How to Lessen Your Risk in a Trade, Part 2
More 3x ETFs have been launched:
Direxion Daily 10-Year Treasury Bull 3x Shares – TYD
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Direxion Daily 30-Year Treasury Bull 3x Shares – TMF
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Direxion Daily 10-Year Treasury Bear 3x Shares – TYO
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Direxion Daily 30-Year Treasury Bear 3x Shares – TMV
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—FAS (3x Financials) has become one of the most popular ETFs, surpassing the volume of the SPY on many days. Their options are also very popular and actively traded. A few months ago I thought there would be a long-term flight to safety. Instead, the opposite has seemed to occur. That’s the beauty of the ETFs. They’re so flexible and eventually their volume tells the industry what the marketplace wants.
–Last week we discussed ways to protect a portfolio. We looked at the pros and cons of using stops and, as we know due to extensive testing, stops tend to hurt results. They whip many traders around and they do nothing to protect from overnight risk (and this is a very important point).
One way to lessen your risk is to lessen position size. This means for example that instead of placing X% of your capital into a position, you use a smaller amount. What this does is it lowers the maximum % loss for any position.
For example, let’s assume you have a $100,000 account and you allocate 20% of your account to a stock (and let’s go further and say you use stops). The stock is at 60. Your stop is at 55. Overnight the company badly misses its earnings and it opens at 30. You lose 50% on your position (and the stop was basically useless). 50% times 20% in the position means the account lost 10%.
Now, if you decided you wanted to be more conservative, you could have allocated a smaller amount of capital to the position. The gains will be smaller but the drawdowns will be smaller because of the better position sizing. What was a 10% loss of capital becomes 1/2 that at 10% per position and only 2.5% using 5% per position. Smaller and smarter capital allocation protected you.
In this scenario you will make less money when you’re correct but the volatility of your returns will be lower (and you will sleep better at the same time).
What’s perfect position size? It’s like asking which religion is best or which political party is best. The debate is endless. I like Kelly, as does Ed Thorp, one of the world’s most brilliant hedge fund managers. But my research partners disagree (and we usually agree on everything). For every person who believes in Kelly you’ll find another who does not. There really is no right answer (you can find an explanation of Kelly here ) but if you’d like to share your thoughts on this let me know and I’ll publish the best ones here in this blog.
Ultimately it comes down to your own risk tolerance level and what you’re trying to achieve. If a position is keeping you awake at night, you likely have too much capital allocated. If you are indifferent to the position, guess what? You should likely be trading with more size.
Your instincts, along with a little math, plus some experience can go a long way to guiding you what is the correct position size in order for you to protect your money while you’re growing it.
Let me know your thoughts on Kelly and tomorrow we’ll look at using options to lessen our risk.
This is from Larry Connors Daily Battle Plan which he publishes each morning. If you’d like to take a free trial click here, or call 1-888-484-8220 ext 1 to start your free trial today.
Larry Connors is CEO and Founder of TradingMarkets.com and Connors Research.