One of the books I always recommend is Trading Risk written by Ken Grant. Ken has been the risk manager for some of the biggest and most successful hedge funds in the industry for a number of decades and his understanding of risk is second to none.
I’m traveling now and with some free time, so out comes Ken’s book again. I’ve now lost count now how many times I’ve read this book and it never ceases to amaze me how I learn something new every time I read it.
One topic Ken talks about is having money set aside for “Special Situations”. In today’s Trading Lesson of the Day, I’d like to spend some time having you think about “Special Situations”.
What is a Special Situation? In my opinion, it something that occurs that’s outside the realms of your day to day approach to trading. For me, it’s the things we can’t quantify either for lack of clean data (especially in options) or a number of other valid reasons. But it’s an edge we feel strongly that exists and it’s something we want to take advantage of. I’m sure you too see these opportunities arise and you feel its best to take advantage of.
But, before becoming reckless, something we never want to do, we want to predefine how much capital we’ll allocate to special situations as a whole and then how much capital we’ll allocate per special situation. This way we’re predetermining our risk and we’ve decided ahead of time to include this in our basket of strategies (Grant feels the ability to have capital available for these situations is very important).
So how do you add Special Situations” to a portfolio? First, I’m assuming you have a basket of strategies you trade, a plan as to how you’ll trade them and risk parameters already measured out. If you don’t ,you should and putting this together is a crucial step in the correct direction.
Then you’ll allocate a portion of your capital to “Special Situations”. Let’s assume this percentage is 20% of your capital. You’ll then break this down further and you’ll allocate a maximum of X% to each situation. For those of you who are aggressive, X% could be 5% of your portfolio. More conservative traders will say 2% of their capital. Those using long option may say 1% of the total amount of capital. If you choose 5%, you cannot have more than 4 special situations at a time (this gets you to 20% of your maximum portfolio). Those who say 2% can have up to 10 positions at a time.
The key thing here is that you’ve allocated a specific amount of capital to what you consider a “Special Situation” and you know ahead of time what portion of your capital will go into each position.
One more key here is you want to be impeccable with your record keeping on this. You want to make sure that your Special Situations really do have edges and its worth continuing to trade. But with the markets so volatile and fear and rumors driving prices all over the place, the number of Special Situations over the past 4 months have been the most I’ve seen in my almost 28 years of trading. And, if you have a solid game plan, Special Situations really can add to your bottom line, especially in markets like we have now.
Spend time today putting together your Special Situations Trading Plan. And order Ken Grants book too. You’ll be happy you did both.
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Larry Connors is CEO and Founder of TradingMarkets.com and Connors Research.