A Short-Seller's Survival Guide
Wednesday, November 18, 2009 | Teeka TiwariRating:
The breakout of the S&P 500 to close above 1,100 cannot be ignored. Whether it's market manipulation, irrational exuberance or the start of a new era in American profit growth, the undeniable truth is that the market is consistently reversing every single bearish indicator.
A Market Gone Mad?
The last time I saw this many bearish signals reverse was in early 2007. The brokerage stocks had been running like mad, but I knew the balance sheets on these companies were rotten with souring mortgage bonds.
Additionally, all of the sector data pointed to massively overbought conditions.
I remember repeatedly attempting to short the brokers and getting stopped out again and again and again. It seemed that every time a meaningful sell signal was triggered, buying would magically appear to eliminate the sell signal.
During the last several months, we've seen similar action once again.
The Market Can Muddy Even the Clearest Signals
When the NYSE Bullish Percent Index (BPI) flipped to Os in early 2007, I got even more bearish. But just a few weeks later, the index flipped back to Xs, once again wiping away my sell signals. (On a very basic level, Xs represent rising prices and Os represent falling prices on the BPI.)
This was a very frustrating time. Everything screamed "Sell!" and, yet, the market just kept coming back.
I knew that the subprime bubble was going to wreck the brokers; the story was already out there and yet they refused to break.
It wasn't until June 2007 that we finally saw sell signals start to "stick." Of course, as we all know now in hindsight, early 2007 proved to be the top for the entire financial sector.
2 Must-Haves in Your Financial Survival Kit
But how do we survive the whipsaws that can corrode our trading capital while we wait for the signals to begin sticking?
There are two keys.
1. You must use stop-loss points on every trade.
2. You must use dynamic position sizing that adjusts your position size as a set percentage of your equity.
I've written several articles on where to place your stop-loss. You can access them here and here.
Today, let's talk about dynamic position sizing.
What exactly does that mean?
Employ a 'Dynamic' Approach to Portfolio Management
Dynamic position sizing means that, as our account value fluctuates, so should our position size.
To keep our position size uniform in relation to our expanding (or contracting) account value, we want to use a set percentage of account value to determine our position size on an ongoing basis.
Most traders will risk no more than 1%-2% of their total account value per trade. This means that, if a single position hits its stop-loss point, their total loss will be no more than 1%-2% of total account value.
So, their position size is always determined by how much they are prepared to lose NEVER how much they are hoping to gain.
Avoid the Gambler's Fallacy
By using a fixed percentage of your current equity, you prevent yourself from falling into the gambler's fallacy of trying to make it all back on one outlandishly sized trade. It keeps your position size commensurate with your account size.
Remember: More than anything else, it's poor position sizing (along with not using a stop-loss) that kills the average investor.
When experiencing a string of losses like I did in early 2007, and now during this very challenging time in late 2009, I take further action to protect my account equity.
One method to consider is to decrease your position size by 25% for every 10% drop in your account equity. As your account equity increases, you can once again increase your position size.
'Sizing Up' the Situation
For instance if you normally risk 2% per trade, you would cut that back to 1.2% per trade, should your account value drop 10%. A further 10% drop in account value would cut risk per trade to 0.9%, and so forth.
I generally like to use a 2% initial position size as a maximum and 0.5% as my smallest position size.
This means that I'm trading my smallest when I'm at my worst and trading my biggest when I'm at my best.
Adjusting my position size is the No. 1 weapon I use for weathering a string of losers.
Every trader -- no matter what system, approach or fundamental research they use -- will go through losing periods where their approach appears to be "out of whack" with the market. Just look at what the value investors went through in the 1990s or the growth guys in the 2000s.
The key to surviving those periods is to keep adjusting your position size smaller (and smaller) until your methodology starts working again. We never know how long a losing streak will last, but we do know that they don't last forever.
Like the rising sun following the long night, markets rotate from bullish to bearish and back again. There is not a thing on this planet that can change this one fundamental fact.
Dynamically adjusting your position sizes gives you a huge edge over the average investor and automatically increases your market survival rate while you wait for that turn to occur. It can go a long way in ensuring that your account lives to trade another day.
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Teeka Tiwari
Chief Investment Officer
ETF Master Trader
