burning through your trading capital.  “Churn and burn, baby.”  It’s just when the flames get too close by putting them at risk of a potential deficit that they’ll step in and tell you to wire more money to your trading account or liquidate your positions.

Surely, the good ol’ US government is protecting you, right?  Well, consider this: The SEC just approved the launch of a 4x leverage ETF.

I wrote in a prior post about how leveraged ETFs are constructed as an easy way to the poorhouse.  You can be right on the underlying market and still lose money.  That’s the effect that double and especially triple leverage ETFs can have.

But now the government is going to allow us to trade in quadruple leverage ETFs?!  Maybe it would be more accurate to re-label these genius derivatives as WTFs…

The point is that nobody is going to be as careful about protecting your capital as you are.  To be successful, a trader and investor must be proactive and accept personal responsibility.  Part of this includes understanding and setting limits on leverage.

It Can Get Worse

Do you have a trading system that you’ve back-tested over decades of data?  Have you tested it on out of sample data as well?  Have you run a Monte Carlo simulation on it, too?  That’s good.  You’ve done your homework.

I’m sure you also remembered to factor in commissions and slippage in order to get a better feel for real world trading.  You now know what sort of worst case drawdown would’ve occurred, which can help you determine your comfort level for the amount of leverage you’ll use to trade it.  Time to get trading.

Not so fast!

The well-respected trader Peter Brandt said, “A trader’s worst drawdown is the one yet occur.”

Consider that fact that the worst drawdown in your back-testing record or even your real-time track record got that title by being even worse than all the prior drawdowns that preceded it.  That means it’s possible that another drawdown can come along and steal that title at some point.

All records were made by breaking another record.   That can be both a good thing and a bad thing.  On the subject of drawdowns, it’s definitely a bad thing.

Storm Prep

One simple way that a trader can build a protective buffer is to prepare for a drawdown that’s double the size of the biggest one to date.  This means adjusting your risk-per-trade to a level that will allow you to endure such a losing streak.

Furthermore, you may want to calculate what your entire portfolio risk is.  This means looking at the effect of a worst-case-scenario where every position in every sector of your account gets stopped out with slippage.  This drawdown is your Portfolio Meltdown Level.  It rarely, if ever, will happen.  But you still need to be prepared for the possibility of it occurring.

Does that Portfolio Meltdown Level make you sick?  Well, it’s a good thing that you’re calculating it then!  You just discovered that you’ve been taking too much risk…and you’re lucky enough to have not found out from experience.  Dial the Portfolio Meltdown Level back down to your comfort level.  Figure out what you want to set for your maximum risk level for each trade, for each sector, and for your entire portfolio.

Preparing a worst-case scenario defense plan also means reigning in the amount of leverage used.  Just because you have protective stops in for your positions, doesn’t mean your maximum expected risk level is guaranteed.  If some of the rock stars of the trading world think the maximum leverage they should use is 3-to-1 or 4-to-1, then perhaps you should consider adopting these levels as your maximum leverage limits as well.

We don’t know when the storm will hit, but we do know that it’s inevitable that it will happen someday.  Your job as a trader is to make sure that you are taking the necessary precautions to survive it.  Remember that your probabilities of trading survival are inversely correlated to the levels of leverage that you use.

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More Articles by Jason Pearce:

US Dollar: The New Bear Market?

Equities: US Against the World

Profiting From Failure: The Wash & Rinse Trade, Part II

Profiting From Failure: The Wash & Rinse Trade, Part I

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead