The biggest danger for any trader is excessive exposure. An unexpected price spike can then trigger a margin call that wipes out all the profits generated over months of hard effort. This is the most frequent reason why traders lose money. How can we prevent this from happening? What do we have to know?
Diversification
As there is no such thing as perfect foresight and an unexpected price spike can occur at any time, a trader should always diversify his risk and trade not just one, but two or three ideas at the same time. It is through diversification that he can improve his risk profile – when one trading idea is in the profit, the other runs a loss and vice versa. Overall his performance is smoother and more importantly, this approach reduces the pressure to perform. The trader is then more relaxed and less emotional in managing the exposure of his trades.
How to realize profits?
Whatever the underlying trading ideas are, the method for converting an idea into a realized profit is always quite similar. First, the trader should define a budget in terms of assets that he intends to commit to the trading idea. It is best to divide the budget into targeted position size and additional capacity that he intends to use in case that the market turns against him. I advise that the targeted position size should be only one third of the overall budget of the trading idea – a large two thirds are additional capacity that is kept in reserve. When he opens his position based on his trading idea, he should split the initial trade into three tranches, because there is no way to know the optimal timing for an opening a trade, so it is better to diversify this risk into three opening trades.
How to manage a trade?
In the blog on why butterflies cause cascading margin calls I explained that a trader needs to be on the continuous lookout for unforeseen events that can trigger a cascade of margin calls. When this happens, any trade can turn into a losing position, where the entry price is so far from the current price level that the profit target is out of reach.
Improving price average to turn losing position into a profit
A losing position can be turned into a winning trade by turning the negative development into a positive and take advantage of the new price level to add to the existing position thus improving the price average of the whole position. In doing so, the trader shortens the distance between price average and current price thus increasing the likelihood of a price bounce that is sufficiently large to turn his position into a profit.
Why are price rebounds bound to occur?
In liquid financial markets up to 98% of all the trading is based on speculative positions and the hedging of those positions. These positions being speculative are temporary and any opening trade will need to be closed. When the closing trade happens, this has the effect of inducing a price reversal. Due to the duality of the opening and closing trade the price movements are never fully one sided. At some stage, sooner or later, positions will be closed and then the price rebounds occur.
A trader can use these reversals to turn a losing trade into a winning position. The method of increasing the position size to turn a losing trade into a winning position has, however, big drawbacks, which the trader has to be fully aware off.
Smoke and mirrors
Human beings do not find it easy to correctly identify price extremes. They typically interpret relatively small price moves as extremes, where in actual effect the moves are only moderately larger than average. This deficiency is even more pronounced when a trader faces mounting losses. When under pressure, the trader’s internal clock ticks faster and he poles the market price at a higher frequency. Time will seem to flow more slowly, minutes will feel like hours and days like weeks. Under these circumstances, the trader’s natural instinct is to time his trades in terms of his internal clock, but this is wrong. Unaware he will focus on smaller-scale price movements that are out of step with his overall trading strategy. He will decide to increase his bet too early. There might be a bounce back, but this will not be enough for him to exit his position with a profit. If the price resumes its slide, the trader will accumulate losses even faster than before because of the larger position.
A trader needs to take into account that his sense of timing is skewed when under pressure: he needs to lean back and slow his natural instinct and wait for a price overshoot that is in sync with his regular trading frequency. Patience is of essence.
Reducing position size
If a trader has increased his position size to improve the average price of his position, he has to reduce the size of his position at the next opportunity, when the price rebounds. This is important because he has to free up margin capital, so that he can increase his position, when the price falls back again. By carefully managing the position size during the ups and downs in the price, he earns incremental profit that turns a losing position into a winning trade.
Trader deep freeze
The biggest danger for a trader is the so-called ‘deep freeze’ mode: a trader, who is close to a margin call, freezes up and does not have the mental energy to take decisions and blindly hopes for a price rebound. He can be lucky once, twice or three times, but not on an ongoing basis. Similar to a mouse that is hunted by a cat and cannot move for fright, the same happens to the trader. It is important to preempt this situation. The trader has to set himself a stop loss, where he will get out of his position, whatever may happen. Ideally, the stop loss is never triggered and he is able to maneuver out of any unrealized loss by increasing and decreasing his position size in response to the local highs and lows of the market. In case he fails, he has to have a stop loss strategy in place that limits his overall risk. It is all too easy to close one’s eyes and hope for the best.
How to trade: managing exposure
32 Responses to “How to trade: managing exposure”
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Rich: Agree with the first comment by L where retail traders has the limit to gain access to high quality data and...
mark brant: Deevz, I think it can be simple if one uses intelligent levels of exposure like in HTT. I’ve read...
Deevz: @Mark: I dont think its that simple. Maybe you should reread Olsen’s papers on heterogeneous...
mark brant: I see excessive price movements as caused primarily, possibly soley, by leveraged trading on credit...
richardo: Behavior of traders is fractal; the impact of a forecasting service is to reduce the size of the big...
richardo: Yes, it is possible: You draw a point and figure chart with the following additional features. For each...
mark brant: Deevz, I think it can be simple if one uses intelligent levels of exposure like in HTT. I’ve read...
Deevz: @Mark: I dont think its that simple. Maybe you should reread Olsen’s papers on heterogeneous...
mark brant: I see excessive price movements as caused primarily, possibly soley, by leveraged trading on credit...
richardo: Behavior of traders is fractal; the impact of a forecasting service is to reduce the size of the big...
richardo: Yes, it is possible: You draw a point and figure chart with the following additional features. For each...
I would just like thank you for your ‘How to trade’ blogs and ongoing tweets. You have completely transformed my understanding of market dynamics and my approach to trading. My position sizes are now much smaller, I’m trading less frequently, and my returns over the last few months have been higher and more consistent, despite the odd mistake here and there. Thank you for sharing your insights so freely.
I might add – this week after joining the herd crowding into long AUD positions and making the situation worse – I still have a bit to learn. Note to self: reread cascading margin call blog…
I have a follow up question – This week there has been continuing speculative interest in long AUD positions in the face of a cascade of lower price levels in much the fashion suggested in this blog. However this appears to be contributing to further declines, since few seem interested in taking speculative short positions. i.e Buying when price are falling can sometimes increase volatility. In this situation wouldn’t it be better (for traders and for market stability) for more traders to be taking short positions?
Yes, you are right. This is, however, not as easy as it sounds, because a lot of fundamentals support the AUD. You have to keep a look out on the technical factors: if as is the case now, many traders continue to be long, then a further drop in the AUD will trigger additional margin calls driving AUD far lower.
[...] lose money. How can we prevent this from happening? What do we have to know? Diversification [...]Read More… [Source: OlsenBlog] [...]
Hi, I loved the article “Why butterflies cause cascading margin calls”. In the ending part of the article, you mentioned that you will talk about how traders can detect potential avalanches building up. Is that article up yet ? Thanks
I have not yet written an article devoted to this subject. OANDA profiles the positions of its customers, see the following link http://bit.ly/dwfywR. This information is valuable, because it indicates, how long or short traders are. The really dangerous situation occurs, when a large fraction of the traders are ‘wrong’ and sit on large unrealized losses that are close to margin calls. With a little of practice, it is possible to glean this information from the service provided by OANDA.
thank you, I am learning how to use the order book information. Looking forward to your article. In the meantime, do you have any suggestion on where I can learn more about this subject ? (prices cascades and butterfly effect).
Thank again.
Thank you for your feedback. Unfortunately, I do not know of a good publication that explains the issue of price cascades and butterfly effect. Having said this I am currently working on a small booklet based on the blogs of how to trade, but I do not want to promise too much.
Is price averaging also beneficial in short term strategies?
For example has Olsen seen evinced that profitable traders also price average intraday strategies? Further, if one compare profitability of very short strategies (less than one hour) without price averaging, vs. intra-day strategies with price averaging vs. long term strategies. Are there any clear findings to which approach seems to hold up better?
Yes, price averaging is beneficial for short term strategies. The difficulty of price averaging short term strategies are the ‘fat-tailed’ price distributions. Short-term the price extremes are far bigger relatively speaking than long term; so the trader needs to be ultra careful about the rate at which he does his averaging. If he is too aggressive, he runs out of margin capital.
So a basic strategy would be to price average at extreme prices. Being a beginner it is difficult to tell a possible price re-bound apart from a trend change.
Do graphically visual support/resistance levels have any relevance to price averaging? Or what would be better suitable to identify suitable extreme prices?
Thank you for sharing with us this focused booklet.
One question, how do you define the 2% fundemantal demand?. something like real cash for tourists or funding for business transactions?.
Thank you
Thank you for your feedback. I define fundamental demand as currency transactions linked to a country’s exports and imports of goods and services and long-term financial capital flows.
Close stops are probably be better than price averaging on the lower time frames, but I could be wrong.
I just put on a trade inspired by the HTT booklet. Long market order initial leverage 10-1; price averaging down every 100 pips at 1-1 per order to a maximum exposure of 15-1. Take profit at 1.0651 for the initial trade and the five orders. I like this trade a lot. CAD is way oversold on the daily chart. Thanks for the inspiration, Richard!
Just read HTT again and adjusted my five 1-1 backups to take profit at the initial market order price so my gearing will be reduced after I’ve passed the danger zone, just like driving. Great stuff Richard! I’ve had some success on my own but HTT is really sharpening me up. Thanks.
Could you explain what moves the spot prices of gold and silver in your view? There seems to be an awful lot of naked trading in those markets. Is interbank trading dominant over the futures markets in setting prices? I’ve heard that futures are the tail that wags the dog of spot bullion prices. Where do you see gold and silver ending up in 2010? Thx!
Mark – there may be a misunderstanding – have you opened a position with 10 times leverage? If yes, then this is far too aggressive. Personally, I would not invest more than 25 percent of your capital in an opening trade.
Thx for your concern Richard. At CAD’s level I put the probably of a margin call at less than 5% so the trade is +EV. Averaging down each 100 pips loser is a great approach for risk control. I just can’t see CAD trading to .9800, in fact I see a run to 1.05 in two weeks time. I’m typing with primate fingers after all! (monkey econ.) I’m testing a system on the 5 min. chart that uses 50-1 to enter trades on the seven majors using limit orders selling at the top two grid boxes and buying at the bottom two grid boxes using the using the top/bottom of the chart
as a tight stop, T/P is the inverse of the entry space. Backtesting has been incredible and I’m ready to start with 1 unit per trade. The system was inspired by your overshoot theories of generating cascading margin calls from short to long term. It’s hard to believe my eyes when I look at the backtesting so I’m going to 1 unit per trade instead of significant funds. I trade for fun. If I were trading millions or billions I would trade exactly as you describe in HTT. It is ironic that the main source of my FX info has become the founder of my broker. Please keep it coming and thank you!
I’ve printed HTT and am studying it closely. My exposure for this trade is safe at 10-1 but I canceled my backup trades to increase exposure because I had not read the chapter “Smoke and mirrors” closely enough. Thank you for the warning. I believe in the trade but at 10-1 I have no room to increase exposure.
Buying and selling the chart tops on the 1-minute is working well with 1 unit and a 10-pip stop. I hope real money works as well. Fun to earn 10% in 2 hours but can it be done consistently? The compounding potential boggles.
@Mark
Nothing is consistent in the financial markets, except maybe the poor trading habits of some people! I remember increasing my capital by 400% in one night using a maximum of 50:1 leverage, which is reckless for sure, but less than most bucket shops offer. Safety is in money management!
Mark – just one further comment of caution: if I had to make bets of the probability of hitting 0.98 or 1.05 in USD/CAD first, I would lean towards 0.98. My reasoning is simple: there are more traders, who are long USD/CAD than short. The longs will have margin calls driving down the price of USDCAD.
Thanks Richard! I like the trade on the charts. I’m not good enough to trade off positioning data alone because I don’t have any experience with it. I’ve traded charts a lot. I was walking the beach last night and had the horrifying revelation that my trading bible HTT -which I was reading with a flashlight- was a manual for competent, mature, and responsible trading for financial institutions. But Wall Street trades trillions on exchanges and OTC the way I do with small amounts as a retail gamer. And they lose money consistently. I recall the returns posted on Olsen.ch and they are all positive and substantial over time. Then Wall Street holds the Fed and Treasury hostage by demanding multi-trillion dollar bailouts that expand the national debt forever. All of this to avoid systemic risk that was in itself completely avoidable and would never be an issue if trading was done properly and intelligently and guided by experts like you, Richard, rather than amateurs playing with trillions. I have to leverage up to make spending money but I would be happy with 3% per year profit on 100 billion trading at .1-1 per trade instead of my 10-1 or Wall Street’s standard
40-1. Bone-chilling reality on a warm night! Thanks for the caution: tick-tock….
Richard, I have consulted the 14-day FX Historical Positions Ratios on CAD for a sign of passive herding as discussed in HTT.
The longs are steady at around 60%. You define passive herding as 70% and higher. If the longs were there I’d get out now but I feel okay. I like that rising MACD on the daily chart. I noticed that the yen longs are herding at 80%. I will consult FXHP whenever I trade. Thx!
@Deevz. Thx for the heads-up! I think I’ll keep re-reading HTT and trade smarter from now on.
Yen and Swissie margin call cascades off of passive herders exactly as explained in HTT! London session. After years of struggle I’ve become a competent trader after two days with HTT
and you. Thank you Richard! I made 8% on the CAD long. That threshold of passive herding of 70% or more is spot on. Less than 70% and you can get lucky and dodge an avalanche. I will definitely be focusing on the over 70%ers from now for big moves. I consider this experience to be a valid credential. You’re a great teacher, sir.
And the Friday seasonality avalanches in the direction of the current trades occurred across the board all day in London just as described in HTT except you use the NY Friday close as an example. London closed their losers all day Friday. And according to HTT the trends will persist into London and NY Monday morning. Maybe a nice counter-trend play will set up later on Monday. I will be trading at much lower exposure from now on. Thx!
“Cascading margin calls turn fundamentals upside down” Does trading against the carry trades qualify as fading the fundamentals? If a carry trade is herding at 70% does that increase the likelihood of margin calls as addressed in this chapter?
@Mark
In my opinion, market mechanics matters much more than fundamentals. If 70% of the traders are in a direction and price is moving against them, to me, that indicates a very strong trend. On a side note, you might want to discuss these kind of things on a forum on account of not flooding this website with comments; this is not my blog however, so I have no say in it. Take what I say with a grain of salt!
Thx. I’ve absorbed HTT completely. I really like that 70% threshold for passive herding because a big avalanche of cascading margin calls will probably rack up hundreds of pips very quickly and soon. Anyone who trades the HTT way will be in the top 0.1% of all traders worldwide and that is no small accomplishment! I’m not flooding I’m just overjoyed with success. Thanks again Richard and Deevz!
I’m selling the tops of 70%ers on the 15-min. charts and the avalanches are coming like Swiss clockwork. 70%ers should be highlighted right on live prices for quick access. XAG is a
70%er but one must refer to the Historical Ratios to find it. If I see a price continue I will follow the coastline with price averaging per the program but so far the 70%ers all fail tests of resistance at the 15-min. tops: yen, swissie, xag. Now I’m thinking like a pro. I’ll bow out and let others provide feedback for a few months. Thanks so much, sir!