Option Investor
Educational Article

The Best Defense

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In both the sports and military world, the saying is "The best defense is a strong offense". In the trading world, I think it should be changed to "The best defense is a strong business plan". That is sage advice in ANY market environment, but doubly so in the volatile, gap-infested trading waters in which we currently find ourselves. Virtually all of the action in the markets in the past several weeks has been due to the changing picture on the war front. To make it even more confusing, what passes for good news (to the market) on one day is taken to be bearish a few days later and vice versa. Then, adding insult to injury, the market will decide to change directions at a point that doesn't really make sense at the time. Traders trying to make sense of the noise have very little to go on, with normal chart studies and technical levels seemingly ignored by the market. And forget about the fundamentals! One look at the recent reactions to the dismal economic reports makes it perfectly clear that the market is ignoring this data right now.

If you're feeling confused, and more than a little beat up over the past few weeks, you aren't alone. I'm receiving several emails per day from traders looking for a viable way to prosper in the current market environment. I shared one of those (along with my advice) in Monday's article. Simply put, we need to avoid chasing every little move in the market unless there is a setup that fits within our own individual business plan. One part of my own business plan mandates that I do not EVER trade on a day with a large gap move. As you all know from the action in the broad market lately, that means that I have been trading very little. I know from years of experience that I can't predict how the market will digest that gap, and by virtue of its existence, that gap makes risk management much more difficult.

I'd like to take our time today to focus on another reader email that I think is closely connected to our topic from Monday. The issue raised is central to trading success, both in this difficult environment and in the future when the market returns to trading on pertinent fundamental and technical data.

Have you written anything about a strategy for traders where they could keep most of their winnings without giving them back to the market? If you have written anything on that subject, please let me know. I have not yet learned that art. I think I must learn to sell too soon. I've seen too many bear profits collected over 2 months vanish in 1 week, and turn to losses. If you have any wisdom on the subject about harvesting profits (when to sell, how much profit to aim at etc) will you please pass it on to me?

Now these are VERY important questions. Those of you that have gone through the work of building a trading plan (and actually trading that plan) know that these are all questions that MUST be answered in the development of that plan. You see, in addition to defining what types of trades you will place, the plan should also specify what is your acceptable risk/reward ratio. I won't take a trade that doesn't offer me at least a 1:2 ratio. The reason why is that it allows me to target a gain of $5 while assuming a risk of no more than $2.50. If I do this over and over and even half my trades are losers, I should still reap a net gain over time.

I don't know if this reader has built his own business plan. If not, then it seems these questions are being asked in the process of building that plan. If the plan has already been built, the questions are being asked in an attempt to improve on the results that business plan is providing. That is also a good thing. We must always evaluate the results we achieve in trading and determine first whether we are adhering to that business plan and secondly whether it would be possible to improve the business plan without introducing additional risk to the account.

Now this is a very important point! Modifying the business plan and how we are going to trade the account is always something that can be considered. But I would be very careful. We shouldn't change our trading style just to accommodate changing market conditions until we've taken the time to paper trade that new strategy and see how it performs under live fire. You see, if we change our trading style to accommodate new market conditions, then we have to determine how we will know when market conditions have changed once again. More importantly, how would the modified trading approach handle that subsequent change in the market?

This gets to the key characteristic of a robust business plan -- it must be able to perform reasonably well across the whole spectrum of market conditions. Certainly it will perform better in some market conditions than others, but it must be capable of preventing large losses in adverse market conditions. That goal may be accomplished by having different strategies that are employed in trending markets than in rangebound markets. Or it may simply dictate abstinence from trading in a choppy news-driven environment, such as we are currently experiencing.

As I mentioned on Monday, my business plan has me getting much more cautious in a non-trending market. That means I place far fewer trades, and those trades that I do place are done so with much smaller position size. That quality of my trading plan ensures that it is not possible for me to sustain large losses to the account during non-trending markets. I may get caught a couple times during the transition, but once I can see that a trend is no longer present, my trading plan has a release valve built in to keep me from compounding the error.

I am not a momentum trader. My style is to buy support and sell resistance, and that approach does not change, regardless of market conditions. What does change (and this gets to the heart of the reader's question) is how much room I will give a trade to move against me. Since my position size is smaller, I am more comfortable with a stop placed the other side of support or resistance. My initial stops are always based on technical levels. I then modify my position size to keep the risk in the trade at a defined level, based on permissible risk in terms of dollars. That part of my approach remains constant. Where it deviates in a volatile market environment is that I am far more aggressive about tightening the stop when the market allows me to do so. As soon as technically feasible, my first goal is to tighten my stop to the break-even point. And I will aggressively follow the position with trailed stops, almost daring the market to take me out of the play.

The other way in which I get aggressive with my trades is by closing out ANY trade that presents me with more than a 75% return. There is no flexibility on this point. The trade may go on to produce a 200% gain without me and I am perfectly happy to let it do so. I got what I was looking for and I don't look back. This is a sharp deviation from how I manage trades in a trending market environment, as in that case I will let a trade run as far as it can without taking out my trailed stops. But very rarely do I let even a great trade run beyond a 200% gain. I like profits and I like them even better when they are booked!

So let's review. The first step in difficult market conditions is to cut back on position size. That allows us to still use technically significant stops while at the same time reducing our risk in any given trade. Then we focus our efforts on tightening that stop to break even as soon as possible. And we don't want to waste any time in tightening the stop, as a booked gain can't be taken back by Mr. Market. Most importantly, we need to reduce our expectations from any given trade, being content with taking modest gains more frequently, rather than hold out for the "Big Score". By modifying our business plan in this manner, we reduce our risk in the near-term, while at the same time giving us continued confirmation that the basic theme of our business plan is workable in both good and bad market conditions. Then, when we see our trades being consistently closed out far too early, we can begin to conclude that the market is behaving in a more rational manner and we can start to remove the "choke hold" on our trading plan.

Once again, we've stayed away from looking at specific stocks or potential trades because I wanted to focus on the big picture. I think we've covered that in sufficient detail. Next week, I'm going to pick a specific stock (I haven't decided which one yet) and show the different ways in which I would have traded it in a trending environment vs. how I would be trading it now. Hopefully that will help to answer any remaining questions on the issue of how best to defend ourselves from the perils of a treacherous market.

Questions are always welcome!


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