Defined risk

Discussion in 'Strategy Development' started by Joe Ross, May 24, 2004.

  1. Defined risk is something to be quite concerned about. We always want to keep it as small as possible relative to the anticipated reward. Risk can come in unexpected ways. As a rule, you don’t count on lousy or unreasonable fills. You don’t count on the market being under fast conditions at the time you enter. You don’t count on the fact that even though you are trading in a normally liquid market, today is the day when traders are just standing around. You don’t count on the fact that tick size may be unusually large just when you are entering the market. Perhaps you have a resting stop, and just when prices reach your stop, the market becomes fast or the tick size unusually large. You don’t count on a huge trust fund entering the market just at the time prices reach your resting order.

    It is because there are so many unplanned for items that can exaggerate risk, that we learn to respect the trend. The reward can be surprising, the risk defined.

    The market contains the knowledge of all the players, therefore it knows more than any one of its players. When a market trends, it does so for a reason. At times, the reason is never fully understood until afterward. Trends usually get underway slowly and then accelerate as they gain momentum. Momentum is potentially as helpful to a trader as an ocean waves are to a surfer. And because momentum is also a function of market psychology, trends can carry to even greater extremes than seem possible, thereby legitimizing the question, “How high is high?” or “How low is low?” It is human emotion that drives markets to extremes.

    For instance, one definition of an uptrend is a series of progressively higher lows on a price chart. By that definition a trend becomes risky when there is penetration of the most recent prominent low. However, that fixed chart point can also help a trader to estimate the depth of corrections, and to identify possible entry points. By understanding the trend you can get a better idea of the amount of your risk exposure.

    Trading with the trend can place the probabilities in favor of your ultimate success. When it comes to trading with the trend there may be as many ways as there are traders.

    I prefer to “nibble” the trend, taking frequent profits as I go and then reentering if/when the trend continues.

    When nibbling the market, I use no indicators of any kind. In a down trend, my trailing exit stop is always 1 tick above the high of the latest price bar. My entries are 1 tick below the latest price bar. If prices gap beyond my entry point I do not enter.
    There was not a single loser in the entire series, and a few very good winners.

    Sooner or later every trend breaks down, and not coming to the full realization of that seems to be the undoing of many traders. There is a tendency to hang on much too long.