CONTINGENCY PLANS FOR CONTROLLING LOSS

The property of Fixed Downside Risk is one of the defining characteristics–if not the defining characteristic–of my investment methodology.

Furthermore, when it comes to Fixed Downside Risk, I’d go so far to say that 99% of all the retail stockbrokers I’ve met–in the Philippines and in the United States–received zero training in how to do this–nor indeed, even know what I’m talking about.

Don’t believe me?  Ask them yourself.

“We focus on risk before we focus on return. The best investors do not target return.  They focus first on risk.”

–Seth Klarman

Controlled Exposure

Fixed Downside Risk is brought about by using a fixed fractional approach to building up a position in a stock. Thus in all of our trading systems the size of each purchase is governed by what I call a fixed fractional position-sizing algorithm.  Put simply, this is a formula which allows us to make carefully measured incremental purchases while at no point exposing your total trading capital to more than a predetermined percentage of risk.

Guess what?  For clients with Professionally Managed Accounts you get to choose the level of Fixed Downside Risk.

.

“How much to buy or sell is the single most important aspect of trading.”

–Curtis Faith, Original Turtle

Outside of the Original Turtle Rules, I’ve never once heard position sizing asserted as the key component of a trading plan.  Yet after over 1000 hours of research, I’m convinced that position sizing is indeed the means by which risk is controlled.  Controlled risk keeps the risk of loss low and ensures we’ll be around long enough to generate higher returns.

.

The way we do this is simple:

1st:  You choose the level of Fixed Downside Risk that will govern your account:

• .5% Fixed Downside Risk
• 1% Fixed Downside Risk
• 2% Fixed Downside Risk
• 3% Fixed Downside Risk
• (Note: I will not accept Managed  Corporate Accounts with > 2% Fixed Downside Risk.  Likewise I will not accept Managed Individual Accounts > 3% Fixed Downside Risk. )

2nd:  When our proprietary trading method indicates a buy signal, it simultaneously provides us with:

A) a precise low risk/high probability entry price and

B)  a precise, technically appropriate exit price–known as a stop-loss.   A stop-loss is a contingency exit in the event the trade goes against us.

3rd: The number of shares we purchase is calculated in such a way that in a worst case scenario if prices were to drop to our stop-loss  price (thereby triggering our defensive exit) the loss would be limited to your chosen Fixed Downside Risk percentage–.5%, 1%, 2% or 3% of your total investment capital.

Take note that all of aforementioned is calculated before we even make the stock purchase.

.

“The most important thing is how good you are at risk control.  Ninety-percent of any great trader is going to be the risk control.”

–Paul Tudor Jones II

.

Rising Prices Lock In Earlier Profits

So then, let’s assume the first trade goes in our favor.  As prices rise a second position is added using the same formula.  And so on.

As prices continue to rise, our stop-loss is continually raised as well.  This means that each time we add to our position,  the profits from earlier positions are, in effect, “locked-in”.  Thus assuming we maintain strict discipline in sticking to our trading system, the Fixed Downside Risk percentage pertains to the most recently added position only.  This is because the latest stop-loss is now higher than the purchase prices of the earlier positions.

.

Position Size Grows.  Risk Remains the Same.

This is an essential property of our proprietary feature of Fixed Downside Risk.  It  means that regardless of whether we have a total of two incremental purchases or twenty incremental purchases (or at any point in between) the risk of loss is still your predetermined Fixed Downside Risk–.5%, 1%, 2% or 3%.

Therefore risk is controlled at your Fixed Downside Risk percentage irrespective of the size of your aggregate position, with reasonable allowance for slippage.

.

E. M. M.

See

When Failure Is Not an Option

The Merits of Rules-Governed Trading

On Mechanical Trading Systems

.