What You Need To Know About Risk

• July 2, 2003
• Dave Floyd

A question of
risk.  For those of you who do a fair amount of
reading of not only market commentary but also the books written by these same
individuals, I think it is safe to say that what it ultimately boils down to is
risk vs. reward. Does the risk compensate the reward?

A colleague of mine who runs a very successful
fund back in Chicago views everything from the risk standpoint first. He often
says; “I do not care if my returns are 20% a year, if I take a draw-down of
10-12% during that time, I have failed and I will not attract the caliber of
investor I am looking for, it is simple as that.”  Refer to the table below
which comes from the beginning of Dave Landry’s book for a sobering look at how
important it is to minimize losses.

% Loss of Capital                      
% Gain to Recoup Loss

 

10                                              
11.11

20                                              
25

30                                              
42.85

40                                              
66.66

50                                              
100

60                                              
150

70                                              
233

 

….and it gets worse from there

Did you ever notice that most
people always ask what the total return has been but rarely ask what the
draw-downs were? Where am I going with this? Just some observations on the
current market, both short-term vs. long-term. As I grow as a trader/investor I
cannot help but build upon past success and more importantly failures, that is
how I/we learn. In the last few months I have really begun to take a harder look
at this market on all time frames and try to position myself so that my reward
on any given trade far exceeds the risk. Sure, I have always done that, but the
market is vastly different than it was back in the late ’90’s and early 2000. As
a colleague of mine says; “The dumb money is not there anymore, you are now
going head to head only with other professionals.”  The result has been
decreased volatility and a market that does not allow for mistakes to be
rewarded. Part of the decreased volatility is a function of a more transparent
marketplace. The advent of E-minis has changed the whole dynamics of the pit in
Chicago. Long time listeners to the Squawk Box will know exactly what I am
referring to.

Trading for me over the last few months has
become far more calculated and restrained, in my opinion, the market demands
it. Gone are the days where you wing it. The idea of sitting and stalking, doing
a little probing, is quite fascinating and frankly a whole new twist on a
profession that I truly enjoy. The market is ever changing and as traders we too
must change. While my Trading Coupon in
yesterday’s piece was meant to be fun and lighthearted, I was dead
serious. Newer traders run the risk more than ever of being caught up in the
hype machine that is the trading industry. Ten years ago there were no trading
conferences, web sites, quote platforms and indicators. While I am pleased all
of these exist, we need to remember they are only tools, not answers. Another
colleague of mine yesterday described a model which he uses for his trading as
simply “a tool which illuminates potential ideas.”  He went on to say “that if I
did not know how to trade, it would be utterly useless.”  You see, a machine or
an indicator cannot make the decision, only you can, and the only way you can
make an informed decision is to stay focused on the task at hand and to not
deviate from it. My most profitable days come when I trade only 1 maybe 2
stocks. Any more than that, and it is safe to say that I was not as
effective. This is my style though, what is yours?

Turning to the markets. Wow, that turn today was,
shall we say impressive/interesting.  I hesitate saying impressive, simply
because the volume ratio was only 63%.  But, to come off that technical
breakdown of the 971 level and finish so much higher is testament to the
strength of the current rally since March. The question still hangs though, Will
this rally continue to have legs?

I read a fair (my wife would say a lot) of market
commentary and research on a daily basis. I cannot read enough. Luckily I have
the ability to filter it out as it relates to my day trading, which is good
because most of it has zero impact. However, from a longer term perspective it
has undoubtedly made me a better investor/trader for one simple reason, it has
assisted me with my number one rule, avoiding risk like the plague and seeking
out what offers the best risk/reward ratio, just like I do when I trade. Some
would call that cherry picking. What I find interesting about our current market
is the following:

-  The lopsidedness of bulls and bears.  Not
since 1987 has the level of bears been so low.

-  The week ended June 20th, there were,
according to Investors Intelligence, 325 buying climaxes, a record (stock hits a
52-week high, but closes down for the week). Accoring to Richard Russel, these
are signs of distribution.

On the flip side, you have the following,
compliments of Mark Boucher:

“New highs have fallen from
above 450 daily to below 100 daily, which is normal for a correction. The key is
whether new highs can expand on any new rally attempt. An attempted advance
without solid expansion in new highs would show that the up-trend is in trouble.
New lows declined to over 900 on the July ’02 lows and then to nearly 500 on the
October ’02 lows, but were under 400 on the March ’03 lows. A correction should
not push new lows above the 400 number. Investors should also monitor big
distribution days. So far most of the down days in the major indexes have come
on declining volume, which is healthy. However days down 1.5% or more on heavy
volume (above 50 day ma of volume) and above the prior days volume are
distribution days and more than three such distribution days would be an
indication that a much more serious correction is developing.”

The bottom line, at least the way I see it is a
market that is really quite polarized. The trend is your friend is a tough
argument to refute, however the nagging internal and macro themes make it less
rosy of a scenario. If there is one thing I have learned it is to never try and
time turning points, boy is that painful. The best you can do is take notes and
extrapolate some conclusions. On the other hand, there is nothing saying you
need to play only the US markets. There are plenty of stocks in the world as
well as other investment vehicles. The advent of technology brings them closer
to your portfolio than ever before. Looking where everyone else is not is always
a good thing.

Support/Resistance Numbers for S&P and Nasdaq Futures

S&Ps Nasdaq 999 1254 994 1251 987 1236-1239 983-984 1227 978 1217-1219 970 1207 968 1194-1195 964 1183 957 1169* 952-953*

As always, feel free to send me your comments and
questions.

Dave