How to Profit from a High Risk Market

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The US markets are now teetering on the edge of a very important technical level. The low in February of 1044 has been tested twice in the past couple of weeks and another attempt to breach this level could see some significant downside.

S+P 500 daily chart

Last night’s price action was fairly bearish with an early triple digit rally in the Dow Jones vanishing in the afternoon and closing with a half a percent loss. BMO capital markets are certainly stepping up to the plate and making a big call by telling clients to go to cash.

A June 8 report by their Quant/Technical research team said:

We advocate switching out of equity positions and going to cash. The European sovereign debt crisis appears to be nowhere near over. The global credit environment is worsening. Cost of capital is going up and availability is going down. There are large gaps between where the credit market prices risk and where the equity market is priced. Equity is lagging the deterioration in credit conditions. Moves in currency, equity and commodity markets are mirroring the moves in the credit market. Global growth, in a credit-constrained environment, will slow. Profits will be squeezed by the higher cost of capital.

If this level can hold we should see a short squeeze back to the 35 day moving average which comes in around 1110 in the S+P. If we were to see that occur I would be a seller there because I expect this downtrend to continue for the foreseeable future.

If we turn to the situation in Australia it is interesting to note a recent survey by the financial sector union which showed that 29 percent of its members “felt uncomfortable about their customers’ ability to meet their financial obligations with new debt products.” About 43% said they were “under pressure to sell debt products, even if customers don’t ask for them and may not be able to afford them”.

So it appears that the risk levels in the market at the moment are still quite high. As a trader the idea of risk is a very important one to grasp.

What exactly is risk? I think it is the most difficult thing to understand in finance. Academia has come up with a number to describe the volatility of returns over time and that number comes to represent the word “risk”. But does it really make you understand what the volatility of YOUR earnings will be over time. I don’t believe it does.

Investors lost 50% of their equity in a year during the crash. Does it really help to know that a crash was only supposed to happen once in a blue moon according to the academics? No not really. End result is that you are down 50% in a year.

As a trader the main thing that you need to manage is the volatility of your returns over time. It doesn’t mean much to be up 100% in a year if you are then down 50% in the next. You are back to where you started, just a lot more stressed out.

The actual volatility of stocks is incredible. Their prices can move 30-50% without too much effort and the so called “blue” chips aren’t immune from the constant gyrations either. In the last few years BHP has gone from $50 down to $20 and then back up to $45. It has since fallen 17% in the last couple of months.

If you are entering the markets as a trader, with the desire to trade a finite number of stocks looking for superior returns, then you have to come up with a plan that manages to duck and weave its way between these skyscraper sized levels of volatility. It is imperative that your eye is always on the volatility within your account, because it is the volatility of your account that will be affecting your mental state and thus the decisions that you make in the market.

Whether the market itself is more or less volatile is really irrelevant. There is more opportunity in a volatile market but also more danger. Conversely in a low volatile market there can be fewer opportunities to make money, which can lead to frustration. The frustration can cause you to look for opportunities where none exist and this can lead to bad losses.

So what can we do to manage the volatility of our account, regardless of what the market is doing?

The first key is the thing that we all know about money management and I am not teaching you anything by saying it. We must limit our capital at risk per trade to 2-3%. At 2% risk per trade (my preferred amount) we are able to have 50 wrong trades in a row before we have lost our dough. With 3% risk per trade that figure falls to 33 trades.

The next thing we can do to lower our account volatility is to trade long and short. (Simplest way I can explain this is that being long means you have bought the stock and make money when it goes up, whereas when you are short you make money when it goes down.) This opens up a whole new world of risk management.

We can trade our portfolio with a market neutral stance when we are feeling unsure about future direction. This can help to mitigate the risk of overall market gyrations while still exposing us to trading stocks based on our technical trading system. There is also a lot of optionality that can open up once we are able to go long and short stocks.

If you have made money being long some stocks, then instead of having to get out of the positions when you fear a pullback in the market, you can short some stocks against the position. Then you have the ability to either make some money on the pullback, or cut the long positions and let the shorts ride if the market falls over from there. Every position still needs to fit into your technical trading criteria but by increasing the options at your disposal you can really start to ratchet down the volatility of your P+L.

There is also something else that can help to manage your risk while still exposing you to significant upside. My technical system is based on taking some profit off the table very quickly and adjusting my stop losses so that I am not risking any of my initial capital from that point on.

This is incredibly important for managing your mental state, which I believe is the most important thing to achieve in trading. It is the unstable mind that is thrown around like a ragdoll by the market.

If you can ensure that a high percentage of your trades get to this first level of profit taking, you are well on your way to lowering the overall volatility of your account. Since starting Slipstream we have reached this profit target 70% of the time, meaning that only 30% of our trades have gone straight to our stop loss level. This makes it much easier to make up those losses with the other trades.

The markets are an incredibly tempting proposition with the promise of huge gains if you can unlock their secrets. Unfortunately the path to unlocking them is never as easy as it seems and it is usually our own behaviour that gets in the way. This is why our technical strategy, trading and money management rules are so vital. Especially in these once in a generation markets that we face currently.

The next month or so is going to be very difficult to predict and the volatility will still be large, so tread very carefully.

Murray Dawes
Editor, Slipstream Trader
for The Daily Reckoning Australia

Murray Dawes
Murray began his career on the Sydney Futures Exchange trading floor in 1993 with Swiss Banking Corporation (SBC). He spent a couple of years in the 3 and 10 year bond and option pits before moving on to the Share Price Index (SPI) futures and options pit. From there he became a broker with SBC specialising in SPI futures and options to institutional clients. After leaving SBC Murray continued his career in broking at Bankers Trust Australia. Then in 2001 Murray moved to Melbourne to work as a hedge fund trader for one of Australia’s wealthiest families. In 2003 he was ready to set up his own firm providing the same proprietary technical trading system to some of Australia’s boutique hedge funds. The success of Murray’s system led to him trading a $10 million account for a high net worth individual. This involved trading Australian and US futures and Australian stocks. Now Murray heads up the technical analysis desk for us passing on to readers some of his experience from 16 years of trading.
Murray Dawes

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2 Comments on "How to Profit from a High Risk Market"

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Stillgotshoeson
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I always raise my stop on stocks as they appreciate. If a stock I like is falling I hold off buying till it returns to upward movement.. Trying to pick the bottom is a mugs game.. as is trying to time the top off the market to get out.. I research a stock I am interested in quite thoroughly.. I assess market conditions for the sector I am interested in. I am staying out of Banks and the Major Miners at the moment as I see more chance of negativity than positve outlook in the short term.. Medium to long… Read more »
Biker
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“Most stocks I have sold have continued past my sell level.. ”

And _every_ property we’ve sold ‘early’ has appreciated well beyond our sale price. One block we quickly trebled our profit on (pre CGT) is now worth sixteen times what we sold it for… . Providing you re-invest your profit, wisely, you’re laughing.

The basic rules still apply: “Buy low, sell high. Set a sell when you set a buy.” (Thanks, dad.) It’s simply _greed_ that catches out unprepared novices. Gotta admire those who know exactly what to hold, _really_ long term, though. Not our scene… .

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