Risk Management

I was reading Dr. Brett’s BLOG and he brought up the Turtles – remember the Turtles - no - mother, not the Teenage Mutant ones. These Turtles were a group of people selected to take part in a noble experiment to see if absolute morons could be taught to trade in the stock market (sort of like the movie - Trading Places). Well that’s probably not true either and perhaps even a little harsh. Well, it’s a lot harsh but the Idea (and we always capitalize the “I” in “Idea” when it is a great Idea) was to take ordinary people not unlike you or I for example and teach them a trading method and then, if they followed that method to a “T” they would make fame and fortune. For some reason or other they called themselves “Turtles” probably because of the absolute slow and boring nature of the work they were doing.

Think about it people – if I give you a set of trading rules that I know has a probability of success of say 55%, plus a very large trading account and I set you in front of a computer terminal all day and you follow those rules perfectly then you should have a 55% probability of success. And if you don’t follow the rules, you won’t. Good grief - for this they needed a test? I’m probably missing something as usual. Anyway if you go to your favorite search engine and you type in Turtle you will probably find the rules. They ain’t much and they have been sold for thousands and thousands of dollars but are now available for free. And there is a reason for that. They basically say buy the trend and when it stops trending sell it - Duh. I can prove this and will a little bit later in the post.

But let’s not belittle the process itself. The most important part of Turtling is risk management. That’s because risk management is the most important thing a trader can do. Above all preserve capital until you hit the home run. Something we day traders sneer at and other people make fortunes doing.

Now the proof. I pulled out one of my favorite tried and true, time tested – oh crap – I threw together a filter that simply selected stocks based on closing price in relation to 2 moving averages and then listed them in volume order highest to lowest. It is a very prolific filter because there are so few moving parts but we only use the top several selections by volume in our back testing so it doesn’t really matter how many are output. I expect this filter to produce about 60% winners over a four-day period – the expectation is based on experience.

When I back test I use a simple baseline – One trade a day with no more than four stocks in the portfolio at any time. The way I have the back test exit criteria set is also simple – after four days exit the trade and take a new one unless you hit a 10% stop loss before 4 days in which case sell that stock and take a new one. Based on a virtual equity starting capital position of $100K this permits 25K per trade to begin. Note that I don’t care how many shares I’m holding just how much money I’ve got in them. After I run the test over an 80-day period or so I look at the equity results and for this baseline we achieved $53860 in profit with a 67% win rate – not bad for 80 days or so.

After establishing the baseline I started mucking with the internals one at a time. First number of stocks in the portfolio. I adjusted this to 1, 2, 8 and 16 stocks in the portfolio at any one time and here are the results.

1 – 47865
2 – 46147
8 – 24325
16 – 11570

This suggests that there is an optimum number of stocks in the portfolio and for this test it seems to be four. (If we doubled our starting cash to 200K would that change the number of stocks in the portfolio factor)? Let’s now look at more than one trade a day with no more than four stocks in the portfolio. (If you answered “yes” to our question above you are correct).

If we take four trades a day with four in the portfolio we can get to 60249 with a 71% win rate. For two trades a day with four in the portfolio we achieve 54891 and 68% win rate which is still better than one a day with four in the portfolio.

Let’s try one more factor – let’s take our best result, 4 x 4, and increase our holding period to 10 days. The result was 24357. If we add a simple measure such as a 15% profit exit criterion it goes to 34334. This is probably trying to tell us that stocks go up and down and unless you are a buy and hold forever type you need to attend to your portfolio a little more often than the broker recommended once per year.

So with a makeshift filter I have shown how money management – changing the way you buy not what you buy can make a large impact on your results.

According to song and story those Turtles who became successful adhered to the process like glue. The ones who deviated from the rules were not successful. It is that simple, kiddo.

There are a couple of exceptions to the above regarding “what to trade”. For those of you who are enamored of low price stocks (less than $10) – same system with a dollar requirement of $2 to 10 – holding four stocks in the portfolio – one trade a day nets 27784 and four trades a day nets 17255. Both produced about a 55% win rate. Two points – with one trade a day you are sometimes holding 20000 shares of some low price piece of crap and I can pretty much guarantee you aren’t going to get out of it alive unless it goes way, way up. Second, it is obvious that low priced stocks are low priced for a reason.

Exception two – note that the trades selected in the above tests were all “highest volume of the set that was output by the filter daily.” Volume matters when selecting trade candidates. Low volume stocks are low volume for a reason.

Also no Turtles were injured during the filming of this report.