Connors Research Traders Journal (Volume 13): 10 Smart Ways To Improve Your Trading; Part 3 – Lower Your Risk

  • June 15, 2018
  • Larry Connors

*******

I’d like to let you know that I just completed a new book which will be released onWednesday, June 20. The title is Buy The Fear, Sell The Greed – 7 Behavioral Quant Strategies for Traders.
 
My new book quantifies fear and greed in money managers, investors and traders. We’ve developed a number of quantified strategies around those high probability trading opportunities. The edges in the book are high – a number of the strategies have been correct well over 90% of the time in predicting prices in stocks and ETFs. As you know, fear and greed is inherent in the market place and when it occurs, substantial opportunities exist for you. 
 
 
*******
 
This is Part 3 of our series – 10 Smart Ways to Improve Your Trading. 
 
In this issue of the Connors Research Traders Journal I’m going to share with you six ways to lower your trading risk.
 
1. Stops – We have strong opinions, supported by data, on the pluses and mostly minuses on stops. We originally wrote about this in our book Short Term Trading Strategies That Work and nearly a decade later our opinion remains intact. I covered this topic in an earlier issue of the Connors Research Traders Journal and you can find it here. 
 
2. Options – I’m a big proponent of options for a number of reasons. Options allow you to predetermine your dollar risk while potentially participating in directional moves in your favor. Instead of open-ended risk on long and especially short equity and ETF positions you can move to a fixed dollar risk – the amount you paid for the option. 
 
Options can also be used for protection. Buying a security and protecting it with an out-of-the-money (OTM) put assures that your risk is contained between the security price and the options strike price plus the cost of the option. This is identical to being long a call but the execution costs on the long stock/long put often work in your favor because on the whole, OTM puts in liquid options, especially SPY, trade at tighter spreads than in-the-money (ITM) calls. 
 
Not only do you have greater protection with options versus stops, you have tremendous flexibility with the options including ways to bring in additional income along with ways to participate on both sides of a major move. 
 
For example, you hypothetically buy a stock at $44 a share and buy the 40 put as protection. Let’s assume the stock rises and you have an exit signal to lock in your gains. Sell the stock. Trade done? No. You can either sell the put for likely a tiny amount or you can keep it until expiration. If you keep the puts, you now have a near-free shot if the stock heads lower again. 
 
Let’s say after you sold a stock a news event occurs and the stock drops to $35. You still own the 40 puts that will now be worth approximately $500 per option. 
 
It’s a great place to be – you made money on both sides. This scenario doesn’t happen often obviously, but do it enough times and over time you’ll likely get rewarded. In more volatile stocks and markets when prices swings back and forth it tends to happen most often. 
 
There are many great books on options. Start your core knowledge with books from Larry McMillan, Tony Saliba, and Jon Najarian. If you’re a more advanced trader read Natenberg (Options Volatility and Pricing), O’Connell (The Business of Options), and Benklifa (Think Like an Options Trader). Learn from the giants. 
 
3. Correlations – Underestimating correlation risk wipes out many good traders and trading firms and has for decades. I’m going to go much deeper into this in Part 4 of our series which will be published next week.
 
4. Know Your Historical Volatility – Too many traders don’t put enough (or any) weight on a stock’s volatility. They should though. Why? Because stocks with high volatility trade differently than those with lower volatility. 
 
Higher volatility stocks, for example those whose 100-day (or 256-day) historical volatility is above 70 or 80 trade far differently than those with much lower volatility. An example of this is simply look at stocks like YY versus C . Over the past year YY nearly tripled in price and then proceeded to lose almost a third of its value. Compare this to Citigroup (C) which has traded within an approximately 20% range over the past year. Trading the much more volatile YY has taken on far greater price risk than Citigroup. Yes, in this market the reward was greater in YY over the past year – unless you were unfortunate enough to buy it near its high before it dropped 30%. Knowing a stock’s historical volatility allows you to better understand how much risk you’re potentially taking on. 
 
5. Know Your Market – Knowing the type of market we’re in is important. VIX is a good measurement of this, but its limitations include that it’s a forward-looking consensus of where volatility will be over the next 30 days. It’s also very suspect to triggering false signals. High VIX readings tend to revert to its mean (meaning they drop), especially short-term. In my opinion the better indicator is simply to use a 200-day simple moving average of prices. Stocks and equity indexes are usually (not always; usually) quieter above their 200-day moving average. We’ve written about this for years, have quantified it, and it remains true today. 
 
6. Read Trading Risk – In my opinion this is one of the best books written providing you with a broad overview of risk. It’s author, Ken Grant, oversaw risk teams for three of the largest hedge funds in the world. Even though this book was written a number of years ago, the application of many of it’s concepts are valid today and go a long way in making you a better trader. 
 
Trading, as is all business, is a game of risk and reward. Being able to contain your risk, while keeping yourself in the position to achieve gains is part science and part art. It’s an ongoing pursuit and I’m hopeful the above concepts allow you to further your knowledge on the subject.