The changing risk profile of a trade after entry

Decision Making Process, Risk Management

Most traders who are committed enough to attempt any sort of learning at all in their efforts to become consistently successful will adhere to the principle of having an initial stop loss.

Those enlightened ones who have a system in place to effectively position size on a particular trade (i.e. identify how many of a particular position to enter to ensure if the stop loss is triggered, the dollar impact is a ‘tolerable’ risk) and even, perhaps, some rules in position sizing within their portfolio as a whole, will do better still.

However, there is a glaring gap between understanding and integration in the decisions we make as traders. The problem is that these are based on the idea of ‘static’ risk.

Risk is a dynamic concept, changing throughout the life of a trade, both to the individual position and the portfolio as a whole.

As traders, we need to embrace this changing risk and – most importantly – have elements within our system that take these changes into account so we can take appropriate and timely action.

Is a trailing stop enough?

Fact: your net worth in a position is its current value, not what is was when we started.

Again, most traders recognise this and use some form of trailing stop. So, if there is a move in the opposite direction, they give back just a fraction of what they have gained rather than letting their position drop down to the initial stop they set when entering the trade.

At first glance it would be reasonable to suggest that this effectively manages the current risk of a position that has gone in your direction.

Before we move on, I wish to strongly point of that any trail stop system is better than no trail stop system.

However, there is usually an issue with a trail stop system. Recognising that a simple dollar or % value below current price is inadequate as:

  1. A $1 stop in a $10 stock is a significantly greater loss in % terms than a $1 stop in a $50 asset
  2. No account is taken for the ‘normal’ movement of that asset (e.g. a 2% move in a materials stock could be seen as not unusual, whereas a 2% move in a more conservative telecoms stock could be perceived as a major change). What this means to you as a trader is that if you use a % trail stop, then you could be ‘stopped out’ early on a normal movement of the former and you are out too late for the latter.

With any leveraged instrument (e.g. Forex, Options), the impact of this is, of course, magnified.

So, most of the indicators or stop systems attempt to take this into account (e.g. moving averages, or ‘Average True Range’ (ATR)). The problem here is that many of the moving stops are lagging, or if we look at the ATR on entry for stop levels, its gain is ‘static’ and does not take into account the subsequent price action of the asset. Even with a more dynamic ATR (often based or 10 or 14 period) this is still lagging.

Let us look at a real example to demonstrate the issue in our ‘Tale of Two Trades’ that were entered. The two potential types of stop that could be used here are a close below the trend dot or below the ‘cross’.

 

Trade 1

Trade 2

Trade entry price versus current price    
Entry price $40.02 (on the 1st green dot) $36.10 (on the 4th green dot)
Initial stop (dot) $39.98 (2.5%) $35.50 (1.67%)
Initial stop (“cross”) $36.80 (8%) $34.60 (4.1%)
Current price 41.98 38.02
Current stop (dot) 40.52 (4.2%) 37.39 (1.65%)
Current stop (“cross”) 38.25 (10.86%) 36.50 (3.99%)

 

So, what we see is that based on current price, the risk associated with trade 2 is almost identical at this stage (although six bars previously it was very different). However, with trade 1, assuming the concept that our net worth in the market is what it is at any given point in time, the risk we are exposing ourselves to is significantly greater than it was originally.

The reason for this is simply that the movement in the asset has accelerated to a degree that a lagging stop has not yet picked up (and it doesn’t make a difference which lagging stop we look at).

One of the things that you will note in trade 2 is the fact that risk pulled back in as the trade progressed. Of course, this reduction of risk as the move in a share slows is acceptable. However, risk events do not always occur gradually. A sharp drop downwards in one or two sessions would have us stopped in trade 1 at NEW inflated risk level.

Our options are, perhaps, obvious and are either:

  1. Accept that it is how it is and that a trail stop of any kind is good
  2. Put something in place in our system to accommodate for the accelerated risk with an asset that move up sharply

 

So what about a profit target?

Setting a profit target is often based on the concept that there are critical price points: technical lines in the sand that have been turning points in price. There is no denying that the market adheres to these support and resistance lines and it often takes the introduction of additional information to the market for these to be broken.

The risk concept associated with this is simple, after all, it is called resistance for a reason. So, we set a profit target at – or, ideally, just below – this resistance level, knowing that we can, of course, take the trade off the table, thereby locking-in the profit. We can of course subsequently re-enter on a confirmed break of the resistance if this happens.

However, let us look at the risk profile of this in a little more detail.

If there is $5 to the next potential resistance point on entry into a position and your initial stop is set at $1 below entry, your initial risk on entry is $1 compared to $5 potential upside; so a 1:5 risk/reward ratio. The position moves up $4. Even if you have trailed your stop loss to $1 behind current price, you now have $1 downside risk and $1 upside potential. The risk profile has changed to a 1:1 ratio.

 

And dynamic portfolio risk?

There are two ‘awareness’ issues here to discuss briefly.

As you increase the number of positions, the initial risk to overall capital increases (e.g.2.5% x the number of positions). This is particularly the case when these are all ‘pointing in the same market direction’ (e.g. all long or short).

‘Attention risk’ may also become an issue as there are only a certain number of trades that YOU can effectively manage in a big market move. This is difficult to ascertain until you find yourself on the receiving end with many positions open. If it helps, then as a reference point many professional traders restrict themselves to 4-5 positions open at any one time.

 

 

And an extra bonus risk for Options traders

As Options traders are aware, unlike Forex or even CFD traders, the one-for-one price movement is not the case for a single leg directional options position (e.g. a bought call of XYZ will not go up $1 if there is a $1 movement in the underlying share). Rather, options pricing models include a particular ‘Greek’ called delta that indicates what this movement may be (e.g. a delta of 0.5 would indicate an expectation that the option value will go up 0.5c for every 1c in the underlying share price – as would be the case for most ATM options positions).

Delta is not a static figure, of course, and will change as the underlying price further away, or closer to, the option strike price chosen. An option that is ITM will have a greater delta and, subsequently, a greater change in value than one which is significantly below the strike price.

As most options traders base their decisions on the underlying share, there is not just the exaggerated risk caused by rapid price movement in the desired direction compared to current net worth, but also further exacerbation of this as delta rises as the option becomes more in the money.

I trust that this creates some things to ponder: risk is real; risk is good; embrace it, but you can only do this if you consider accurately and fully what those risks may be.

See you at our next FREE LIVE options trading room. Enrol now at http://hawkeyeoptions.com/pages/room/

Trade safe and as always please feel free to drop in a comment, share it or email me at mike@hawkeyeoptions.com

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