Risk Management!!!

This is a topic that I actually was published in the Worden Report and received an honorary title and an award. It's also the "Holy Grail" that everyone is looking for-risk management is it, you can stop looking. It's also a highly personal, variable and sometimes complex subject. We deal in percentages, not dollars. So I'm going to throw out a few ideas for you to absorb and I want you to promise yourself never to enter a trade without a risk management plan in place.

1 You should always think about your potential loss before any potential gains.

2 You must be consistent in applying it and disciplined in sticking with it, one bad trade can really hurt you. One bad trade has brought down multi-Billion dollar trading firms.

3 A few things to remember

- A loss of 50% needs a gain of 100% to get back to break even.

-"When you find yourself in a hole, stop digging"

-"Only losers average down losing trades"

-Never meet a margin call with cash-sell the position

-If you lost your money in XYZ, why would you think that loser stock is going to make it back for you?

-"Money in a losing position cost more then just money, it costs opportunities"

-"If you have a trade you lost 30% on and I gave you the equivalent of what value was left in the position in cash, would you buy that same stock again right now?" If the answer is "No", then why are you still holding onto that loser?

-The market doesn't care where you bought your stock or how much you have lost, only you do. If you find yourself saying "I'll sell XYZ when it gets close to my buy price" you are doing yourself a disservice. You are holding that stock out of pure ego, because you don't want to admit you were wrong. It's like saying, "I lost this money here, I'm going to make it back here"

-NEVER DOLLAR COST AVERAGE A POSITION-You are throwing good money after bad. This is a myth that Wall Street has perpetuated so brokers can keep their clients and make more trades that cost the client more money and put money in the broker's pocket.

-Think about it, is that stock you lost so much money in really the strongest stock you could own right now to make your money back?

-When you are down, don't swing for the fences and try to make your money back fast-it almost always puts you in a worse position.

-If you are out of sync with the market, reduce your position size until you get back in sync with the market-this happens to all traders, we get hot and then run cold. You want to turn it up when you are hot and back down when you are cold, but human emotion wants to do the exact opposite of that-think about that.

-Drawdown is not the same as a losing position, draw down is a reality of any trend trading system and trend trading systems are where the money is to be made.

-Look at the big picture, do not chase every move in the market, it's designed that way to take your money. Instead, look at the big picture, use a 5-day chart and see if your plan still makes sense.

-If you can't take small losses, you will take large losses

Now, "The 2% Rule"

The idea is, you never want any one trade to cost you a loss of more then 2% of your portfolio's worth.  However there are many different interpretations of this. If you trade one stock at a time then it's this easy.

Portfolio worth=$10,000 and 2% of portfolio =$200. So your trade, if you get stopped out, should not cost you more then $200. When I'm not in sync with the market or it's a speculative trade, I will reduce my risk to 1% or even half of a percent. If I'm on a huge losing streak I'll take a month off from trading.

Now, here's the problem-diversification. Very few people trade only one stock at a time. I recommend not trading more then 6-10 stocks, depending on how large your portfolio is. Wall Street talks about diversification and generally the number they talk about is 20 stocks. Do you know why? Because the financial products that most Americans own in their 401k or IRA accounts are Mutual Funds and by law, a Mutual fund must have at least 20 stocks in it. So to sell you on mutual funds, they have to sell you on "over diversification". That's right, it's too many stocks and why? Because with good risk management you don't have to worry too much about losses, but with too many stocks, you biggest performers barely move your portfolio. A stock that gains 100%, that only represents 5% of your portfolio can only give you a 10% gain and with the inevitable losses you will have with 20 stocks, that gain will be a lot less. You need enough stocks to have good market coverage and you can do that with 8-10 stocks.

So if we have a 2% rule for 10 stocks that means we have 20% open risk all the time-it's way too much. So here's how you handle it.

I have $10,000 and I feel comfortable trading 5 stocks at a time. 2% of $10,000=$200 of risk. I divide that $200 of risk among my 5 stocks. that would mean that each stock can carry a total risk of $40. You may be thinking, "So I buy 100 shares of a stock and when I lose $40 I get out?" Wrong. Now we have to talk about Position Sizing.

When I am interested in a trade, the first thing i want to do is determine my risk. When you enter a new position it is better to have a wider stop most of the time to allow the trade some time to work. So I found XYZ for $10. I see that there is a strong support level at $9.75. We know that the market likes to take out obvious support levels to hit stops so we say I will place my stop just under that support level at $9.50. You are buying a $10 stock, and your stop is at $9.50, now you know how much risk per share you have-$.50. You already know that you can't lose more than $40 in any one position so you divide your risk $.50 into your risk per position $40 and that gives you the number of shares you can purchase which is 80 shares.

Now suppose your stop is very close on this trade, it's at $9.90 (the stock still sells for $10), your risk per share is now only $.10 and that divided into your risk per position ($40) allows you to buy 400 shares. The only problem with this scenario is 400 shares at $10 will cost $4,000 which is nearly half of your portfolio. There's one type of risk that is very difficult to deal with and that is the gap in the morning, when a stock you buy falls because of bad news over night and opens much lower. If you have nearly half of your portfolio in a stock that gaps down 20% (which happens everyday) you just lost $800. That's 20 times your proper risk amount of $40. So I always try to keep my portfolio position cost at 15% or so. This is one of the few ways you can lessen the impact of a bad gap, but still have a position that is meaningful in size. Sometimes I may take it to 20%, but I have a high tolerance for personal risk. So what do you do when you can buy 400 shares, but it's too big for your portfolio, simply buy 15% of your portfolio. In this case you can buy 150 shares of that stock.

Some people prefer to use the 7 or 8% rule, when you lose 8% of a position you exit it. If it works for the stocks you are trading that is fine, but I personally think it is not an objective rule. What if the stock you are buying has an Average Trading Range "ATR" of 7 or 8%-meaning it can swing that much intraday? You can't trade those stocks, you will be stopped out for a loss every time. so I prefer to have an objective rule, maybe a support level, maybe a moving average....

Here's my solution, it's called my Trend Channel and it is another indicator I developed and received an award for.

Here is AAPL, the Trend Channel is still long AAPL and has caught the entire trend from the Breakout in AAPL in Q1 2009 at $102 all the way to now ($259.27)-More then a double! If you have TeleChart or StockFinder I can give you this indicator, if you don't and would like to try this and 3C as well as others, click the links to TeleChart and StockFinder at the bottom of the page.

The way the Trend Channel works is to use a moving average and then to automatically,for each stock, figure out the average volatility of that stock over a certain period of time-usually 20 days. then it adds a standard deviation above and below the center of the channel. So if the stock moves more than 1 standard deviation away from it's average volatility, I know something big has changed. In a long position, the bottom of the channel's highest point is the stop. Currently the red arrow at  $237 is the stop today. In an uptrend, the Channel will lock in gains higher every day. I always stop out at the end of day closing price, that is why the green arrow did not cause a stop, because that was an intraday violation, not an end of day.

When entering a position I can look at the channel and get an idea of where my stop should be, but I consider all things when placing a stop. In a short position/downtrend, the lowest level of the upper channel is the stop at the end of the day. This system will never allow you to catch the top or bottom of a trend, but it will keep you in a strong trend with objectivity. Human emotion, fear and greed would have most people out of this trade at 20%, maybe 50% but then they become very afraid of losing their gain. This channel takes all that away and replaces it with objectivity, it knows how the stock behaves and when the stock does something out of character and crosses the channel, you know the trend is about to end.

So when choosing a stop, try to match your stop with the stocks trading habits, maybe it always holds a 50 day moving average in the past and that may be your stop or maybe it has big swings so you know you need to allow for them and by less shares. This is all part of risk management.

By the way, you decide how many stocks you want to trade and you decide how much open risk you can tolerate. Maybe it's not a 2% rule for you, maybe it's a 4% rule or a 1% rule. Maybe you only trade 3 stocks at  time, it's highly individualized, but what I gave you is the standard format. It may seem a little conservative, you can change it to fit your style, but I can tell you by experience, making money in the market is about patience, good risk management, building your wealth not try to create it in a week and most importantly, protecting it because it is a lot easier to protect your money then it is to make it.

Please, just never move your stop away from where it should be because a trade is going against you. You must be disciplined for this to work, but if you are disciplined, you won't be upset about a 30% loss in your portfolio. You will gladly take a 2% loss when a trade doesn't work out and it won't bother you. And believe it or not, you can take 10 trades, be dead wrong on 6 of them, have two of them basically do nothing and have one or two that are like AAPL and you will build wealth.

Sit down with  calculator (I could give you the answer, but find it out for yourself and it will really be exciting) and figure out how much money you can make in a year if you make 7% a month and compound it. For example-$10,000 is what you start with, you make 7% in January, it is worth $10,700, you make 7% in February and it's worth $11,449, then in March another 7%=$12,250 and keep on going for 12 months. You'll be surprised.

Wall Street Turns On Each Other

That's what appears to have happened today. PLEASE READ THE TRADE GUILD POST FIRST.

OK, now you understand what I mean...

Here's a few more charts for all of you.

First lets take a look at some more breadth charts. Some people don't feel breadth charts are all that useful anymore, I still appreciate their insight. When a market moves you see the headline price-"The Dow Was Up 2.3% Today!" and the media acts like it's a big deal and there's nothing more to the story except to give you every reason why, which are almost always wrong because the real reasons often appear days or weeks later.

So are two days when the market is up 2.3% on both, the same? Do they have the same meaning for the market? Of course not. It depends on where it happens, when it happens, to some extent why it happens and what really matters is how strong was the day. You can have a race car do 230 miles an hour and be ready to fall apart the next time you turn the engine on or you can have a race car do 200 miles an hour, but be reliable all season-there's a difference and that difference can be found in the breadth charts.

This shows us new highs made in the NASDAQ 100 vs. new lows. You can see, all day the new highs diminished and the new lows stayed at the same level-this is not a market with secret "extra underlying strength" it's a market falling apart.

This is the advancing issues in the NASDAQ 100 minus the declining issues, a steady trend up shows strength, a trend down shows weak breadth.

This indicator should follow price up or even lead it up in a strong market, you can see it's been very weak.

This is a crossover system I developed to help identify real signals vs the false signals that plague moving average crossover systems. For a buy 3 things need to happen, the price moving averages in the top window have to cross, yellow over blue. The custom indicator in yellow in the middle window must cross above it's blue moving average and finally Wilder's RSI must cross above the 50 level in the middle. For a short or a sell, reverse all of that. In the green boxes are the long signals in the red boxes are the sell signals-at the end of day we had a sell signal.

As you can see, between the Trade guild post and this one, there are many things to consider when judging the strength , meaning and outlook for a stock that moves in a particular direction. Not all race cars are built with the same quality.

Here's are outlook, with everything in 3C as bad as it is, I just can't see any meaningful change in character. As we saw today, the market can do what it wants for a little while, but eventually it'll catch up to all of those 3C signals. How many failed 3C signals have you seen? Probably very few.

If there are strong earnings and you know what I thin of MCD's earnings as they will be a biggie, then the market could try again to break $110 on the SPY. If it breaks out and sometime later in the day falls below $110 on heavy volume, you can short just about anything you want and you'll most likely make money. I would suggest the June 3rd ETFs until we are out of earnings season. If the market just continues the late day slide it began, then you can add to shorts (the June 3rd ETFs are the best candidates right now, but email me if you see something on the list that you'd like an opinion on). For new subscribers, don't go all in until we break the July lows, then it's fair game. I'm saving 25% cash no matter what.

So we'll see how our earnings positions do, today SBIB did fantastic for a 10.4% one day gain.

One issue I want to address and I'm going to do it in the next post, so read on.

Last Update

Even I'm getting tired of them in my email. The market is up big, it appears that volume will be down, this is bearish, but beyond that, as I've said, this market looks like a deadman walking on the charts. It's pushed up against resistance all day trying to break $110 (SPY) and now it's looking as if it has given up the ghost as it just broke 3 minor resistance levels on increasing volume in 3 consecutive minutes. You have to look at a price move in context, not just the headline advance, but was it healthy, strong, and to my eyes, this looks like a zombie. I can not believe it's still hovering this high. Lets see what kind of close we get.

PRSP Earnings Trade

Whenever I say earnings trade, understand we are talking about the most speculative trade I will give you. So risk management all the way, be cautious if you decide to go with this.

PRSP to me looks as if it's been under some pretty solid accumulation and for awhile. If my information is correct, they report tomorrow a.m. pre-market. This is what a few people did yesterday with SBIB which is up over 8% from yesterday afternoon's long call.

So I'm saying I like what I see in PRSP, it's your choice if you want to trade it. I will be.

Sorry to Spam you

The only thing I can see, because by the charts, this market looks like dead man walking, is that they may be gunning for the orders at $110.

$110 is a nice round number, the human mind gravitates toward whole numbers like this, there's resistance in the area that is recent and the way the market's work would point to a logical, short fishing expedition above $110, it doesn't need to be long, just long enough to trigger those orders.

Why would they do this? If what I'm seeing is correct and I have no reason to believe it is not, then they are in distribution/short selling mode. If they can hit $110, there will be a bunch of shorts covering, that means buying and volume and the market makers are paid in part on the spread, the more volume, the more they make so trigger those orders and you make money. Then in addition, the long bulls will come rushing in on their limit orders, then they drop the market back below $110 and all the longs are at a loss; it's called a false breakout. The further down the market goes, the more of a loss the longs are at. So the longs start selling and that adds fuel to the fire, theirs more supply then demand and the market continues to snowball down. False breakouts happen quickly, the fall fast and hard so watch for this to happen, if you see it you may want to try to ride the fall for a quick trade.

Market Update

I'm not posting charts, but take my word, all of the SPY divergences are getting worse, the 1 and 5 minute charts on all 3 3c charts. I can't believe it is still hanging up there.

McDonald's-Can They Hit the Hype?

I tuned into CNBC yesterday-I promise it was only for like 5 minutes. I caught the end of Maria B. (Still can't decide if she's attractive or not-I have no idea what she knows about the market) and then I caught a few minutes of Fast Money-it was all I could stand and I turned it off.

I did however catch some hype from one of the guys, maybe the one with an unusually small amount of hair on his head and and unusually long pony tail, I imagine him in a leading role of some Attila the Hun Saga. Any way there was some chit chat about how great the chart looks I think and then about them taking on Starbucks and the McCafe' and it seemed pretty hyped (on CNBC) so naturally I got a little suspicious and put it on the list of stocks that are reporting and decided that I don't think this looks that good.

This chart is hard to see so click on it and look at the blue indicator, it's just a indicator I put together showing cumulative volume-it should rise on rallies, fall on sell-off, a lot of the time it doesn't and this is a defining feature of a top.

This one day chart has been very accurate, it too doesn't look so good.

The 15 min 3C chart has been very accurate and again we see more negative divergences (red arrows)

Here's another version of 3C and a 10 min chart, the same story as above.

Finally, the 1 minute 3C, they are reporting in the am tomorrow and this doesn't look like anyone is out there accumulating the stock. Now this is an earnings assumption which is probably the most volatile of trades. MCD is very close to a double top-sort-of formation. MArket manipulation wise, they could knock out a bunch of orders and trigger a lot more if they run it up over yesterday's highs or above the April/May highs, but I would think that maybe they would have already done that, but anything is possible. Maybe this is not a quick pop like SBIB today was, maybe this is more of a short side position trade, but either way, I'm bringing it to your attention because it just doesn't look right.

Update

3C is very much in line with last night's market observations, price isn't quite there although we did get part 1 correct, part 2 seems to be taking some time. The bear flag I pointed out last night was crushed.... How silly of me, you know I always warn that these obvious patterns get taken out, I'll have to go back and look to see if I warned of a false breakout last night.

This 3C 1 min chart is in line with the earlier update, however the zoom level makes it appear as if there's a positive divergence around 12 pm onward, but....

Closer inspection shows if anything it would be an extremely weak divergence at the blue arrow, the rest is 3C in line with price which tells us nothing and does not imply anymore strength then what we see in the price trend, however......

You know I use multiple formulations of 3C in multiple time frames and the blue 3C is the fastest to pick up on emerging divergences. This also happens to be a 10 min chart where we cross we see a mish-mash of activity from market makers/specialists and some smart money, it's a fairly substantial time frame and can alter the course of the daily chart. These negative divergences are pretty powerful and right now 3C is pretty much in a leading negative divergence which is much stronger then the relative divergences you see in most of the chart.

I'll be watching and keeping you updated.

SBIB beat

This was an earnings play from late in the day yesterday, they beat in a surprise by .06 and are up over 7%. One subscriber already emailed me that he caught a good chunk of that one. I hope some of you were able to get in on it.

First Negative Divergence in