Playing great defence

As a trader, I am always more concerned with how much I could lose on a trade than win. Good risk control certainly helps you with that, but there are some other ideas that can help you keep losses as small as possible. 

Here are some examples of playing 'good defence', as Paul Tudor Jones would call it, which have helped me as a trader.

The first is a European stock that I recently identified - here is the chart from last weekend which is when I put the stock on my watchlist:

This set up had a number of factors that I particularly like:

• A move up off the February lows;
• A contraction in volatility;
• Price consolidating just below recent highs.

Theoretically then it was a no-brainer to keep an eye on it with a view to trade the breakout to new highs.

And, on Monday, it did pierce the breakout level. But I did not take the trade. Why was this?

Simple - earnings were due later in the week, and I have a strict policy about not trading breakouts that occur just before earnings or a trading update is due to be announced. I've seen too many breakouts fail and gap down against traders once earnings are released. I want the odds to be as far as possible in my favour, and initiating a trade just ahead of earnings in my view is gambling, not trading. So I passed on the trade.

If I was trading a longer-term method, then earnings would in all probability play little or no part in my thinking. But on my own timeframe and parameters, then I have to take them into account. The possibility of a price gap going against me, causing a loss bigger than -1R, makes me avoid trading around those times.

Here is what subsequently happened:

We can see that the breakout quickly failed. Although it is not shown on this chart, there was a price gap down on Thursday morning following the earnings release, and price kept falling throughout the day. Being prudent and playing great defence helped keep my equity intact.

Now, onto a different example, This UK stock I HAVE traded recently - twice. And this acts as a good example about how aggressive I am in taking small losses. I have marked on the chart below the entry and exit points.

Again, you will see the similar characteristics of a contraction in volatility and a price consolidation near recent highs prior to breaking out.

If you look at my trading log, you will see that most of my losing trades are cut very quickly, when price falls back below the breakout level used to initiate the trade. This is something I picked up from David Ryan, who had this to say in Market Wizards:

"I want to buy it as soon as it goes to new highs."

"If it re-enters its base, I have a rule to cut at least 50 percent of the position."

"In some cases, it will break out and come back to the top of the base, but not re-enter. That's fine, and I will stay with the stock. But if the top of the base was $20 and it breaks back to $19 3/4, I want to sell at least half of the position because the stock didn't keep on moving. Frequently, when a stock back into its base, it goes all the way back down to the lower end of the base."

"Stocks should be at a profit the first day you buy them. In fact, having a profit on the first day is one of the best indicators that you are going to make money on the trade."

I took Ryan's approach to heart, but instead of cutting 'at least half' of the position, I just get the hell out of the whole position, and move on.

Yes, you can get whipsawed around, but in the long run it has proven far more beneficial for me to be this aggressive on taking losses. You can see in this particular example I re-entered a couple of days after the first failed breakout, when the stock made new highs, but it failed again. So I took another small loss. And we can see what has happened since.

Here is another trade I took this week which quickly failed. Same principles, and again no hesitation in taking losses:

As an extreme example of this type of approach, in Way of the Turtle, Curtis Faith gave a whole list of trades taken on cocoa in 1998 and early 1999, which yielded 17 consecutive losing trades before a winning trade came long, which covered all those losses, and left some profit over. The first four trades in that sample were longs, before a whole series of short trades were taken. Indeed, all the subsequent profitable trades (four of them) were on the short side. 

This was a great example of the age-old principle of cutting losses and letting profits run, mixed in with changing direction. In some of those failed long trades, prices were making new highs, but the choppiness of the trend meant that stops were being hit, before price then moved up to make further new highs, triggering new entries. Similarly, thirteen consecutive short trades (!) were stopped out on price retracements before the 14th short trade in that period made the huge profit. And even with the attempts at pyramiding that winning position, some of those failed before the additional 'units' traded also made profits.

The other benefit to me of this approach is that, if a trade fails quickly, then my capital is not tied up in a loss making or non-performing trade. There is also no possibility of me allowing a small loss to develop into a much bigger loss.

Can this sort of thing happen in stocks? Absolutely. While I have never come across such an extreme example as those cocoa trades, here is a stock which I traded in late 2014/early 2015. Again, I have marked the entries and exits on the chart:

We can see here Ryan's principle in action, as the initial price breakout failed and started falling towards the lower end of that base, before price came back up and triggered a new entry. Taking the second entry was beneficial as it generated a profit in excess of +6.5R, far outstripping the small loss suffered.

Again, this approach doesn't always work out in my favour - you can read about my missing out on big profits on Weight Watchers last year. And a lot of people may find my own methods too aggressive. But in the long run, playing great defence has helped me far more than hinder me, and a similar approach could help you too.