What's Your Risk?

So you decide your going to swing trade Wellcare Health Plans (WCG). It's got a decent trend, had a little pullback...looks like a decent trade. How much will you risk? Lots of traders will suggest you should decide where to put your stop and determine your position size from there. So let's say you're conservative and put a stop 5 points down at 110. Let's also say you have a $100,000 portfolio and you're willing to risk 2% of your account. So you buy 400 shares for $46,000 or $23,000 on margin. But you're only risking $2,000 because you have a stop...right?

Then, the next day, WCG opens 60 points below your stop. Assuming your order was a market stop, your $2,000 "risk" just resulted in a $26,000 loss. 26% of your account...gone...overnight.

Now, some will say "That just doesn't happen very often". And you're right, it doesn't. But it just takes once to put a serious dent in your account. Too often traders let greed control their position size. I think a better method of position sizing is to just have a system of slots. Say you want to have a maximum of 10 positions. In our hypothetical account we would allocate $10,000 to each position. So instead of 400 shares, we could buy about 87. And instead of a 26% hit, we would have had around a 6% loss. Still not something you really want, but it's not nearly as daunting.

GTD, Trading Systems and Trust

I'm a fan of David Allen's "Getting Things Done" system. I don't actually follow it very well, but at least I like the theory. Yesterday I was listening to some podcasts from the 43folders website. David was talking about patching leaks in the GTD system. The whole point of GTD is to get everything out of your head and into folders or lists or whatever you're comfortable with. You process all the stuff in your life into a manageable system. He said many people will do most of it, but for whatever reason they won't completely trust the system. They're afraid they'll miss something so they leave a piece in their inbox rather than process it. Then they'll do the same for one more thing and one more until the system falls apart. It's not because the system is broken, they just didn't follow it.

So what does this have to do with trading? I was trading the emini Dow futures (YM) intraday today. As I explained in an earlier post, I don't have these trades automated. I have rules for them, but there's a good amount of discretion there as well. I only took one trade today even though there were at least three setups that I could see. The one I took didn't work out so great, the two I didn't take did. All three setups were pretty good, but "something" told me not to take the two that did well. It may have been the TICK readings or the advance/decline line...I couldn't really tell you for sure. It doesn't really matter. The setups were there, I just didn't trust the system. One trader I know used to say that the most unreliable part of any system is the pink blob that drives the mouse.

So how does one trust a system? Do you trust it because some author said such and such pattern usually works? Or someone said some indicator predicts price movement (just a hint..if anyone says something predicts price, run away)? I do believe there are some really good discretionary traders out there - guys that just have a really good feel for market movement. Unfortunately, I'm not one of them. I need something that has concretely defined rules that I can backtest. Then I can see what percentage of trades were winners, how big the average winning and losing trades were. And whether or not I can expect to make money over time.

I've seen some traders debate the usefulness of backtesting. Their argument is they aren't concerened with what happened in the past because they do not believe history will repeat itself. In the "Way of the Turtle", Curtis Faith addresses this very issue. To those traders Curtis asks these questions: "What is the alternative? How do you arrive at any strategy without knowledge of the past? How do you determine when to buy or sell? Do you guess?" I am firmly convinced that some form of testing is essential to the success of any system. It does not have to be completely computerized, although if it isn't, be prepared to spend quite a bit of time in the process. Computerized testing also has the advantage of not introducing bias into the results. If you do it manually, be sure you aren't cherry picking trades.

If you know what 'normal' is for a system, it's much easier to trust it. If you've had 3 losing trades in a row but you know that in the past there have been as many as 10 losing trades in a row yet overall the system is profitable, it's a lot easier to take that next trade.

All that was a lengthy way to say I really need to code up my intraday system.

Garmin vs Nokia

I have shares of Garmin (GRMN) in my IRA account. It's been a fantastic investment for me. And it's a great company. They have absolutely no debt. Zero. They have great products. I have an eTrex model that I bought several years ago. I actually took it with me when I was deployed to Iraq. I ended up using it more than the Rockwell GPS systems the Army has.

Anyway, my last purchase was around $56 and it's trading around 107 now. Unfortunately it was trading as high as 122 on Friday. Yesterday Nokia (NOK) announced it was purchasing Navteq (NVT). Navteq happens to supply Garmin with it's maps for their GPS systems. In fact, Garmin is their largest customer. Nokia is paying $8B for them. Assuming this acquisition goes through, Nokia will become the most important customer. This means Garmin will have less influence on features as well as reduced negotiating power for pricing. I'm not sure why Garmin did not put in a bid themselves. TomTom, a direct competitor to Garmin, recently purchased Tele Atlas who was a competitor of Navteq. So now, Garmin is stuck with getting its mapping data from either Nokia or TomTom - that's generally not a good thing when you have to get data from direct competitors.

My plan right now is to give a little bit of time for things to shake out. I have plenty of profit from GRMN, so I can afford to do that. Maybe Garmin will make a counter offer, although I think they should have made an offer before Nokia did. Or maybe there is some other plan that they haven't announced yet. I still like the company, but this news threatens their long term prospects a bit.

How I Trade

I've mentioned I have several different systems I trade. I also mentioned The Trading Digest as helping me not only with those systems, but also in allocating funds across to them. Yes, I do mention their site a lot. You should visit it.

I have six systems I currently trade. By system, I don't necessarily mean entirely mechanical, but some are. I'll list them here in order of capital allocation:

Option Spreads
Dip Buyer
Trend Following
Another Dip Buyer
Discretionary Options
Intraday Futures system

Currently, I'll allocate about 40% of my capital to the Option Spreads. I usually don't tie up anywhere close to this during a given month, so I'll also use that for any discretionary trades. 50% gets spread across the dip buyers and trend following. That leaves 10% for futures.

The option spread strategy is not mechanical. I don't think I can make it that way. Since the volume of trades is relatively low, I don't think I will spend a lot of energy trying to mechanize it. I primarily trade the RUT and occasionally the IWM if I need a little more granularity in my adjustments.

The Dip Buyers and Trend Following are entirely mechanical. I'm just an order taker for those. I will adjust my allocation to each as I see fit depending on the market conditions.

The Discresionary system is just that, discretionary. This is where I take the occasional speculative bet. I'll usually use options for this and it's usually a straight call or put or a vertical spread. Nothing more fancy than that.

Lastly, I have my Futures system. This one is not entirely mechanical, but I am striving to make it so. It's a little trickier to code because there are more variables (like different TICK readings, Advancing / Declining volume, sector ETFs, etc.). I only trade futures intraday because I don't want to comb through a zillion stocks and I can use a relatively small amount of capital. The capital I use is generally what's left over from the other systems. If I'm loaded up on my other systems, I'm not trading any futures. However, if things are relatively slow on the others, I'll add that capital to my futures capital and maybe trade a little bigger.

So, that's how I trade in a nutshell. The reason I trade multiple systems is because each has it's inherent strengths and weaknesses. The dip buyers do well in higher volatility markets regardless of trend, but not as well in strongly trending markets. The trend following model obviously does well when things are trending. They kind of complement each other.

I know this wasn't the most coherent ramble. I'll try to detail these a little more in future posts.

Alan Greenspan and Jon Stewart

Alrighty Then

So the Fed opted to pull out the big guns and lower the funds rate by 50 basis points. I must say, I was not expecting this price action on Tuesday. All morning the tone was decidedly bullish and after the announcement the S&P moved about 30 points in a little less than 5 seconds (ok, maybe it wasn't quite that fast, but it was fast). By the time my data feed caught up, the move was done. There were a couple of decent entry points after that, but I opted to stay out.

My systems did surprisingly well. I was a little nervous Tuesday morning because I was very long. I don't really like having a lot of positions open going into a big market moving announcement. But, if there is one thing I've learned the past couple of years it's "trade the stinkin' system". It doesn't matter what I think will happen - if the system has me long, be long. Obviously, that worked great this time. Next time, maybe it won't, but as long as I'm within the drawdown parameters of the system I'm trading, then just trade the stinkin' system.

My options positions, however, did come under a little pressure the last couple of days. I had to add some vertical put spreads to bring my deltas in line. These are October positions though, so there's still quite a bit of time and anything can happen.

Short What?

I've had some questions on just what the title of this blog means. I begin by saying that it wasn't my first choice and I may end up changing it in the near future. I originally wanted to name it "Delta Neutral" or something like that, but I couldn't find a suitable combination that wasn't already taken. Delta neutral describes my main options strategy fairly well. I sell an Iron Condor and make adjustments to it to keep the delta's relatively neutral.

My next choice was "Long Theta", which also describes this strategy. The whole idea in selling options is to collect the time decay or theta until close to expiration. However, my wife thought this just didn't sound right and it may be mistaken for a very different type of blog. I decided I'm way to close to this stuff since that didn't even register with me until she mentioned it.

So the third choice was Short Gamma, which didn't sound quite as bad. It doesn't exactly describe what I'm doing, but it's close enough. Gamma is the rate of change or acceleration of delta. Generally speaking it will be negative (or short) for an iron condor if that condor is also relatively delta neutral.

While this represents a large chunk of my portfolio, it's still only a portion of the overall. Hence my thought that maybe this isn't the best name either. I use other options strategies occasionally, but most of the rest of my strategies are straight equites or futures.

So, that was a long winded way to say I may be experimenting with the blog name. All two of my readers may be affected by this. I'll also be looking at different templates to jazz things up a bit. I kind of like the minimalist look, but it's a little drab. Once we get through tomorrow, I'll outline how I trade this stuff.