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Tharp's Thoughts Weekly Newsletter (View On-Line)

April 08, 2009 — Issue #418

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Back to Back Workshops in April

Article

Understanding All the Risks in a Trade by Van K. Tharp, Ph.D.

Sale

Peak Performance Home Study Course

Trading Tip

Top Notch Internet Resources—Yahoo! Stock Screening by D.R. Barton, Jr.

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Advanced ETF 202 Workshop Coming Soon

Mailbag

Confused About What Percentage I Should Risk

Offer Ends April 8

Back to Back Workshops in April

April 24-26  Blueprint for Trading Success
April 26  Dinner at Dr. Tharp's (Photos)
April 28-30  Peak Performance 101

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Feature

Understanding All the Risks in a Trade

by
Van K. Tharp, Ph.D.

Typically, I teach people to think about two kinds of risk in a trade: the risk in your stop and position sizing risk (or the total risk to your portfolio). However, there are many other types of risk in a trade, especially in these market circumstances. I thought this would be a good time to detail all of them. 

My complete list of risk types:

• Predetermined risk in a trade (1R)
• Position sizing risk (the total risk determined by R and your position size)
• Market risk
• Group risk
• Instrument risk 
• Underwriter risk
• Currency risk 1 (inflation/deflation)
• Currency risk 2 (a decrease in the value of the underlying currency)
• Government risk 
• Psychology risk

I had no idea that there were so many different kinds of risk in a trade until we entered into this market climate. Let’s review each of them.

1) Predetermined Risk (1R). I have said for many years that you should not enter into a trade without knowing when you are wrong about the trade and having a stop order in at that point. For example, a good substitute for buy and hold in the stock market is the 25% trailing stop. Your initial risk should be 25% of the entry price. You are wrong about the trade if it drops below that price and should get out. This is a typical example of what I’ve called 1R throughout my teachings. With a trailing stop, every time the stock makes a higher close you should raise your stop so that a 25% drop from the current level gets you out.

2) Position Sizing Risk.  It’s your total risk when you multiply 1R times the number of shares that you purchase. For most of you that should equal about 1% of your portfolio.

3) Market Risk. All ships go up or down with the tide. If the whole market goes down, most stocks go down with it. However, this sort of risk is well-controlled by position sizing.

4) Group Risk. This is risk in the group of stocks or commodities that you are investing in. For example, precious metals stocks tend to move as a group. Financial stocks tend to move as a group. However, this sort of risk is also controlled by your position sizing.

5) Instrument Risk. I hadn’t thought much about this type of risk until I wrote about the GLD ETF. You can find my article on the topic in a previous newsletter. When you invest in the GLD ETF you think you are investing in GLD, but you have no real idea whether or not GLD owns the gold you are investing in. There are no guarantees. Thus, gold could continue to go up, but suddenly GLD could plummet simply because something happens to show there is no gold to back up the investment. You should always ask yourself, “What is the safety of my underlying instrument?”

6) Underwriter Risk. What happens if you own GLD and HBSC (the bank that is supposed to have the gold) fails? HBSC has numerous custodians and subcustodians that theoretically have the gold behind GLD in their vaults. What if one of those banks fails? And that’s just the bank behind GLD. What if the company that underwrites a whole group of ETFs (i.e., Lehrman Brothers) fails? What if the company behind your mutual fund fails? What if your hedge fund fails? Or what if one of those companies turns out to be running a ponzi scheme? These various forms of underwriter risk  are VERY REAL in today’s market climate. Thus, you should ask yourself, “What could possibly fail, making this investment worthless or tied up in the courts for some time?”

7) Currency Risk 1 (Inflation/Deflation). The current secular bull market started in 2000. Bear markets can be inflationary and deflationary. In an inflationary market you might find that the government could depreciate the value of your currency by 90%. Right now the S&P 500 is at 768. Suppose we started a good rally that took the S&P 500 to 3072—that’s 400%. 

But what if the currency was inflated so that the dollar was only worth 10 cents by today’s terms? That would mean that the S&P 500 at 3072 was only worth about 307 in terms of today’s dollar. You would have really lost about 60% of your money. This is very real because the government manipulates the inflation data to make it seem much lower than it is and the only real solution out of the massive debt of the U.S. government is to inflate it out of existence. Notice the Zimbabwe note below. It’s actually a real note for $100 trillion Zimbabwe dollars. If the U.S. dollar did that, then our $100 trillion debt would be almost gone. I believe that this is the largest note every printed in history. I have a $500 billion Iraqi note, but this one is 200 times bigger.

By the way, I bought one of these on eBay for $18. At the end of March they were selling for $8 each and a 100 pack for $299. The currency no longer exists and it is still going down in value. Always keep your eye of the inflation/deflation potential of the currency in which you are investing.

8) Currency Risk 2 (Relative Value). Let’s revisit our example of the secular bear market starting in 2000. The first downleg ended in 2002, and then in 2003 the S&P 500 went up about 30%. However, that downleg corresponded with a huge decline in the US dollar. It lost about 40% relative to the Euro in 2003. While Americans thought they had made money, most of them hadn’t relative to the Euro and most other major currencies. This brings up another thing to monitor: “How well is my currency doing relative to other currencies?”

9) Government Risk.  Do you trust your government? The government can make its own rules and change the value of your investment in a heartbeat. For example, when the Hunt brothers tried to corner the silver market, the government decided to stop them. First, margin rates were raised. That didn’t stop them. The rates were raised again, but that still didn’t stop them. And then the government did something that I, to this day, can’t believe. They decided that you could not buy silver anymore—you could only sell it. And since there were no buyers for the seller, silver dropped like a rock. The government has also confiscated gold coins, refused to honor its pledge to back our currency by gold, and told the U.S. states that income taxes would only apply to the very wealthiest of Americans and would not exceed a top rate of 6%. You should always be looking at what the government might do to ruin your investment.

10) Psychological Risk. This is probably the biggest risk of all because you are the biggest risk to your investments. The average trader is probably about 90% efficient, meaning they make a mistake in one out of ten trades, where a mistake means not following a sound trading system with written rules. This is probably the biggest risk you face at any time with your investments. And if you don’t have written rules to guide you, well, that just illustrates my point—everything you are doing is a mistake.

Typically, people enter into a trade oblivious to the number of potential risks they are taking. However, if you study and understand these risks, then you can minimize them.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling book Trade Your Way to Financial Freedom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com. 

 

Sale

Peak Performance Home Study

 

This spring, Dr. Tharp will be releasing an updated edition of his masterpiece, the Peak Performance Home Study Course. But this second edition will not be available for another month.

Trading Tip

More Top Notch Internet Resources Part III
Yahoo! Stock Screening

by
D.R. Barton, Jr.

I’ve been doing some work with the Yahoo! Java-based stock screener, and I really like what I see.

When it comes to low-cost tools for the equities markets, Yahoo! Finance is at the top of the heap; there is not even a close second. I have written before about their easy access to companies’ quarterly reporting figures, their huge historical database of stock prices, their excellent news features and their active message boards. If you could only go to one site no-cost, this is as good as it gets.

But this week, let’s focus on their upgraded and greatly improved stock screener. First of all, there are no software add-ins required (this assumes that you have the ubiquitous Java software on your computer that is reasonably up-to-date).

Once loaded, the screener allows you to make what I call identity screens. For example, you can screen by exchange or membership in the S&P 500 or Dow Industrial indexes. I’d like to see some more possibilities here—a broader list of indexes represented would be useful. They also have a list of sectors, so you can limit your screens to stocks in a particular sector. But most impressive in the identify filters is the one for industrial grouping where there are literally hundreds of choices. For anyone doing research within a given industrial group, this is a very powerful and detailed filter.

Other useful criteria that one can use in the Yahoo! stock screener include some standard but needed fundamental items: valuations, analysts projected estimates, and shareholder criteria (float, share outstanding, shares short, insider, institutional holdings, etc.). Continuing in the fundamental vein there are fairly standard measures such as those found on the balance sheet and income statements and profitability and growth measures.

Before I introduce you to the most impressive aspects of the screener, I have to list a couple of downsides. First, while the application allows exports of screening results, the format used is very cumbersome. I have messed around for quite a while trying to find the universal settings that allow me to simply populate a spreadsheet with my results. So far, no luck! I’ll let you know in next week’s article if I find the key to the exporting kingdom. Second (and this is a nitpick), you have to experiment to find a way to delete criteria from the list. There is no menu for this. You need to right click on the criteria and from there you get a small dropdown menu that allows you to delete the cell.

Despite those issues, there are a couple of additional features that really show promise. Despite a limited technical analysis arsenal, it has a couple of useful ones: a way to scan for gaps and to list stocks that are big price and/or momentum movers. More on that next week along with another really cool tool—the ability to do cash flow scans (my favorite fundamental measure). Until then …

Great Trading,
D. R.

About D.R. Barton, Jr.:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  “drbarton” at “iitm.com”.  

Workshops

Workshops Coming in May

NEW Two-Day ETF Add-on

 

May 11-13  How to Develop a Winning Trading System That Fits You
May 15-17  Highly Effective ETF Techniques 101
May 18-19  Advanced ETF 202 Techniques (ETF 101 is a prerequisite)

Learn More...

 

Mailbag

Confused About What Percentage I Should Risk

Reader Question: After reading (in 3 days) "Trade Your Way to Financial Freedom" I am stumped by a seeming contradiction.  After analyzing personal account trades over the past 6 months, it seems clear I need to be much, much bigger in my trades.  However, the trades are already 10% positions in my IRA. When I calculate the position size suggested by your formula in the book, my position sizes should be 25%....yet throughout the book, I am reminded to keep position sizes at 1% of equity.  The book was extremely useful but I continue to scratch my head about this topic.  Regards, J.L.

A: Thank you for your email.

You are mixing up position size and initial risk. The 1% you are referring to is the initial risk amount. That’s the amount of money you are willing to risk or lose on a trade often expressed in terms of percent of equity. Position sizing is the total dollar amount of a trade or total shares, which is also often stated as a percent of equity. Additionally, your risk amount or 1R should generally not exceed 1% of your equity and any single position size should generally not exceed 20% of your equity.

Use the CPR Method written about in the book and calculate your risk first to determine your position size for a trade. If you had a $100,000 account and were willing to lose $1,000 on a trade, you would risk 1% of your equity. $1,000 is your 1R. Say you liked a stock at $10 with an $8 stop price. You would buy 500 shares ($1,000/$2 per share risk = 500 shares). In this case your position size would be $5,000 which in equity terms is a 5% position. Now say you wanted to buy another stock at $10 because you believe it just hit a major bottom at $9.80. You set your stop price for the trade at $9.75 and you would calculate a 4,000 share position ($1,000/$.25=4,000 shares). This $40,000 position is 40% of your equity. Even though your 1R is at an acceptable 1% of equity, this big of a position exposes an unacceptable share of your equity to market risk or price shocks. Imagine if you had taken on a position this big on the afternoon of Monday, September 10, 2001 or on the eve of some other market moving event. With that much equity exposed in the market in a single position, you could take a hit from which it would be hard to recover. You need to manage both the initial risk amount and the position size. 

In your IRA account, it sounds like you have a real life example closer to the second scenario mentioned above where the optimum position size for trades might be larger than your equity allows. This can and does happen— even in leveraged accounts. There are several things you can do about this situation, but the best alternatives really depend on your objectives. 

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