An excellent question that I received today in regards to balancing risk, reward & total gain/loss exposure when trading a volatile sector like the shipping stocks. I expanded on a few closely related points to consider when determining the optimal profit targets, stop levels & position size on trade ideas with above average gain/risk potential:
Question 1:
Randy, I’m having trouble understanding how to invest in the shippers while maintaining a R/R ratio of 3:1 or better. I use the R-value method of calculating position size and thus determining R/R. Pretty sure you must be familiar with it, but it’s explained concisely here: https://www.stocktrader.com/2013/09/14/van-tharp-risk-r-multiples-successful-investing/
The formula looks like this:
((Account size)*(risk as a %))/(initial price per share – stop price per share) = # shares to buy
The R/R calculation is related:
((target price per share – initial price per share)*(# shares held))/((Account size)*(risk as a %)) = the R:R ratio
So for a shipper like TOO my spreadsheet calculates the share size to buy at: 800 for a position size of $5000 (at yesterday’s closing price of $6.25 and a stop set at $5.00 for a hypothetical account of $100,000 and risking no more than 1% or $1000). The R/R on that is a compelling 5.8!
The problem arises when I artificially adjust the position size down to $1000 (175 shares) without tightening the stop, I get an R/R of 1.3. Not so compelling.
What to do in this situation?
1. Buy the big position and trust the stop but risk a big gap down on bad news for a low-priced stock?
2. Buy the small position and set a tighter stop based, not on a logical T/A placement but on maintaining a 3:1 R/R?
3. Buy the small position with the stop set at a logical place based on T/A and chill out about the R/R?
Reply 1:
I take a similar but more simple approach in determining my position size as well as my stops & targets. Essentially, I break it down into two parts:
1) First & foremost, you need to use favorable risk/rewards rations on every trade. Unless you have some magic formula that produces an 80%-90% plus success rate, I like to use an R/R of 3:1 or better. In doing so, I first analyze the chart in order to determine where my entry (or entries, if scaling in) will be and where my target (or targets, if scaling out) will be. To keep it simple, if my sole price target would be a $3 per share gain, then my stop would be $1 below entry. I will add that I typically adjust my stops at or near that level to be placed just below the nearest support level, assuming there is a clearly defined level such as a gap or horizontal support.
2) Now that the R/R is taking care of, I will then simply adjust my position size down based on the EXPECTED volatility of the position. In my book, basing your position size on recent volatility & measures like the current ATR can be akin to driving while looking in the rear-view mirror. For example, I love trading breakouts from falling & rising wedges. The closer prices get to the apex of a wedge, the less volatility & smaller the price range become. However, wedge patterns, along with most other chart patterns, are like coil springs, with the stock ”building” energy in a consolidation type phase with that energy released like a bullet when you pull a trigger & the firing pin hits it. After a breakout, stocks often explode higher (or plunge lower on a short-setup), as such, I anticipate the likely future volatility when determining my position size.
To expand on that, let’s just say that I was only trading one security in a sector, such a NUGT for the mining stocks (which already provides me diversity among many stocks in the sector), I might simply reduce my position size in two steps: 1) By 30-50% to account for the above average volatility of the mining sector/GDX and 2) Then by a third to account for the 3x leverage of NUGT.
As far as the shippers, where I often take a shot-gun approach in order to diversify among numerous stocks vs. just one or two, I simply determine how much of my overall portfolio I want to allocate to the sector (whether buying into that full exposure at once or scaling in), and then try to get a feel for how many total stocks that I might ultimately hold in that sector. If I decide to put 20% of my account into the shippers & I decide that I will probably hold 10 stocks, that would be about 2% of my portfolio size into each stock. To take it one step further, I might knock that down to 1% or less for any very low priced, micro & nano-cap shippers (e.g.- SEA, EGLE, SALT) while increasing to 3% or so for the less volatile, higher priced stocks with small to medium sized market capitalizations (e.g. KEX, SSW, MATX).
That might sound complicated & although maybe I should, I don’t always pull out my calculator to get an exact numbers of shares but rather quickly glance at the market cap, stock price and most importantly, the historical trading history (which I’m pretty familiar with anyway, having trading the shippers long & short for many years) in order to come up with a quick rough total value for each position that I decide to take, again, keeping the total current AND eventual allotment to the sector in mind.
Looping back to that whole R/R thing that you were struggling with, it’s all relative.. meaning if you use a 3:1 or better R/R on each position, regardless of the position size, that is all that matters. Don’t get tied up in the fact that you are adjusting the total position size down to account for the above average volatility/risk of loss potential because it is all relative. If you would normally put $10k in a typical trade with a beta of 1.0 (vs. the broad market) and you decide to put $2k into a shipper that has a history of running 50-200% in just days or weeks when the sector is hot, you will make (or lose, if wrong) about the same DOLLAR amount as you would on a typical trade. That assumes that you might normally target a 15% gain with a 5% loss allotment on a typical swing trade but, using that same 3:1 R/R, you are risking a 25% loss for the change to make 75% on the shipping stock. I never get tied up or swayed by percentage gains & losses… its the total DOLLAR gains & losses that will make or break me.
Q2:
So it seems like what you are saying is that continue to use the 3:1 R:R discipline to select trades as those setups where the price action supports a 3:1 R:R are more likely to succeed, and as a trader, it keeps you out of the lower percentage trades. But go ahead and adjust position size manually when necessary. It’s that part where, lacking experience, I find it more difficult to judge.
I have to say, it’s very helpful when you say things in your videos and posts like, ”please be cautious and don’t put your whole portfolio in these stocks…” and your description using NUGT was great because that was my next question (how to translate stops, targets and position sizes between the 1x and 3x ETFs).
R2:
Exactly; Using an R/R of 3:1 (or whatever your preferred minimum R/R is) or better AND adjusting your position size below (and sometimes even above, for low-beta securities such as TLT) are mutual exclusive. The minimum R/R should be applied to every trade whereas you need to recognize which trades are either currently volatile or have a past history of periods of elevated volatility. The shippers & miners are two good examples of that. At times, like any security, they can trade flat or sideways with relatively low volatility for weeks & even months on end while consolidating after a big move. Therefore, don’t be fooled by the recent low volatility or ATR as that is most likely the calm before the storm or the eye of the hurricane (which is marked by a period of calm winds, in which it gives the false appearance that the storm has passed).
A quick study of the charts for a stock or sector going back a few years will give you a good idea of how volatile a stock or sector can be at times. If you aren’t sure by visually glancing the chart, focus on the periods were you see big moves up & down and then use a measuring tool on the chart to gauge how much the security when up or down (in percentage terms) over a certain time period (days, weeks, etc…). When you look at a sector like GDX in which gains of 30% or more in just a few weeks are quite common, then you need to expect moves like that to continue going forward (and multiple that by a factor of 3 if trading DUST or NUGT).
On a final & related note which I feel is very important to consider is the relationship between volatility & stops. A lot of traders that I talk to have a very difficult & frustrating time trading the miners because their stops are constantly being clipped, with the trade often going on to play out for what would have been a very nice gain, as they (for the most part) read the charts correctly. I realize that the stops on some of my trades might seem excessive & some might immediately think ”Are you crazy?.. a 20%+ stop-allowance on a trade?..No way!” Well first of all, to each his own; never take a trade that you are not comfortable with or doesn’t mess with your trading style or rules.
Now for my reasoning behind what might appear as excessive stops on some of the trade ideas posted here: It is all relative. For example, if I decide to short DUST for what I plan to be a multi-month long swing trade on GDX (shorting DUST gives you a long exposure plus, it lets the decay work for your position instead of against it), I might allow for a 20%+ stop if my profit target is for a gain of 60% or more. First of all, one must not forget that DUST is 3x (300%) leveraged ETF. Therefore, that is effectively about an 8.3% equivalent stop loss on GDX or the mining sector with an equivalent profit target of about 30%, still a 3:1 R/R.
In mid-Feb, the ATR (average true range) on GDX peaked at over 1.00, which means that GDX, ON AVERAGE, was experiencing daily price swings of more than $1 per share at a time when the share price was only $19 or less. That equates to an AVERAGE intraday price swing over over 5.3% on GDX. Now juice that up by 300% and you get an average daily price swing of about 16% on DUST & NUGT. Therefore, this is what I’ve said to traders in the past when swing trading the miners: Either allow for very wide stops (commensurate with your gain potential/profit targets, of course) or don’t bother trading the miners at all because you are all but guaranteed to have your stops run if you plan to be in that trade for more than a few days if using tight stops.
Given, most traders don’t have the stomach or deep pockets to swallow a 20%+ loss on a typical position but they do if they adjust their position size down accordingly, because again, percentage gains are relative whereas DOLLAR gains & losses are what matters. If you normally trade the SPY (with a typical ATR between 1-2%) in $10k position sizes with 5% stop-losses & 15%+ profit targets, then GDX should be traded in a position size of at least half that ($5k), cutting that down by another 1/3rd of trading NUGT or DUST while allow doubling (and then tripling from there if DUST/NUGT) your total percentage stop-allowance & price targets, which should expose you to roughly the same total dollar gains or losses, per trade, as would trading the SPY.