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Archive for October 15th, 2009

Admired Traders discuss placing stops on leveraged trade and compare it to unleveraged trade.

David: A question has been sent in: I’d like to hear your thoughts on placing stops on leveraged trades either shares or margin or CFD compared with an unleveraged trade. If for example for an unleveraged trade, you followed a system where the risk has no more than a certain percentage of your total trading capital on any given trade and place stops accordingly, what are your thoughts on how this strategy might change when using leverage?

If you applied the same system in a leveraged trade considering only the margin component as being your own capital protection, the stop would be much tighter, increasing the likelihood that you would be stopped out as a result of a comparatively smaller dip in the share price. Alternatively if you set a stop a fixed percentage away from the trade value you will avoid the potential issue but leave yourself exposed to higher leverage and loss.

I suppose the question is how it works setting stops on leveraged instruments. Can you take the same strategies and methods you are using in unleveraged instruments?

Stuart: People may want to step up to the next level and include leveraged trade, and CFDs are a great way of doing it. There are certainly other ways of doing it like options and the like.

What do we do for support and resistance? Do we tighten our stops or do we leave them where we would normally? To me trading leverage you’re trading a very short term approach. I do know people who trade CFDs for the more medium to longer term. The key advantage of CFDs over options is there is no time decay. With options you have a life. With CFDs you don’t have a life.

But for most people when they do trade leverage and trade CFD they do use it on a very short term approach. Generally speaking our stops for short term trading are quite close anyway. That just means that our analysis and our trade execution and our timing and getting in at the right time at the beginning of a short term trend really become quite critical.

Because our stops are so tight, we are certainly increasing the chances of our being stopped out. We are increasing the likelihood you’ll be stopped out because you will be so much closer to the price. To me this all boils down to being a balance because if we have our stops where I think they should be, you know really nice and tight, just a little under the lows of the day for our short term approach, yes you are increasing the likelihood of being stopped out. But good execution, good trade entry, good timing of that and good analysis can reduce that probability.

Or we just get away from the action, we move away from the price we move out of the short term trend, place our stock a lot further away. So yes we’re probably increasing our chances a little bit that we don’t get stopped out, but when you get stopped out you get belted.

So you are really probably adopting a more medium approach where when the short term trends end in a few days and then comes back down you still want to be in the leveraged trade. Because then you want to reverse and continue on a short term uptrend again for the next week, come back down again and then continue higher. So you need that trading profits to be substantial to overcome again the losses that you will take should you get belted in a more medium approach and getting stopped out.

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David Jenyns and Stuart McPhee, well known, experienced traders, discuss the merits of keeping part of one’s trading float back from active trading.

David: We have a question: do you recommend having all your trading capital in active trades or should some be kept as cash, and if so what percent?

Stuart: Good question, but it all depends. For example, my super fund I always have roughly ten percent in cash because, and this is probably more specific to Australian taxation law, during the year you have an obligation to pay tax, pay as you go. So I’ve always got that account with about ten percent of my capital – it’s cash, it’s secure, nothing will happen to it. Using nearly everything in active trading is a great idea in the trading system.

David: I’m in a similar frame of mind about that. If you’re looking to trade the markets and you’ve set aside your trading float that’s your intended purpose for the money assuming you have appropriate trading candidates. My gut feeling would be you should have, whenever possible, all your money invested. You don’t want to put your money in just for the sake of having all your money in.

But I don’t see any reason to limit, oh, I’ll keep ten percent of the trading float just sitting in the account, just accruing interest, not involved in active trading. It’s part of how you structure your wealth creation; you’ll have a certain amount allocated for your trading float, you’ll have a certain amount allocated for your real estate, you’ll have a certain amount for cash in the bank. I see that separate from my trading float.

Also with regard to backtesting you can see the utilization of your trading float. You can enter your trading float in before. You can see over a set period of time whether you’re fully utilizing or partially utilizing your cash and I always try to get as close to the top of that band as possible. So I’m as close to being maxed out as possible without being maxed out all the time.

If you’re maxed out all the time and new trading opportunities pop up and you don’t have any capital available, it’s going to throw out your backtesting a little bit because with trading opportunities you may not have been able to open.

Depending on which trade you ended up taking could affect the ultimate end of your testing as to whether you made a profit or not because of whether or not you took a particular trade or investment trading. So that’s why if you are going to trade a particular type of system where you are constantly maxed out, where you look at Monte Carlo testing, where you look at what is the standard deviation of my trading system. How far is it between my backtesting results? What is the least profitable scenario and the most profitable scenario and you find that gap widens the more you fully utilize your cash for trade entry.

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