Why position sizing is so important
In last week’s columns I listed some ETF’s that
were extremely oversold (read
Tuesday and
Wednesday’s columns here). I indicated that they were due for a bounce
and one way to play it would be to begin scaling into them, with the
anticipation of selling on the bounce. That bounce has not yet arrived. Most of
them have continued to hemorrhage. If you started scaling in last Tuesday or
Wednesday like I did, then you are underwater in these positions right now. So
what is the proper course of action at this point?
I believe the best thing to do is continue to scale in and remain patient.
Playing reversal trades from extremely overbought or oversold conditions can
require great fortitude. This is because many times the trade may go against you
initially. There is no oscillator and there is no level of oversold that can
perfectly time reversals. Over the long run, the key is not perfect timing. The
key is proper position sizing. Position sizing is what keeps the account from
getting hurt too badly when the bounce doesn’t come right away. It is also what
allows you to keep perspective. It is much easier to continue to scale in to
1%-2% lots than 20-30% lots.
With big positions you will run out of cash to invest quite quickly if your
timing is early. It may also be difficult to actually wait for the bounce before
selling. After having researched, developed, and traded numerous systems that
look to take advantage of oversold (or overbought) conditions, I strongly
believe waiting for the bounce is the proper way to manage these kinds of
trades. Stops are typically not beneficial for reversal trades. For trend trades
stops are crucial (and I have been stopped out of almost all of my
intermediate-term long positions at this point), but not for reversal trades. If
the premise of the methodology is to buy securities when they reach a certain
oversold level, then additional selling will likely make your oscillator of
choice even more oversold. Therefore the likelihood of a bounce up increases,
and using a stop simply guarantees that you will not be able to participate in
that bounce.
The bottom line is that I don’t believe it is time to exit these ETF plays just
yet. I will be looking for a nice bounce to exit my positions. When that bounce
does come, you can be sure I will be out. While I like the short-term prospects
of the market, I don’t like the intermediate-term prospects. A lot of damage has
been done and it is going to be a long time before solid growth candidates with
good basing patterns are ready to emerge again.
Best of luck with your trading,
Rob
For those who may be looking to expand their
knowledge beyond just market timing, my
Hanna ETF Money Flow System utilizes the VIX in generating trading
signals for spread trades.
Rob Hanna is the principal of a money
management firm located in Massachusetts. He has spent the last several years
developing and refining methods for trading in stocks across multiple time
frames. He selects stocks using both fundamental and technical criteria, and
then trades them using technical analysis techniques.