Technical Analysis Power Course: Basic Risk Management (Concluded)
Fan Yang CMT, Chief Technical Strategist here at FXTimes will be the instructor. The old saying goes let your profit run and cut your losses short. Trading is as much risk management as it is analysis. What are some techniques to control our risk exposure in trading?
Here are some notes from the lesson:
Analysis vs. Trading:
•As a trader we begin as an analyst, but in the act of “trading” we basically become risk managers.
•A famous military quote goes something like this: “Every battle plan is only good until the first shot is fired”
Profile of a Trader’s Performance:
1.% Profitable: In a statistically valid number of trades, how many were profitable
2.Average Reward to Risk: The average gains on profitable trades vs. the average loss in losing trades.
– Maximum Consecutive losing trades
– Maximum Drawdown: The sum of losses in the worst performing period in equity curve.
– Risk of Ruin: Risk of losing all capital
Types of Stops (Purposes)
–When the market goes against you, you want to make sure you cut your losses quick, but not too quick.
–When the trade is in the black, the trade becomes a management of profit. Trailing stops are designed to reign in as much profit as possible before a reversal from your trade direction.
–We don’t always have to wait until the protective stop is hit. If there are earlier signs that the market have turned away from your original outlook, and there is convincing evidence a sharp trend against you is forming, we can exit earlier. This is hardly a mechanical method, although we can consider the appearance of a large (defined specifically with the ATR) marabuzo against you to be one.
Types of Stop Placements
Money Management Stops
–Based on how much you want to risk.
–Based on where you think the market invalidates your trade
–Combining these two concepts to respect market developments (enough elbow space for the current market condition) and money management rules (such as not risking more than 5% of equity with a single trade.)
We refer to this chart as a case study of placing stops based on the ATR (Reward and Risk ratio was calculated), and also trailing stops using Parabolic SAR. There is also a suggested emergency exit.
-Misconception: Brokers look for their traders’ stop levels and try to push the market to clear the stops
-Reality: Markets do have the power to move prices beyond powerlines to some extent. Therefore, it can sometimes clear stops.
-Hence, powerlines and obvious decision levels should be avoided as stop placement, in consideration of stop hunting. Anticipate clear out actions.
-There are several methods to deal with clear out action.
Better to enter with smaller positions and wider stops than larger positions but closer stops.
This approach tries to avoid the stop being cleared by noise.
Place a stop at a level which you believe invalidates the reason you entered the trade
Avoid noise by NOT placing in obvious levels such as a powerline
Average True Range (ATR)
Introduced by Welles Wilder in his book “New Concepts in Technical Trading Systems” (1978), the Average True Range (ATR) is a measure of a trading instrument’s volatility. It measures the degree of price movement, not the direction or duration of the price movement.
The True Range is first calculated using the greatest of the following:
–Difference between the current high and the current low
–Difference between the previous closing price and the current high
–Difference between the previous closing price and the current low
The Average True Range is then formulated by adding smoothing to the True Range. The True Range can be smoothed using a variety of techniques to create the final Average True Range indicator In VT Trader, the user may select Wilders Smoothing (default) or a simple moving average smoothing which are the two most common smoothing methods used to calculate the ATR.
Stop-Loss Using ATR
Big moves do not have enough strength to move beyond certain levels
Basically the ATR reflects the volatility in the market, or the degree of market movements.
Use the ATR to measure possible moves against you. The higher the ATR, the farther you may want to set your stop from the current level. The lower the ATR the you may be able to set stop closer to the current level.
Classical Stop-Loss Approach: Use 2 to 3 times ATR as distance to stop.
–Example: if ATR is 30 pips: 3 x 30pips = 90 pips. Set stop 90 pips in opposite direction of trade beyond the valid pivot.
Protective vs. Trailing
–Defined before entry and placed immediately after.
–Not to be adjusted
–Defined and placed only when the market is moving in your favor
The trader must decide when he or she will switch to trailing stop
Trader may also decide to have different exit strategies for different market conditions. He or she must decide when to switch from the different indicators and chart and candlestick patterns etc. ie. market shows doji after exhaustive push, and is at major powerline.
Trailing After a Corrective Reversal
– Trailing a trend is one way of attempting to “ride the trend” (a trend-following method)
– We can pick a starting point to be when the first correction to the trend has been completed and a resumption of the trend is confirmed.
– We can then move our stop closer (ie. ATR from pivot). We continue to do this every time we see a minor correction completed.
– Parabolic SAR and Chandelier are examples of some other methods.
The Parabolic Time/Price System, developed by Welles Wilder, is used to set trailing price stops and is usually referred to as the “SAR” (stop-and-reversal). This indicator is explained thoroughly in Wilder’s book, New Concepts in Technical Trading Systems.Interpretation
The Parabolic SAR provides excellent exit points under certain market conditions, like those when the market is accelerating, and likely to be in exhaustion. It also performs better as an exit and even re-entry signal in expanding patterns, or markets with increasing volatililty as defined by range.Slow vs. Sharp Trend
The parabolic SAR is a better tool during a sharply trending market.
Stop-and-Reverse vs. Directional
The SAR stands for Stop-and-Reverse
– System is always in the market.
–Stay out of the market if entry signal is not in the same direction of underlying trend.
–Re-entry in the direction of the trend
-This shows how you hang the chanelier (ie.2x ATR from the close of a candle in your direction).
-The last chandelier however is misplaced, and it should NOT move backwards. We should only move it in the direction of your trade if it is already in profit.