Knowing how long to hold your trade

June 18, 2007 10:26 AM

No matter how much an account is diversified, all the eggs are still in one basket known as “equity.” Absent any concrete evidence that a stock purchase was sound, investors often panic and sell too early. Or, the notion of “in for a penny, in for a pound” can freeze common sense and keep us in a bad investment far too long.

There’s a simple solution to this age-old trading problem. By tracking your personal liquidation sweet spot, you can develop a visual indicator of where you are, where you should be and what you can do about it.

“How sweet it is” (below) depicts the sweet spot concept. It’s shown above the unforgiving breakeven delineator. It represents a cluster of equity win-loss ratios positioned over a certain range on the winning percentage scale. Not only does this chart show where your results stand in terms of breakeven, but it serves as an excellent defender against the insidious losses that can accumulate into a severe equity drawdown.

A profitable investment portfolio must have an overall win-loss ratio above the breakeven delineator. The sweet spot circle high above the breakeven curve is clearly a desirable location. At the high end of win percentage, where there is a danger of large losses in proportion to wins, the ratio of average wins to average losses will be small. That’s because short-term traders, such as floor traders, screen traders and arbitrageurs, tend to win often, but when they lose, they can lose big.

At the low end of the winning percentage scale, wins must be large to offset the many losses. The danger here is when wins become too infrequent. Examples at this end of the winning percentage scale include long-term trend followers and options traders who take many small losses in exchange for a large win.

Moving much further down the low end of percentage wins is where the trifecta bettors, slot-machine players and lottery-ticket buyers reside.

The risk for many of these traders, regardless of where they are on the scale, is slipping too far in either direction on the winning percentage spectrum. When you get away from what you know, you increase the likelihood that you’ll reject the indicated trades in favor of the counter trade, jumping from one extreme end of the scale to the other. But in most cases when traders look at a loss and consider how they might see it turn into a winner, this is precisely what they are doing. Some systems depend on multiple small winners while others can lose as often as they win but are successful because the winners are much larger. The sweet spot is a good graphic indicator to remind a trader to stick to his particular niche and avoid style drift.

FINDING THE SWEET SPOT

One preferred sweet spot location is in the upper right sector of the chart, where results with more than 60% wins and a 2:1 win-loss ratio would be ideal. Investment portfolios with sweet spot data clusters residing in this region are the result of robust strategies and skillful execution. The sweet spot target location to strive for is along an imaginary line that runs above the breakeven curve perpendicular to the tangent that touches the breakeven curve at 50% wins and a 1:1 win-to-loss ratio.

Finding the sweet spot attributable to a particular personal win/loss data record starts with constructing the breakeven curve. If “f” stands for the percent wins (the number of wins divided by the sum of wins and losses), then the breakeven delineator is a curve described by (1-f)/f.

The win-loss ratio for a particular period is the average of the equity gains on winning days divided by the average equity losses on losing days. The same holds for stock prices, where the sweet spot input from advancing and declining prices reveals the nature of price volatility and trend cycles.

For a quick look at the sweet spot covering the history of a personal record, the overall averages for wins and losses may be plotted as a single point. However, “Rolling along” (below) shows the additional information gained from using the rolling average, with the 40-trade rolling average results for an actual equity record. This performance data reflects Larry Williams’ independently verified trading record from www.ireallytrade.com.

This record of trades, rather than trade-days, is shown for the last portion of a string of 152 separate trades in a variety of futures markets for more than 14 months. The chart starts in the fifth month with high-end percent wins at more than 70%, then drops steadily to below 40%.

After briefly dipping below the breakeven curve along the way, the win-loss ratio turns up sharply just below 50% wins, only to follow the rising breakeven curve to the point where it abruptly climbs to end on a safe high. The last cluster of data above breakeven illustrates a profitable equity rally.

MASSAGING RESULTS

The next step, after you have identified your sweet spot, is using the information it provides to improve your trading results. Consider this: A cautious trader takes the trades shown in “Rolling along” but steps aside when the rolling average closes on the breakeven curve; he re-enters the trades as the rolling average re-crosses it higher a second time.

The trader would miss out on about 6% of the overall equity run shown, not counting the trading costs saved for the 46 trades not taken (see “Time out from trading,” below). If the trader were to walk away after initially stepping aside and not re-enter, the equity gain booked would be 56% of the overall run shown. Would either of these tactics be an overzealous defensive position, or would the gain forsaken be a reasonable cost to endure for the assurance of not losing a bundle in case the rolling average plunged further below breakeven?

The correct answer for the situation depends on the available alternatives. Knowing the source of the indicated trades and having a good feel for your tolerance for taking losses must factor into the decision to step aside or stay with it. Other traders might set a boundary some fixed distance below or (even somewhat above) the breakeven curve to serve as an indicator to step aside.

In the case shown here, some traders would presumably stay with the shallow dips in equity, awaiting a more decisive indicator, as long as the sweet spot rolling average hugged the breakeven curve. When the sweet spot resides in a comfortable region above the breakeven line — as it does for the last part of the trading run shown here — even the most squeamish investor has the assurance needed to stay the course in the face of brief setbacks.

A shorter-length rolling average is more sensitive to changes than the longer rolling average, which will yield a tighter data cluster to reveal long-term trends. Applying more than one rolling average helps answer the question of how large a setback is acceptable to continue riding a trend.

USING YOUR SWEET SPOT

The primary information gained by employing the graphic sweet spot as a tracking tool is in avoiding the pain of slipping into a prolonged equity drawdown; watching the sweet spot keeps you alert to adversity, while the ongoing feedback allows you to focus on further equity enhancement.

For example, if the visual data cluster starts drifting, the direction it takes indicates what is essential for correction. When the sweet spot for equity moves down from above breakeven, the correction will invariably be to take stop-losses and profits more quickly to increase the win-loss ratio. When the sweet spot moves negatively to the left, the number of wins in relation to losses needs to be increased, usually by trading less, or perhaps by pruning the diversified mix or just bypassing weak entry signals. Any move toward the area below breakeven suggests the possibility that it is time to lighten up on the amount of money committed, and vice versa. When the successive sweet spot data points rush off in one direction or another, it broadcasts a strong surge of momentum. The trailing rolling-average data points offer the best clues for adjustment, and most corrections boil down to a variation on taking losses sooner and riding winners longer.

Visual chart representations help money managers by presenting equity accumulation in a way that reveals the character of changes so they can be better understood and acted upon more effectively. Before lingering too long below breakeven, some action is necessary, and sweet spot tracking will recognize the success or failure of any corrective actions taken.

While tracking the sweet spot cannot replace specific price entry and exit signals, the visual image confirms the validity of these signals and reinforces the will to stay with winners longer and exit losers sooner.

It’s a great tool to add to the trader’s basket of essentials. Using the sweet spot chart is especially useful for following equity generated from investments in managed accounts, such as mutual funds, where the only control the investor has is the decision to exit.

It is also useful for comparing opportunities in stocks, trading systems and trading strategies because converting recent performance histories into sweet spot visualizations can be telling for picking the best opportunities.

Keeping track of your equity sweet spot is a financially healthy habit to develop.

To check your personal sweet spot moves and prospect for opportunities through comparison of recent performance, see the interactive web page linked from the Futures Web site at www.futuresmag.com.

Data for comparing stocks and related investments may be found online in several places, including Yahoo Finance.

Richard Thomas Canfield is a retired engineer trading commodities. He can be reached at canfield@patmedia.net.

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