Today’s Trading Lesson From TradingMarkets

Editor’s Note:

Each night we feature a different lesson from



TM University.
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any questions.

Brice

Money Management
(Pt. III): Insights From The Pros


By Dave
Landry

 

What separates the pros from
the would-be pros? Money management. Read on and find out why.

Manuel Ochoa, who chronicles his trades in

Financial Futures Insight
, has enjoyed a great deal of success as a
trader and hedge fund manager, but he learned some very valuable lessons about
money management early on in his career–the hard way.

As the following discussion will detail, after being wiped out in just one
night, Manuel quickly realized that if he was to survive long term as a trader
he would not only have to study the markets but the risk associated with them.
What impressed me about Manuel is that he not only considers the chance of
extraordinary events occurring that will cut into his equity, he actually plans
for them and expects them to happen sooner or later.

Dave Landry (DL): Manuel, you seem to be known for your money
management techniques. Did you always use strict money management or was this
learned through experience?

Manuel Ochoa (MO): It was learned experience.

DL: At what point did
you realize the importance of money management?

MO: In 1989, I was
in college and had a personal account of $20,000. I had a large position in
currencies. One night, while I slept, there was a big news development involving
Britain’s Prime Minister. At 4:00 a.m. I get a call from a clearing broker
notifying me that my account had a balance of -$2,000.

DL: That must have
been a pretty humbling experience.

MO: Yes. Up until
that point, I only thought about how much money I could make–I never thought
about how much money I could lose.

DL: When you started
trading again, did you immediately implement risk controls to keep this from
happing again?

MO: I began to
control risk more carefully but I noticed my equity swings were as much as 10%
in one day. I knew I had to reduce risk even further or it was only a matter of
time before a string of losses would wipe me out again.

I think stop
placement is the number one misconception when it comes to trading.

So, I continued to increase my focus on money management.

DL: How do you define
money management?

MO: I think it’s
half art, half science–but mostly common sense.

DL: Let’s talk about
the science of it.

MO: It’s a matter
of stop-loss level placement, what size position you trade, how much risk, how
much leverage (i.e., dollars controlled vs. account size). You have to know all
of this ahead of time. You don’t want to be making decisions while you’re
attempting to pull the trigger on a trade. It’s like swinging a bat: Half way
though your swing, you can’t think, am I going to hit it high or low, to right
field or left.

DL: Let’s break down
these concepts. People seem to be first and foremost interested in where to
place their stop-loss. (Note: Manuel can best be described as a swing trader;
he normally holds positions for several days. This discussion on stops assumes
the positions are held overnight).

MO: I think stop
placement is the number one common misconception when it comes to trading.
People think that the tighter the stop the less they are risking when in reality
they often guarantee themselves a loss.

DL: For instance?

MO: People try to
trade a high-flying stock like eBay with a $2 price stop. The stock trades in a
range of over $30 in one day alone. People are kidding themselves if they think
they can trade a stock like this with such a tight stop. In a case like this
they will almost always be guaranteed a loss. The same applies to other markets.

Let’s say that someone is trading S&P futures and using very tight stops. In
all likelihood, they’ll get stopped out hundreds of times in one year. I’d bet
in many cases, at the end of the year, when you add up all those hundreds of
small losses from tight stops, it comes to much more than a few large losses
through somewhat looser stops.

Now, this is not to say that you should take excessive risk. You should have
your stop far enough away that random noise won’t take you out. Suppose someone
decides to dump a position or a sell program kicks off, this has absolutely
nothing to do with the overall market or the reason you are in the trade in the
first place.

No professional
money manager that I know risks more than 5% per trade; most keep it much
lower that that.

Don’t get me wrong, I’m not saying use “loose” stops as a general rule. What
I am saying is learn to place your stops wisely so the random price action or
noise won’t take you out.

DL: Obviously, you
can’t pace a stop too far away.

MO: True. In order
to avoid being stopped out, you should have a stop that allows for the
volatility of the past three to four days and make sure your stop is outside
those levels. Otherwise you’re almost guaranteed a loss. You have to use the
volatility of the market or you will almost surely get shaken out of good
positions.

DL: How do you define
the volatility?

MO: I have various
techniques that I use but it can be defined with something as simple as the
average range for the past three to four days. Again, the key is to make sure
your stops are outside of that level.

DL: How much do you
risk per trade?

MO: No professional
money manager that I know risks more than 5% per trade; most keep it much lower
that that. I think more important than how much you risk is how much you can
lose above and beyond that risk. At least once a year, some extraordinary event
will create a price shock and you’ll lose at least twice what you thought your
max loss per trade was. Therefore, I never risk more than 2.5% on any given
trade. That way, the worst that can happen to me on anyone trade is probably
twice that amount (a 5% loss).

DL: So you not only
consider your calculated risk but the possibility of an extraordinary event
occurring?

MO: Exactly.

DL: Although you use
a lot of discretion in your trading, you’re known as an expert on systems
(computer generated signals). Can you elaborate on using systems testing when
studying risks?

MO: System testing
is great, or least it appears that way on the surface. People forget that these
are just stats, historical estimates if you will, but they accept them as if
they were fact. They fail to realize that they are only historical estimates.

DL: For instance?

MO: They look at
worse loss on a single trade or the drawdown (string of losses) and think that’s
as bad as it gets.

Controlling risk
is much more important than the system itself.

What missing is the hidden features or phenomena of a historically based
system. One phenomena that doesn’t show up in the stats is that longer you trade
the system the bigger the largest losing trade will be as well as the maximum
drawdown.

DL: Is this from
increased exposure to the markets?

MO: Yes, every
decade and often much less, something really “bad” will occur: someone will get
assassinated, a war will break out, or some sort of financial meltdown will take
place. The system can never adjust for this. These things do and will happen.
For instance, the crash in 1987 took out many professional option sellers in
just one day.

The bottom line is that everyone is searching for a method or system that
will generate enormous profits. What they fail to realize is that controlling
risk is much more important than the system itself. No matter how good the
system, without risk control it will surely blow up.

 


Dr. Paul Ruggieri, who writes TradingMarkets.com’s Medical
Technology Insight
column, is a surgeon who also has enjoyed great success
investing in medical and biotech stocks. Paul strikes me as a man who really
does his homework and has found his trading niche–he truly has a passion for
medicine, research and investing in medical stocks.

Paul’s perspective is especially interesting because he approaches the market
from a more traditional, non-technical vantage point. Although he doesn’t follow
strict money management rules like many technicians, he does consciously avoid
excessive risk through other means.

First, even though he’s willing to buy companies that have under-performed
the market, he takes reasonably sized positions and does not buy stocks because
they are “cheap.” He’ll only “bottom fish” in well-diversified companies that
show promise. Second, in riskier, single-focus companies, he realizes it’s all
or nothing. Accordingly, he takes a only very small positions and accepts the
fact there is a high likelihood the stock will go to zero. Third, although he
classifies himself as a long-term investor, he’s willing to take profits as
approval for drugs nears versus holding out for top dollar.

Dave Landry (DL): What’s your basic approach to the markets?

Dr. Paul Ruggieri (PR): I trade stocks but I’m not a “trader” per se. I use
fundamentals to select my stocks and consider myself more of an “investor.”

DL: So how you select
stocks?

PR: For
pharmaceutical companies, I look for drugs in the pipeline. I carefully study
these drugs and their potential for success, the demand and size of the market
for these drugs, and of course, the possible side effects.

DL: Being a
technician who only keys off price action, I have to bring up the classic
technical vs. fundamental argument. If a stock looks good to you at $100,
wouldn’t it look even better at $75? Suppose it kept dropping: Is there a point
where you just give up? For instance, a while back you liked Pfizer; the stock
has recently dropped from 150 all the way to 110.

PR: On a stock like
Pfizer, I feel that they have a strong pipeline of drugs. Although the stock has
been dropping as of late, nothing has changed on a fundamental basis.

I never take a
position so large that it will have a material effect on my lifestyle.

So, in this case, yes, I view it as a buying opportunity, and as long as the
fundamentals stay sound, I’m willing to buy more at lower prices.

This is not to say that I buy something just because it is “cheap.” Merck ,
for instance, has made a similar move down like Pfizer. However, Merck has
patents on drugs that will be expiring over the next few years and I don’t feel
like they have enough currently in the pipeline to make up for it.

DL: Doesn’t this
approach require you take a very long-term outlook?

PR: Yes, many times
these drugs are years away from getting approval. I’m willing to wait.

DL: What about losses
while waiting?

PR: I never take a
position so large that it will have a material effect on my lifestyle. Also, by
diversifying and holding positions in many medical companies, some of the drugs
will get approval and some won’t, some sooner, some later.

DL: How do you know
when to take profits?

PR: Clinical trials
are based on a limited number of people. Even if the drug shows tremendous
promise, once it hits the masses, there will likely be unforeseen side effects.
This only stands to reason as the statistical base increases. Take Viagra, a
huge drug for Pfizer.

If I buy a very
risky company, I know there’s a good chance it will go to zero. Therefore, I
would only take a small position.

Once it hit the masses, there were cases of people dying due to heart
attacks. Many of these people may have died regardless, but it did have a
negative impact on the company. Therefore, I’ll often take profits in a medical
company as approval nears because I know there will likely be unforeseen side
effects once it hits the market.

DL: I was fascinated
by your article on cloning technology. Genetically cloned goats that produce
blood-clotting drugs, keeping cells alive forever. It’s pretty amazing.

PR: I have to admit
I myself was amazed while doing the research. It’s almost scary–science fiction
in nature.

DL: In the case of
companies like these, with just one drug or process in the pipeline, isn’t it
all or nothing?

PR: Absolutely.

DL: So, how to you
trade these stocks?

PR: Take a company
like Geron. They are a single-focus company concentrating only on developing a
technology that will keep cells alive forever–a fountain of youth, if you will.
They’re years away from perfecting the technology, let alone getting any type of
approval. I think if anyone has a shot at succeeding, they do. However, I’m not
going to bet the farm on the company. If I buy shares, I think there’s a very
good chance that they will go to zero–and I’m willing to live with that.
Therefore, I would only take a small position. I think the risk to reward is
tremendous. I’m not looking for a small gain in these small, single-focus
companies–I’m looking for a homerun.

DL: Do you ever think
of becoming more active as a trader?

PR: Every chance I
get, I follow the markets. However, I work out of two hospitals, I’m writing a
book on surgery and spend many nights researching medical technology for
TRADEHARD and my own personal investments. I know that due to time constraints,
it’s not feasible for me to be an active trader. Therefore, I take long-term
positions based on sound fundamental research. This approach has worked quite
well for me.