The markets finished the week back at their highs and there is little indication of the weakness that plagued us in early January. Sector rotation out of emerging markets, metals and energy produced significant cash flows into techs, blue chips and even some small caps. It appeared as though funds were just holding their breath for the first week of January to see if a correction would appear. Once they were confident support was going to hold they put their energy, metals and emerging market profits from 2006 back to work in techs and brokers. The Nasdaq 100 was the strongest index for the week with a +3.3% gain while the broker/dealer sector saw the strongest influx of cash with a +5.9% gain.
Dow Chart - Daily
Nasdaq Chart - Daily
Economically it was an off week with a peppering of non-critical reports that were mostly ignored by the markets. It was a week where oil news took center stage followed by earnings warnings, the iPhone and the Cisco/Apple battle over the name. Those companies that did warn saw their shares punished but we did not see the sectors collapsing as we have seen in the past. All in all the market was very well behaved, volume was strong and internals improved daily.
Next week the economy will be back on the front line with our first real look at the full month of December. Leading the list of critical reports will be the Producer Price Index (PPI) on Wednesday. The PPI came in at a very hot 2.0% for November and the December number is expected to decline to +0.4% due mostly to the continued slide in energy prices. This will be welcome news for the Fed to see prices at the producer level soften. However, on Wednesday the Consumer Price Index is expected to rise +0.4% compared to its flat reading in the prior month. This will be only a slight blip on the Fed radar since they know the prices for Jan/Feb are likely to take a significant drop due to the further collapse of energy prices in 2007.
Overall the reports this week should show a growing economy, shrinking inflation and the soft landing relatively intact. If anything the numbers could begin to show more of a touch and go for the economy rather than any landing at all. This expectation has produced a rise in the yield on the ten-year note to 4.77% and nearly a 3-month high. You may recall the yield hit a ten month low back on Dec-1st at 4.4% and analysts at the time were calling for an eventual 2-handle due to the softening economy. That means a rate somewhere in the 2.x% range. Expectations have changed significantly over the last month, as have expectations for Fed policy. Currently there are no expectations for a Fed rate cut through September and many analysts are quickly reverting to expectations for the next move to be a hike if the economy continues to rebound at its present presumed pace. Some analysts were thinking Q4 GDP could have fallen into the 1% range as late as month ago. Now there is talk of a rebound into the 3% range which would put the Fed right back into hike mode if that growth failed to moderate in Q1.
Investors will get an idea about Bernanke's economic view when he testifies before the new Senate Banking Committee on Thursday. That could be a tense time in the markets if Bernanke uses the opportunity to talk tough to the markets. Analysts believe the various Fed heads will begin to take a harsher stance in their public appearances and try to talk up rates rather than actually be forced to raise them. This will not be market friendly if Bernanke fires the opening salvo on Thursday.
The Fed Beige Book will also be a look into how the Fed sees economic activity developing across the country. There are several other economic reports of note I have highlighted in the graphic below.
The market will also be more focused on the Q4 earnings cycle as the larger companies begin to report. Intel will be critical on Tuesday and even more so after AMD warned this week that the chip war was taking a serious toll on AMD profits. Analysts expect Intel to post positive results but the key will of course be the guidance. Some feel Intel has been popping out new chip models at a rate that cannot be absorbed by the market. Multiple new models means corporate buyers have too many decisions to make and too many options. This can fragment the market and not produce enough sales in any one model to make it cost effective. The other models that were quickly bypassed end up languishing in inventory and lead to future write-downs. AMD has been fighting a good fight and they may have impacted Intel margins more than analysts expect. AMD warned on Thursday that revenues would be up a mere +3% for Q4 compared to prior estimates of +6% to +13%. Intel has been turning out new processors on almost a monthly basis while cutting prices at the same time to regain market share. Just how much those price cuts and new product production expenses have impacted Intel profits won't be known until Tuesday night. Although the AMD warning subtracted -9% from AMD stock on Friday it is hard to imagine any Intel news that would burst the current Intel bubble. It is always possible but just hard to imagine today. AMD traded 123 million shares with average volume only 17 million. Goldman Sachs downgraded them to a sell two weeks ago. Good call.
Market research firm NDP Group reported this week that corporate users were warming to Vista much quicker than expected. The sales results for December showed an adoption rate that was only -4% below the same rate for the Windows XP release. Considering the major impact of this release and the significant challenges of hardware upgrades needed for Vista this should suggest a strong hardware cycle in progress. Microsoft surged on this news to a new 52-week high. This should have been a benefit to Intel as well so Tuesday's earnings will be interesting to say the least.
Apple reports on Wednesday and everyone will be looking for any notes to earnings related to the stock options violations for Steve Jobs. GE, Citigroup and Motorola will close out the week with their reports on Friday. GE could have news about the projected sale of their plastics business. Motorola has already warned but will give the exact details on Friday. Samsung, the 3rd largest handset maker, reported earnings last week that fell -8%. Mobile phone sales rose to 32 million from 30.7 million in Q3 but profit margins dropped as much as -11% as margins were squeezed in an increasingly competitive market place.
Oil field services company Schlumberger (SLB) also reports on Friday and earnings are expected to be strong despite the drop in oil prices. SLB has said that US gas well services have slowed as drilling declined slightly with prices but international demand for services is continuing to climb. After warnings from BP, Chevron and Conoco it will be our first real look into earnings not directly related to refining and production. Service companies and drillers are expected to post strong results. Earnings for the entire energy sector are only expected to decline -2.7% because oil prices in Q4-2006 were comparable with Q4-2005. The next two quarters will have favorable comparisons since oil prices did not peak until early August.
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In stock news on Friday BP saw a huge bounce in its stock price, +3.05 (+5%) when it was announced that CEO Lord John Browne would retire earlier than expected. He will step down at the end of July instead of sometime in late 2008. Browne started with BP in 1966 and rose through the ranks to eventually become what some called the worst CEO in business in 1995. He will be replaced by Tony Hayward who is currently the head of exploration and production at BP. Browne has been blamed for dozens of major BP problems that developed during his reign. Having new leadership of the floundering oil giant is a definite positive for BP shareholders.
Conoco Phillips announced a $1 billion buyback that was good for a +$2 bounce.
Back in December Chevron announced a $5 billion buyback over the next three
years. Both have warned that production levels are slipping and they can't add
reserves at the rate they are currently producing. Instead of putting this money
to work trying to find more oil they would rather give it back to investors for
a temporary pop in the stock price. This is bad news for future production
because it proves they have nowhere to explore that has not already been drilled
or is in hostile hands.
While on the subject of oil we heard on Friday that OPEC may hold an emergency meeting in February and "might" cut another 500,000 bpd in February. This is about as wimpy as it gets. You have to make the November cuts of -1.2 mbpd first then the previously announced February cuts of -500,000 bpd before you can expect anyone to believe you are going to cut another -500K. OPEC has no credibility in light of recent production volumes and this may be the strongest evidence that a substantial cut must occur. According to Platts OPEC production was 27 mbpd in January, +700,000 bpd above their stated target. According to Petro Logistics actual shipments only fell -100,000 bpd in Nov and Dec and were on track to rise in January. According to tanker tracker Oil Movements OPEC shipments have actually risen +350,000 bpd in January. Obviously everyone has different numbers but they are all showing substantial shipments over the stated OPEC quotas.
Now, because they did not cut as promised they have an even bigger problem and it will cost them more money now to fix it. Had they cut production back in November to keep oil over $60 they would still be getting $60+ for that lowered production level. Now with oil hovering around $50 they will still have to cut production but they are going to be getting $10 less per bbl for that lowered production. Their greed is going to cost them big time. They know how this story ends if they don't follow through with their cuts. Oil will continue falling and they will end up selling their basket of OPEC crude for $40 rather than $60 and that is a major blow to countries already strapped for cash. They had the opportunity to control prices at a much higher level and blew it. Now every day that passes costs them even more money and that same tough medicine is waiting to be taken. $50 is seen as a key psychological level and they will need a major announcement with teeth next week to keep that level from breaking.
Bloomberg surveyed 47 analysts, dealers, traders and brokers and 20 said prices
will decline next week, 11 expect an increase and 16 predicted little
Last week 23 expected a drop. In the weekly Commitment of Traders report as of
Jan-9th commercial positions increased to a net long status while speculators
reversed into a net short position. Speculators increased their short positions
by 21,161 contracts or +13% for the week while reducing their longs by -3,391
contracts. Typically commercials are on the right side of the trade and
speculators are on the wrong side. This suggests we may be near a turn in the
sell off is overdone and while we may not have seen the exact bottom
it may not be far from here. Oil settled at $53 on Friday
February Crude Oil Chart - Weekly
Ethanol is going to significantly raise the price of your food in 2007. The 2006 corn harvest was the 3rd largest ever in the US but global supplies will drop to the lowest level since 1978 according to the USDA. The US is the largest corn producer and exporter in the world. The USDA said global consumption this year will rise to a record 725.8 million tons, exceeding production for the sixth year out of the last seven. Global inventories will drop to 86.4 million tons, down -55% since 2000. Corn futures rose +20 cents to $3.965 a bushel on the USDA news. This was a lock limit move and the maximum allowed for any single day of trading. Late in the afternoon there were 60,000 contracts bid and none for sale ahead of trading next week. It appears Tuesday will also be limit up and anybody short is in a world of pain. With no sellers and 60,000 contracts to buy it could be several days before they can cover. A full size contract is 5,000 bushels and each 1/4-cent move is worth $12.50 per contract. The limit move is worth $1000 per contract. Good if you were long but painful if you were short. Yes, there were shorts. Over the first five days of the month corn prices fell 45 cents from what had been the closing high for 2006 at $3.90. You can bet there were shorts on that decline given the +$1.40 rise the prior 3 months. That is an unheard of move in corn futures and plenty of traders were probably expecting it to decline back to some decent price in early 2007.
March Corn Futures Chart - Daily
The shortage of corn suggests to analysts that acreage devoted to wheat and soybeans will shrink as farmers try to capture this bull market in corn. They estimate 7.5% more land will be moved to corn farming with soybeans taking the biggest acreage hit. Corn also requires more nitrogen fertilizer, which comes primarily from natural gas. Companies benefiting from this expectation are John Deere (DE +3.83) for additional corn specific tractors and Potash (POT +6.23) for fertilizer. Other related stocks are AGU, CF, MOS and TRA. You can also buy the new Powershares Agriculture ETF (DBA +2.00), which is not specifically corn but covers four commodities, corn, wheat, soybeans and sugar. It was up +8% on Friday to $27.30.
DB Powershares Agriculture ETF Chart - 15 min
Last week was the strongest week in the markets since November with the Dow, Nasdaq and S&P closing at new 6-year highs. As I stated on Tuesday the Nasdaq was leading the charge and that was clearly evident over the last three days. That tech-based charge may not be as strong as it appears on the charts. The charge was led by the big caps MSFT, INTC, AAPL, CSCO, GOOG, SHLD, etc. The big caps impact the index by a much larger margin than the smaller stocks. For instance on Friday Microsoft rose +0.51 cents but that was worth +2.02 in index points. On the reverse Amylin Pharma (AMLN) gained +2.27 but that only represents 0.33 index points. Intuitive Surgical (ISRG) gained +2.79 but that was only worth +0.18 index points. Since Wednesday's low Microsoft gained +$2 and that was worth +7.92 index points or +13% of the 60 points gained by the NDX over the same period. I am sure you get the idea. Big cap techs suddenly found themselves in favor again and the index was rewarded with a strong sprint higher. I am sure there are good reasons for suddenly buying Intel and Microsoft and their tech sisters but I still believe one good reason is liquidity. Fund managers are not completely convinced there is not a correction lurking around the corner and are more comfortable in parking money in those big cap pockets of liquidity than a smaller stock that only trades a 2-3 million a day. Intel traded 90 million shares on Friday and Microsoft 104 million. It is not a bad sign that the index moved higher because the big caps excelled because it would have been nearly impossible to move without them. It is just a reason for concern, a point we need to keep tucked away in out mental bias for next week.
The Dow rallied to another new high, the 24th since October and tacked on +41 points on Friday to close at 12550. Like the Nasdaq the Dow benefited from strong gains in a few key issues. Exxon lead the winners with +1.68 on the rebound in oil prices. HPQ was up on the benefits of the price war between Intel and AMD. Dupont benefited from the fertilizer story and IBM rose on an upgrade. All good reasons but only 18 of the Dow 30 posted gains on Friday. Yes, it was a new high but the index is looking a little tired. It has good reason to be tired. It has not seen a -2% drop since July-06 or a -10% drop since early 2003. The current bull run for the Dow has lasted more than 1500 days for a +72% gain. This is the second longest streak on record and the 3rd longest cyclical bull out of 34 since 1900. It is no wonder fund managers are worried about putting money to work in this market.
Earnings are slipping simply because you can't continue to improve double digits forever. Q4 is suspected to produce +9.4% earnings across the entire S&P-500. Not bad but just not as good as the prior four years. However, conditions are looking up for the bulls. If the economy is rebounding as analysts currently expect then the Fed did manage to pull off the soft landing without a crash. If the economy does continue to improve the Fed may have to hike rates again by summer but rising rates in a rising economy are somewhat tolerable. Eventually the bull train will derail but possibly not until 2008. This hope is what fund managers are betting on. One more year of strong gains, a neutral Fed and decent earnings.
Next week could either cement those hopes or send them crashing to the pavement. The economics for December will be revealed and the earnings cycle will start in earnest. Traders will be willing to overlook almost anything next week in hopes of keeping the dream alive. Hopefully any bad economic news will be easier for us to stomach than the medicine in front of OPEC next week. Heck, some soft economics might be just what the doctor ordered to keep the Fed in check and the dream alive. Strong reports could wake up the Fed and have them back in the picture before managers are ready to weather the storm.
SS&P-500 Chart - Daily
The S&P-500 rose over resistance at 1415 and came to a dead stop at 1430 on
Friday. Obviously it is reading my articles and knew that was our short/long
decision point and exactly where
I was expecting a repeat failure. After
watching the market internals this week I believe there is a good chance we
could see a breakout on this attempt. Instead of each bounce weakening the
internals just kept getting better. For whatever reason market sentiment has
improved significantly over the prior week. This leaves me with a bullish bias
for next week if we can make that break over 1430. Otherwise I will be riding
the SPX back down again with any failure at that level. A lot
of the gain on the
S&P was due to buy programs on Thursday and Friday morning followed by some late
afternoon short covering on Friday. I am always leery of gains made entirely on
the back of program trades. It is better to see a gradual climb supported by
broad based buying instead. So, for next week we will be going long over 1430
and short on any failure of that level. Since Monday is a holiday I will be back
with you Tuesday night to report on Intel and the outcome of the
Chaparral Steel - CHAP - cls: 45.16 chg: +1.33 stop: 41.99
Why We Like It:
BUY CALL FEB 40.00 ZHQ-BH open interest=115 current ask $6.00
Picked on January 14 at $ 45.16
iShares China Index - FXI - close: 105.40 chg: +2.40 stop: 99.49
Why We Like It:
BUY CALL FEB 100 FJJ-BT open interest= 483 current ask $8.40
Picked on January 14 at $105.40
China Life Ins. - LFC - close: 46.86 change: +1.41 stop: 43.95
Why We Like It:
BUY CALL FEB 45.00 LFC-BI open interest=1017 current ask $4.20
Picked on January 14 at $ 46.86
Teleflex - TFX - close: 67.11 chg: +0.91 stop: 64.75
Why We Like It:
CALL FEB 65.00 TFX-BM open interest= 22 current ask $3.20
Picked on January 14 at $ 67.11
Lehman Brothers - LEH - cls: 82.74 change: +1.63 stop: 77.99*new*
LEH continues to post strong gains. The XBD broker-dealer index set another record high on Friday. Shares of LEH followed suit with its own new high and a 2% gain on strong volume. Boosting the stock was a price upgrade before the open. An analyst firm raised their price target on LEH to $91. Last week's breakout over resistance at $80.00 is very bullish but don't be surprised if we get some profit taking. Fortunately, broken resistance near $80 should now be new support. We're raising our stop loss to $77.99. More conservative traders may want to use a tighter stop loss. We would not suggest new positions here. Wait for a dip back toward $80-81 before initiating a new play. We have two targets. Our conservative target is the $84.85-85.00 range. Our aggressive target is the $89.00-90.00 range. LEH's Point & Figure chart shows a very bullish pattern called a bullish triangle breakout that points to a $111 target.
Picked on January 11 at $ 80.25
Lockheed Martin - LMT - cls: 96.31 change: +0.65 stop: 90.95*new*
Last week was very bullish for LMT. Shares rose more than 4% and broke out past potential resistance at the $95.00 level. Furthermore LMT hit our conservative target in the $94.85-95.00 range. Chart readers will note that Friday's rally in LMT appears to have broken the six-month trendline of resistance (across its highs). We remain bullish on LMT but we're not suggesting new positions at this time. LMT may be due for some profit taking and a dip back toward $94 would not be a surprise. Our aggressive target is the $99.00-100.00 range. We are raising the stop loss to $90.95
Picked on November 29 at $ 90.62
Merrill Lynch - MER - close: 97.02 change: +0.74 stop: 93.99*new*
MER is another broker-dealer stock soaring to new record highs. The stock broke out over resistance at the $94.00 level last week and did so on strong volume. We expect that shares will make a run for the $100 level before the earnings report. Our target is the $99.50-100.00 range. We do not want to hold over the January 18th earnings report so we plan to exit on Wednesday the 17th at the closing bell if MER has not hit our target by then. We are not suggesting new positions in MER at this time. Please note that we're raising the stop loss to $93.99.
Picked on January 10 at $ 94.44
Altria Group - MO - close: 88.42 change: -0.98 stop: 84.75
Shares of MO hit some profit taking on Friday. Readers should not be surprised. We warned you on Thursday that the action looked like a short-term bearish reversal. The only good news on Friday was a minor bounce from short-term support at its rising 10-dma. Meanwhile in the news on Friday it was announced that the U.S. Supreme Court will review the "lights" case between the state of Arkansas and Phillip Morris. The Supreme Court is reviewing whether or not MO can successfully keep the case in federal courts or whether it belongs back in state courts. We're not suggesting new positions in MO at this time. More conservative traders might want to consider a tighter stop loss near $86. We are targeting a rally into the $92.50-95.00 range. The P&F chart currently points to a $114 target. We do not want to hold over the late January earnings report.
Picked on January 04 at $ 87.65
Cummins Inc. - CMI - close: 116.75 change: +0.87 stop: 118.15
More conservative traders may want to strongly consider an early exit in CMI. As we expected the stock struggled to make it past short-term resistance at the $118 level. However, our concern now is that if the major averages continue to rally higher next week then CMI will eventually follow and we'll be stopped out. Currently CMI is trading near its four-week trendline of resistance. Yet on the weekly chart the stock has broken a long-term trendline of support. At the same time we notice that on the weekly chart the latest candlestick looks like a potential bullish reversal. We are not suggesting new plays at this time. Currently the Point & Figure chart has a triple-bottom breakdown sell signal with a $96 target but is also testing support in the $114-115 region. We have two targets. Our conservative target is $110.50 and our aggressive target is the $106.00 level.
Picked on January 10 at $114.50
eBay Inc. - EBAY - close: 30.00 change: -0.23 stop: 31.26*new*
Tech stocks, especially Internet stocks, turned in a strong performance last week. Yet EBAY under performed and closed with a loss for the week. The stock continues to trade under a bearish pattern of lower highs and it's struggling with technical resistance at its 200-dma. Even with EBAY's relative weakness we hesitate to suggest new put positions given our time frame and the market's strength. The company is due to report earnings on January 24th and we do not want to hold over the announcement. Please note that we're adjusting our stop loss to $31.26. Our target is the $26.00 level.
Picked on January 08 at $ 29.70
(What is a strangle? It's when a trader buys an out-of-the-money (OTM) call and an OTM put on the same stock. The strategy is neutral. You do not care what direction the stock moves as long as the move is big enough to make your investment profitable.)
Blue Nile - NILE - cls: 38.91 chg: -0.52 stop: n/a
After two months we're right back where we started. News that NILE would be added to the S&P small cap index (the announcement came out weeks ago) has reversed the stock's direction. Unfortunately, we're down to our last four days before January options expire. We're not suggesting new positions. We're adjusting our target to $1.20, which is half of our estimated cost. The options in our suggested strangle are the January $45 call (JWU-AI) and the January $35 put (JWU-MG).
Picked on October 29 at $ 38.92
Goldman Sachs - GS - close: 213.99 chg: +2.11 stop: 199.75
Target achieved. The broker-dealer stocks continued to run on Friday. The XBD index rose 1% to close at another new all-time high. Meanwhile GS paced the move and closed up 1% for its own record high. The intraday high for GS was $214.22 and our suggested target was the $214.00-215.00 range. More aggressive traders may want to aim higher (maybe the $218-220 region).
Picked on January 10 at $208.11
Reynolds American - RAI - cls: 64.30 chg: -0.71 stop: 64.90
We are giving up on RAI. It was our plan to buy calls on a breakout over resistance near $66.50 but shares of RAI are not cooperating. We're dropping the play unopened.
Picked on January xx at $ xx.xx <-- see TRIGGER
Sepracor - SEPR - close: 61.30 change: -0.42 stop: 59.99
SEPR is still not moving even though biotechs and drug stocks have turned in a strong rally this past week. We're suggesting an immediate exit to cut our losses and move on.
Picked on January 07 at $ 61.89
It never fails. When I tell people that I am a writer but make my money trading, someone compares my career as a trader to that of a gambler. I chafe at such comparisons. I'm a technical trader, I want to assert. I employ indicator systems that are complicated enough that I gain the same pride I used to gain when working with Fourier series in college.
But do traders have anything to learn from gamblers?
You bet they do. The first lesson is that traders can lose their shirts, better known as their trading capital. Dare I say it? This is particularly true for options traders who must bet on both direction and timing. These traders, more than anyone else, need to employ two strategies to protect trading capital: determining the appropriate size of their bets or positions and setting appropriate stops.
The risk of blowing through trading accounts has a name we can borrow from the betting world: risk of ruin. Let's be honest when addressing the risk of ruin. If the term is given its strictest interpretation for traders, that of blowing through a trading account, the risk of ruin is greater for those with small trading accounts. Why? Drawdowns.
Drawdowns occur when a trading plan suffers a number of losses in a row, an inevitable event, no matter what the trading style or system. Add in the costs of commissions and slippage, and it's not a hard concept to grasp that a series of losing trades is going to run through small accounts faster than it's going to run through larger ones, even if traders with the smaller accounts are entering smaller position sizes. The costs of commissions and slippage are going to represent a larger percentage of their trading capital, adding to the risk of ruin.
That series of losses happens to all of traders. The better traders are and the better their systems, the less the likelihood of the drawdowns being too deep or prolonged, but make no mistake. They happen to everyone. Even a system that produces 90 percent winning trades over a long period of time will occasionally suffer short periods of one losing trade after another, and only a few people can claim a system that produces 90 percent winning trades. Most systems produce fewer winning trades. Traders with small accounts run the risk of paper trading or backtesting a new system, verifying that it works, only to have that inevitable series of drawdowns begin to occur once real money is at risk in real positions.
This is a risk that all traders must accept. It's the reason brokerages make traders agree that trading is risky before they'll take their money and open accounts. Recognize that it can happen because that recognition makes traders more realistic about the amount that they should devote to a particular position and also helps control some of the shame of a losing trade. Or several in a row. No system is 100 percent.
So what is the optimum amount that should be risked on each trade for those traders with a $5,000 account or those with a $100,000 one? You're not going to like my answer because I'm going to tell you that there is no one right answer. Google "risk of ruin" and you'll find a number of online calculators put up by betting sites that will chug out a percentage number. I suggest that you try them to get a feeling for how quickly your trading capital can be depleted if positions represent too high a percentage of your trading capital. All traders should have an absolute feeling for what can happen if they invest too much in positions and hit one of those inevitable periods of one losing play after another. However, while you're gaining some understanding of how this works and attempting to optimize your position sizes, as I absolutely believe you should attempt to do, be aware that these calculations require some assumed inputs and also that they're leaving out something important. A couple of somethings important.
Those inputs include the relationship of the loss traders will accept to the profit they seek and the probability that each trade will be profitable. For example, in the November 2006 issue of STOCKS & COMMODITIES, Lee Leibfarth ("Measuring Risk") computes the risk of ruin for a system that produces a 50 percent likelihood of a trade being profitable, actually a rather high percentage when many profitable trading systems produce winners only 40 percent of the time. This system works on a 2:1 profit/loss ratio. The stop is set at half the value of the profit limit, the profit number at which the system automatically takes a profit. In other words, imagine that you want to make a $2.00 profit on each options trade and so will set your stop at a $1.00 loss for each. Your position is either automatically closed with a $2.00 profit or a $1.00 loss. This system determined that the optimum percentage of the account to be risked on each trade was a rather high 25 percent, not a percentage that I would ever suggest for our readers.
If you haven't guessed already, Leibfarth points out that this was based on a coin-toss system and that in this idealized system that gambles on a heads-up successful outcome, no accounting was made of the costs of commissions and slippage. Fortunately, no one charges us yet to toss a coin and calculate successful outcomes, but in the real world of trading, those commissions and slippage costs would eat into the profit. Trades would no longer produce the 2:1 profit/loss relationship. Even this optimum 25-percent position risk in the coin-toss test resulted in a 20 percent risk of ruin, however, without those extra commission and slippage costs. The risk would have been higher without them.
At www.traderscalm.com, a writer employs the same 50 percent winners/losers coin-toss methodology to calculate risk of ruin. The writer starts with $100 and calculates the risk of ruin if $1.00 were bet on each toss of the coin and then compares that to the risk of ruin if $10.00 were bet on each toss of the coin. The risk of ruin for those betting $1.00, or 1 percent, on each bet turns out to be less than the chance of winning a lottery--a very low risk of ruin--since the wrong outcome would have to occur 99 times in a row for ruin to occur. Before options traders with small accounts are tempted to decide they'll just keep their position sizes at 1 percent, though, I hasten to add some cautions. First, some might decide to keep their position sizes at such a low percentage by buying far-out-of-the-money options. I regularly hear from traders who have bought such options. The reason I hear from them is that those options aren't increasing in price enough with each movement of the underlying to make them profitable by the time they pay part of the bid/ask spread to buy them and give up part of the bid/ask spread to sell them and then pay commissions for both trades on top of that. Far-out-of-the-money options feature extremely low deltas, the measure of how much the option's price will move as the underlying does. A 1-percent position size may not solve the problems incurred by traders with small accounts, not if they must seek low-delta options to keep positions at that size. Even if these traders are finding some options with reasonable deltas, their profits may not be enough to pay for their commissions and slippage costs because the profits are so limited by the small position size. Leibfarth's calculations also found that risk of ruin rises when position sizes are too small because profits don't accrue quickly enough to build up a cushion against the inevitable periods of several losing trades in a row. Something higher than 1 percent may be necessary.
In the TradersCalm example, the risk of ruin for those betting $10.00 on each throw of the coin was 1 in 1,000. If $7.00 is thrown bet on each throw, the betting account could weather 14 tails in a row. I have to caution here that, again, no commission or slippage costs were included, and those would change the risk of ruin because they change the profit/loss ratio that was established at the beginning. It's no longer 2:1. Still, the profits would build a bit faster and the costs of commissions and slippage wouldn't eat into them as fast.
Perhaps traders will find, after making these calculations on the online sites that offer calculators (TradersCalm doesn't, at least not that I can find), an optimum position size that feels right for them, realizing that the risk is never zero unless the coin is never thrown and the bet is never made. Something else must be considered. It is also important to realize that, even if traders have calculated that their trading account could weather the drawdown that would occur with 14 bad outcomes in a row or even 20 or 40, something might start happening along about the seventh or eighth or twenty-first loss in a row. Emotions might kick in and start getting in the way. In a real-life situation, traders might be tempted to alter the size of their positions or engage in more or less risky trades with different profitability ratios. They might vary from their trading plans.
TradersCalm calls that last response the trader-emotional-response risk. Some might find that risk too high for certain trading styles, requiring them to adopt trading styles that are more in tune with their personalities so that they incur less trader-emotional-response risk. The risk of ruin is not cut-and-dried, as many calculations as we make and as much as we'd like it to be. When traders are assessing risk of ruin and trying to determine an appropriate position size and type of trading, they have to know something about their emotions and trading personalities, too. We can't rely on these coin-toss analogies alone to decide on position size.
For example, some well-known traders and market gurus have determined in the past that break-out plays tend to be more profitable over the long run, but the drawback to such plays is that the proportion of winning plays to losing plays can be much lower than in other types of trading systems. Long strings of losing plays in a row can occur as breakouts appear to be occurring, only to have a quick reversal happen. The overall profitability depends on having an account large enough to weather the drawdowns, on keeping losses on each losing play small in relationship to the sometimes significant gains when a breakout play runs a long distance and on managing the emotions that arise in dealing with those prolonged drawdowns.
There's another pesky problem: even if traders carefully calculate risk of ruin, market conditions can change and the calculations no longer work because profitability ratios have changed. There's a possible solution for this. Another suggested method of managing risk is to employ two different trading styles, each with different risk profiles, but with the requirement that one tends to be profitable while the other might be experiencing a period of drawdowns. In more complicated terms, they should have a negative correlation with each other. For example, a trading style that benefits from breakout plays might be combined with one that benefits from range-bound trading, the old buy-low-sell-high type. When the range-bound trades are souring, markets are likely trending, which means the breakout plays might be performing well, and vice versa. This method of managing risk of ruin requires some complicated decision making when deciding how much of an account will be devoted to each type of play, and it means that the emotional risks might rise if some trades are always losing. Traders who suffer the most shame when trades are losing will find it difficult to employ such a methodology.
A third method of managing risk is termed the anti-Martingale method, and it's one that I have been employing for the last eighteen months. Explained simply, traders using the anti-Martingale method would increase the size of their positions as their trading system produced profits. This can backfire, as the size of trades can be increased just as a period of losing trades and the inevitable drawdowns set in, but the anti-Martingale method helps to manage that difficult-to-quantify risk, the trader-emotional-response risk. That emotional response can heighten as the number of options contracts escalates. Accustoming oneself slowly to increasing position sizes can help manage that risk. Traders who are accustomed to trading well with five contracts at a time might not do so well if they deposited a hefty amount in their trading accounts and decided to trade fifty contracts at a time. Having fifty contracts appear to go wrong at one time could lead to a panicked decision, one not in keeping with the trading plan. Traders might bail before either the profit limit or the stop was hit, for example. The anti-Martingale method would suggest that traders would scale up gradually from five to fifty contracts, lowering that trader-emotional-response risk.
The www.traderscalm.com website offers ideas for managing trader-emotional-response risk as well as ideas for position sizing. All traders should remain aware of these basic maxims: risking too high a percentage of one's trading account on each trade increases the risk of ruin but risking too little can do that, too, as this method will not build enough profit to pay for the costs of commissions and slippage or weather drawdowns. The smaller the trading account, the more vigilant traders must be about position size, keeping losses small in relationship to gains and managing that trader-emotional-risk. Stops must be used and losses managed, no matter what the size of the account, because the size of losses in comparison to profits is an important input in calculating risk of ruin. The risk of ruin can not be reduced to zero by micro-sizing the size of positions or even by vigilantly setting stops, but it can be managed.
This may sound pessimistic, but it can be reassuring, too. If you've ever blown through a small account, it might not be the fault of your trading style or your acumen as a trader. Of course, your system itself may have been faulty, and that's something you should examine, but also you may simply have been using too large or too small a position size, heightening your risk of ruin. You may have simply had bad luck in the timing of inevitable losing plays, a fact you can accept if you think about all this in a purely mathematical way and realize that the risk of ruin is never zero. That doesn't get you off the hook from thinking about the issues related to risk, however, and it doesn't absolve traders with big accounts from employing sane account-management practices. While a larger account may be able to better weather drawdowns, it's going to hurt a whole lot more if you run through that account. Ask me. I know some people who have run through big accounts.
Google "risk of ruin" and try out some of those online calculators. Get a feel for the way that changing position size and the profit/loss ratio might change the risk of ruin, given the proportion of profitable trades you think you're producing. Check out some of the ideas at TradersCalm for managing that traders-emotional-response risk.
One caution. Some portions of the TradersCalm site lead me to suspect that
following links may result in a pitch to serve as a trading coach. I haven't
followed all the links so I can't be sure,
and the site says all services are
free, but enjoy the free portions and think long and hard before seeking and
paying for a trading coach, if following a link should result in that offer.
Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda
Piazza, and all other plays and content by
the Option Investor staff.
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