Algo Trading: Managing your risk in money markets

It’s very important to understand the risks of trading in the financial markets and therefore always aim to live in full awareness. Let your positive beliefs lead you, to take the actions necessary to succeed.

For traders to blindly enter the markets to trade, simply because they are thinking positively, is to ignore the full spectrum of what is possible.

However to live in constant fear of losing, will cause you to trade the financial markets with fear, anxiety, negativity, and aggression, which are equally destructive.

Instead, acknowledge both sides of the coin, the good and the bad.

React to market activity with full awareness and pay close attention on how to control and manage the risk. Then it becomes possible to create a positive reality, with a feeling of abundance and goodwill. By acknowledging the good and the bad; the reality; and by fine-tuning of your money management system, you are on your way to greater prosperity.

Accepting risk
Before effectively accepting risk in your finances, first believe completely, that there is a true benefit for you in doing so. This inner belief very often comes, after having experienced the power of the markets, in the form of a painful and substantial monetary loss. Regardless of how you ultimately develop the motivation to manage your risk, it is imperative that you implement it also.

There are six primary types of risk you need to accept:

1. Trade Risk – is the “calculated” risk you take on each trade. With any Algo Software you fix, your risk will never be more than 2 percent on any given trade. You will maintain this 2 % risk by adjusting your trade size and setting a stop-loss exit. Advanced traders, or Positional traders must secure their position by hedging.

2. Market Risk- is the inherent risk of being in the market. This type of risk, involves the entire gamut of risk possible when in the markets. Market risk can exceed trade risk. For this reason, Algo traders never actively trade, more than 10 percent of their net worth. Market risk encompasses catastrophic world events and crashes that paralyze markets. Events causing market “gaps” in price against your trade position is an example of market risk.

3. Margin Risk- involves risk, where you can lose more money than that in your margined trading account. You would then owe your Brokerage firm money if your trade goes against you. (Specifically in case of derivatives assets classes).

4. Liquidity Risk- If there are no buyers when you want to sell, you will experience the inconvenience of liquidity risk. In addition to the inconvenience, this type of risk can be costly, when the price is going straight down to zero and you are not able to get out, much like the experience of Enron shareholders in the year 2001.

5. Overnight Risk- For day traders, it presents a concern as to what can happen overnight when the markets are closed, and can dramatically impact the value of their position. There is the potential to have a “Gap Open” at the opening bell, when the price is miles away from where it closed the day before.

6. Volatility Risk- It can present a bumpy market that may tend to stop your trades repeatedly, creating significant draw down. This occurs when your stop-loss exits, are not in alignment, with the market and are unable to breathe with current price fluctuations.

Risk is inevitable in the markets but there is an art of managing the possibilities. It is not a matter of fearing the risk; instead, focus on playing the “what if” scenario, so that you can adequately prepare yourself for any outcome.

SEVEN BASIC STOPS-Which can help you to handle the risks.
A stop-loss exit, or a stop, is a predetermined exit point, you must select
prior to entering the market. Designing an effective stop-loss approach will be crucial to increasing your profit potential.

If your trade or investment goes against you, a stop-loss approach enables you to cut your losses quickly so that you have capital with which to re-enter the market. The alternative to using an effective stop-loss strategy is to sustain severe and devastating losses at one point or another. The market is unforgiving in this regard, and ignoring the inevitable is to tempt fate and invite painful financial loss into your portfolio or trading account.

Following are seven of the most common stop approaches:

1. Initial stop. This stop is set at the beginning of your trade and entered as you enter the market. The initial stop is also used to calculate your position size. It is the largest loss you will take in the current trade.

2. Trailing stop. This stop develops as the market develops. This stop enable to lock in profit as the market moves in your favor.

3. Resistance stop. This stop is a form of trailing stop used in trends. It is placed just under countertrend pullbacks in a trend

4. Three-bar trailing stop. This stop is used in a trend if the market seems to be losing momentum and you anticipate a reversal in trend.

5. One-bar trailing stop. This stop is used when prices have reached your profit target zone or when you have a breakaway market and want to lock in profits, usually after three to five price bars moving strongly in your favor.

6. Trend line stop. A trend line is placed under the lows in an uptrend or on top of the high in a downtrend. You want to get out when prices close on the other side of the trend line.

7. Regression channel stop. Very similar to a regular trend line, the regression channel forms a nice channel between the highs and lows of the trend and usually represents the width of the trend channel. Stops are placed outside the low of the channel on uptrends and outside the high of the channel in downtrends. Prices should close outside the channel for the stop to be taken.

Other stops used are generally a form of one of the above stops or a derivative of them. Setting stops will require judgment by you, the trader.

Judgment is based on experience and the type of trader you are. You can set your stops based on your psychology and comfort level. If you find that you are getting stopped out too frequently, or if you seem to be getting out of trends too early, then chances are that you are trading with a fearful mindset. Try and let go of your fear and place stops at reasonable places in the market.

Position your stops in relation to market price activity, and don’t pick an arbitrary place to set your stop. Many traders incorrectly buy and sell the same number of shares each time they trade. Then they choose a stop so their loss is the same dollar amount each time they stopped.

By doing this, they are disregarding the meaningful market support and resistance areas where stops should be set.

Remember, you can use any Quant based software that does an excellent job of identifying stop signals. These are identified by choosing key levels of support and resistance.

This enables you to set stops that are in alignment with current market dynamics.

Not setting stops
If you do not use stops, you are setting yourself up for failure. For example- When trading stocks, if you do not use stops and hang on to losing trades to a point where you emotionally feel you cannot exit the trade because the loss is so large, you are doomed.

If this happens, you are “married” to that stock and it may not be a stock you really want to own as an investment. Some stocks we trade are good for short-term trades only because we are taking advantage of the momentum in the stock. It may be a stock, we would never invest in and hold for a long time.

If you find yourself wishing for a stock to turn around, you’re not trading well. Based on the reasons you entered the trade and the location of your stop, you should always know in a second whether you should be in or out of a trade.

What happens when you don’t have a stop-loss exit strategy?
Never trade without knowing exactly where you will get out if the trade is against you. All large losses start as small, manageable losses.

I often receive calls from traders who either did not set a stop-loss or failed to get out of their trade when their stop was hit. They tell me that it is impossible to get out now because their loss would be too large to bear. If, this is what is happening to you, then you do not have the trader’s mind-set yet.

You have to realize that being stopped out is a natural part of trading. You must accept this and not let it get you angry or upset.

Remember, it is better to cut your losses short. It is the only way you can remain in the winning position..

Setting mental stops
For some markets, it is better not to put the stop actually in the market when you have some active positions . Some market makers will see your stop,and, if there are enough traders with similar stops, the market makers may try and hit your stop. Then they make money and you do not. In markets like this, you can set a mental stop and get out immediately if it is hit. Be sure you have the psychological toughness to get out when you are supposed to. If you don’t, then go ahead and enter the stop when you take the trade.

Moving stops
Never move your stop for emotional reasons, especially, when it is your initial stop. As new trailing stops are determined to lock in profit, you can move your stops based on newly confirmed Pyramid Trading Points and/or Reversals. If you add on to your winning trade (increase your trade size), your stop must be adjusted to control your risk in relation to your new trade size.

When adjusting your stop due to an increase in trade size, always adjust the stop closer to your current position to lower the risk in relation to your larger trade size. Once you do this, you should never roll back your stop, since now your larger trade size will warrant the tighter stop to maintain proper risk control.

Many students ask about moving stops based on different time frames.This is an advanced technique. As a general rule, always set your stops on the same time frame as you entered the trade. In other words, if you use a daily chart to base your trade entry, use the daily chart to set your initial stop. There are exceptions to this, but only after you have developed enough experience.

Becoming profitable using the same time frame, would be first step and goal, then you can perhaps venture into multiple time frames later.