CHAPTER 14

Building Positions and Risk Management

Position building and risk-management techniques go hand in hand. You can take steps to limit and control the amount of risk you are taking with each trade and each position. A very popular method of building a position while limiting risk is the use of the pyramid method. After you are in the trade, effective uses of stop losses and take profit stops will help you quantify and limit the amount of loss possible on a trade, all the while locking in the profit target of the position.

Buying the Cheaper End of the Trade

A good thing to remember when you are thinking about entering into a trade is the fact that you are buying the cheaper end of the trade. What this means is that the product that you are in, whether cash, a stock, ETF, or future is more expensive than the product you are buying. For example, if you are in cash, and you are thinking of buying a stock, then the cash is priced higher relative to the price of the stock. If you have a stock that you are thinking of selling, then cash is priced lower than the stock. In other words, when selling stock, cash is a better value than the stock. It is the cheaper end of the trade.

In order to find out which end of the trade is the cheaper one, you need to know quite a bit about security analysis, including fundamental analysis and technical analysis. Often, though, when trading a security for a long time, you will develop a gut feeling of what is the cheaper end of the trade.

This system is a really good way to value any purchase or sale of a security. Ask yourself, what's the better value, the cash or the stock (ETF, etc.)? Even thinking of entering into a currency pair, you should ask yourself, which currency is the better value? (Or, what's cheap? What's expensive?) By answering this question, you will prevent getting into a position that is at the top of its value against what you are selling. Buying the cheaper end of the trade is a good system to help you decide if a trade is worth getting into, and deciding when to reverse the trade and go back into cash.

Risk Management

The use of risk management can be a very effective tool to keep your account intact, even after a series of bad trades. The system that is best used is one of limiting position size, limiting concentrated positions within industry sectors, and using stops effectively. The goal of effective risk management is to develop a system of using a bit of math to get your positions built and closed in a profitable way while minimizing the chance of losing money. While the market can turn against you, and trades can go bad, you can follow some steps to limit losses.

The first method is to limit position size. This is true if you are using an equity broker, an FX broker, or a futures broker with or without margins. Think of your total amount of available trading value to be no more than 20 percent in one position. If you have an account with a $50,000 value, and you use one-half margin, you will have a buying power of $75,000. If it is your normal procedure to use 50 percent of your buying power at any one time, the total amount you can have for one position is $75,000 × 50 percent = $37,500 × 20 percent = $7,500.

Risk management is often one of the most misunderstood departments in an investment bank. In a big investment bank there are all sorts of traders who are building positions in their own sectors. The risk management function of the bank sometimes acts as the police, preventing any excessive buildup of a position across the company.

This 20 percent rule is a good method to force you to diversify your positions to no less than five positions at any one time. This diversification between securities will go a long way in keeping your account intact. Twenty percent is the high end of the position size rule, and a drop in the percentage to 15 percent or even 10 percent will further enhance the diversification of your day trading portfolio. In addition to limiting position size and therefore diversifying the securities you are trading in, you should limit concentrated positions by diversifying across industry sectors, or even products. This can be achieved by bundling all of your positions in each industry, such as energy, metals, financials, retail, etc., as one position. This is done because there is a good chance that all of the securities within an industry will go up or down at the same time according to the market's movements.

If you are in three positions in the banking sector, then you would further enhance your risk management by bundling these together as one position. A second level of risk measurement would be to bundle the markets in which the securities trade, such as equities, commodities, or FX. Remember, you are trying to get a snapshot of your overall risk and trying to quantify the overall uncorrelated diversification of your entire day trading portfolio. The uncorrelated diversification of your day trading portfolio is when you have different positions spread across many securities, industries, and markets, so that when one trade turns bad, it is supported by many others that are not related or affected by that trading/market event or news.

Using Stops Effectively

Another method of risk management is the proper use of stops. A stop is an automated sell order that is programmed into your trading platform at the time of the trade's placement. An account's risk can be measured in the percentage that the stops are placed behind the entry price. For example, if you enter into the ETF QQQQ (the Nasdaq 100 Trust) at $50 and you place the stop for that trade at $45, the stop will automatically sell QQQQ when it gets to $45, limiting your loss on the trade to $5, or 10 percent.

Won't the placement of stop losses make me lose money?
Stop losses do the exact opposite. While it may look as though you are selling out of your position at a loss and losing money, their real purpose is to prevent you from losing even greater amounts of money if the position moved a large percentage against you.

If you place all of your stops at 10 percent below the entry price of your trades, you are, in effect, limiting the loss of your trades to 10 percent across the board. If you are using 100 percent of your tradable assets, and you only have ten positions, you will zero out your account after ten losing trades in a row. For example, you have a $1 million account with ten trades each of $100,000 in value. If you place the stops at 10 percent behind the entry price, your trading platform will automatically sell out the positions with a $10,000 loss. If all ten trades went bad and were automatically closed out, the total loss would be $100,000 × 10 percent = $10,000 × 10 trades = $100,000 loss in total. As you can see, this $100,000 loss is 10 percent of the total fund. You are limiting your total losses to 10 percent of each trade with this system. If you continued along with these position sizes (100 percent of the account with ten trades total), you would have to lose over 100 trades in a row to zero out your account (this does not include the trading costs).

The use of stop losses is a form of defensive risk management. An offensive-orientated risk-management technique is to program your trading platform to automatically sell your positions at a predetermined profit point. This will lock in your gain and help you to plan ahead how much you would like to make from each trade. For example, you could program your trading platform to automatically sell a security at a price that is 10 percent above the entry point. This price can be programmed in as a percentage or dollar amount before the trade is actually placed. The fields in the order entry window of your trading platform would be filled out as to dollar amount or percentage of gain, and you would then place the trade, and wait for the automated sale at the profit point.

Run the Business Like a Casino

Here is some food for thought: if you believe that the markets are completely random, are volatile, and are affected by many, many factors, you could make it your trading philosophy to run your day trading business like a casino. Casinos make money by providing gambling where the house plays the odds. If a game table has a 2:3 odds, the gambler will win twice for every time the house wins three times. If you think of yourself as the “house” and if you believe that the markets are totally random and a game of chance (which some do), you could set all of your trade stops to any odds you would like. If you wanted 2:3 odds, you would set your stops to a ratio of 2:3 with the higher being the take-profit order.

For example, you could buy QQQQ at $50, set your stop loss at 4 percent behind the entry price and your take profit at 6 percent above the entry price (2:3 ratio). If the market was totally random, you would make an automatic 2 percent on every trade (lose 4 percent gain 6 percent equals 2 percent net gain.) In order to get this system of randomness to work properly you would have to enter many trades to get the averages to smooth out and the statistics to be spread evenly. A study can be made with a sample set of as little as 100 trades, but the higher the better. This might be a good experiment to set up in a dedicated practice/demo account.

Using the Pyramid System

The pyramid system is a method of splitting your building of trades into three different time periods, thereby in theory giving yourself three different price levels. It is similar to the dollar cost averaging theory of investing, but each of the three trades is on the books separately, instead of grouped together.

Deciding on Trades

To use the pyramid system effectively, you would first identify a potential trade. Second, you would go through your risk-management calculation to determine the total position size that would be appropriate for your account. You would then divide this dollar amount into three trades spread out during the course of the holding period. If you are buying an ETF and you determine that the trade setup will last two days, a one-third entry point would be made at your initial signal point. If you are trading DIA (the Diamonds-Dow 30 trust) and you determine a buy signal at 110, you would buy in one-third of the total calculated trade amount at this price.

Don't eagerly jump into a setup with one big trade. With setups there is often a tug of war going on with the day traders across the globe, and the effect is to push the security up and down until it starts to move in one clear direction. Until that happens, stagger your entry points with the pyramid method.

As the price of DIA moved with the up and down movement of the Dow 30, you would make another one-third buy in at a price that appeared favorable. Since the Dow 30 may be moving upward during the trading period, the second and third buy in doesn't have to be at a lower price. The system is not intended for you to buy in at three lower prices, rather it is intended to spread out your entry points if the security falls in value allowing you to have additional capital to invest at the lower price. Three different priced entry points will give you an extra cushion of risk management that can be very helpful in limiting your exposure to a falling market. Positions that are broken up into thirds are also easier to enter psychologically, as it is easier to emotionally commit to a trade if you know that you have a cash reserve to buy in at lower prices if you misjudged the opportunity for the trade and the market moves against you.

Closing Out Trades

The pyramid system can be also be used to close out trades as well. Your total position would be divided into three equal parts. As the total position turned profitable you would begin to close it out in three trades. This dividing up the closing out into thirds would lock in your profits but at the same time allow for the further growth in the gains of the trade. As the trade gained further, the second one-third would be sold off, locking in at that profit point, leaving the last third to be closed out at the next point. The combined effect of buying in thirds and selling in thirds can be a very effective risk-management tool, as it spreads the cost of the trade over time and prices, acting as a smoothing agent to the overall cost basis of the position. At the same time, when it comes time to close out that position, the pyramid method will allow you to lock in your profits while giving flexibility to capture further gains in a moving market.

How Many Positions at One Time?

When you are just starting out, you may find it very helpful to only have between one and three positions open at one time. This is due to the fact that when you are first starting to day trade you are learning to identify and interpret all of the market indicators that go into making successful and profitable trades. For example, you will be monitoring the short and long-term charts and the market news while at the same time remembering the overall big picture information, such as overall market trends as well as security and economic fundamentals.

Keeping the number of trades you have to the minimum will give you enough time to react to all of the market's developments and how they relate to your trades. At first you might find that watching the market develop and seeing it make your positions (and fortunes) go up and down a bit thrilling and overwhelming at the same time. It takes some time to realize that it is real money in your account, just as it takes time to learn how to feel the emotions of winning and losing trades.

It often takes time to be able to comprehend all of the information on a trading screen. If you are starting out and you have too many positions open at one time, you might suffer from fatigue very quickly and have to end the trading session before the exit point of your trades.

If you keep the number of trades you have open to three or less, you will also be allowing yourself time to analyze each trade after it has been closed out. Your goal at first should be to have enough trades and positions open to give yourself the training to have multiple information inputs and situations to follow, but at the same time not to have too many things going on as to lose track of good trades, or worse yet, suffer from information overload.

Moving to More Positions

After you have got the knack of day trading with three positions, you can gradually move to higher amounts of total positions open. Keep in mind, however, that when you have a great deal of trades open and you are using margin, you are running the risk of the losses compounding into your margin account even faster. For example, let's say you usually trade five currency pairs, commodities (a gold ETF) and equities (an S&P ETF.) You have your currency account set to a margin of 50:1, and you are using the following risk-management parameters: at 50:1 margin, total FX positions will not exceed 33 percent of available margin at the time of the trade. You trade the gold ETF and the S&P ETF in an equity day trading account with 50 percent margin max. You decide to use the additional use of across sector risk management of one-third commodities, one-third equity, and one-third FX in your total investment portfolio.

With this ratio you are able to have $4,995 in commodities (gold ETF), $4,995 in equities (S&P ETF), and $11,088.90 in each of the currency pairs or crosses per $10,000 in your total day trading account.

Gold ETF	33.3% × 1.5 margin × $10,000 total day trading account	= $4,995
S&P ETF	33.3% × 1.5 margin × $10,000	= $4,995
FX Pair	33.3% × 50:1 margin × 33.33% total FX margin available	= $11,088.90

The compounding of positions on themselves was one of the factors that lead to one of the most famous hedge fund collapses of all time. The Connecticut-based hedge fund Long Term Capital Management was using this compounding effect in their hedge fund; when one of the positions fell suddenly, it caused the rapid unraveling of their entire portfolio.

More Risk-Management Techniques

Further risk-management techniques would be dividing the market long, short, and neutral position into further thirds. One-third would go into a bucket of market long positions: long S&P ETF positions, long AUD/ JPY, AUD/USD, and USD/SEK positions, etc. One-third would go into market short positions: long gold ETFs, short AUD/JPY, short USD/SEK, etc. The last third would be in market neutral positions, such as the soft commodities and grains, and the FX pairs with a market neutral bias (EUR/SEK, EUR/ CHF, EUR/NOK, AUD/NZD, and USD/SGD). Additional risk management could be the additional purchase of an alternative investment mutual fund that uses a market neutral global macro style, such as UBS's Dynamic Alpha (BNACX). Dynamic Alpha is a mutual fund that is managed as a hedge fund, and has extensive use of derivative overlays to neutralize risk and give a market neutral bias. Consider the addition of an alternative investment fund as a buffer in your overall day trading account, acting to further smooth out peak highs and lows due to concentrated positions. A position in a market neutral alternative hedge fund — styled mutual fund would be held for the medium-longer term, and consist of around 10 percent of your total portfolio.

Profits, Losses, and Your Buying Power

The total buying power in your accounts will be constantly changing, moving up and down as the value of the trades in your account moves with the market. With higher leveraged trades such as futures, commodities, or FX, your total buying power will be affected greatly by the number of open positions in your account and how well they are doing. For example, when you first buy or sell a position to open, you are committing cash and margin to the trade. When the trade becomes profitable, more margin will be added to your account in proportion to the amount that the trade is in the profit zone. The gain in a trade actually allows you to buy or sell more positions to the open with the additional margin created with the gains. To review, margin is used to buy a position to the open; as it moves into a profitable position, the gains are added to your account (unrealized gains). This additional account value is then interpreted as additional margin available, and therefore additional buying power.

Using a High Rate of Margin

If you are using a high rate of margin in an FX or futures account, the gains will equate to even more amplification with the use of margin on the available buying power. Example: you have $10,000 in an FX account. One of your trades used $2,000 in margin, and at 50:1 the position has a total value of $100,000. As the trade becomes profitable, the gains are added to your account as more margin. If you made 2 percent on the trade, the gains would be $2,000, and this would be added to your account. This fresh $2,000 can be then spent on an additional trade at 50:1 or another FX trade with a value of $100,000. The process would be repeated with each trade's gain until you had huge positions built upon higher and higher leverage.

The problem with this trading philosophy and style is that the risk is amplified higher and higher and eventually comes to the point that your whole account would have multiple positions all built on the gains of the trade before them. If the profits in percentages and dollar amounts were impressive with the multiple leverage method described, the losses in the account would be equally as impressive and equally as dramatic if the market turned against you. As the prices of the FX trades came down, the positions would unwind very rapidly and your account would collapse the weight of its own leverage. This is essentially what happens to some major hedge funds and other major financial institutions when there is a shortcoming in the risk-management departments. It is a form of maximum profit generation, and when done right for short times (often through automation) it can lead to very high returns, but it can also lead to an account's rapid destruction.