The full title of this book is “Better Stock Trading: Money & Risk Management”. The book goes through a number of different strategies on risk management. The problem I find is that there are so many different methods and there is no clear cut winner. For example, just in this same book, you can capture profits by using the Profit Dollars At Risk Strategy or you can capture it by selling using the Count Back Line trailing stop loss. Which one is better? I guess the answer is simply what you would feel most comfortable using, but you need to use something.
While the book gives a number of strategies, I find it a not-so-easy read in order to extract the nuggets. I think the writing can be more succinct, and the points presented in a more structured manner. For example, the book devoted chapters on writing about why various strategies are bad. In those chapters, two bad strategies can be discussed, one used by Trader Success and another used by Trader Novice. My natural assumption would be that the one used by Trader Success is the recommended good strategy. After plowing through the chapter, the chapter concludes to say that both strategies are bad! I would much preferred to be just presented with the best recommended strategy, before explaining why other strategies are not as good.
There are also a number of confusing points in the book. For example, in the pyramiding chapter, using a 2% rule to size the position, Guppy wrote that the size could be ~$28,000. However, to be safe, he entered into a ~$9,000 position. Later on, the book implied that the Grow_Up strategy resulted in the risk being kept much lower than 2%, which has more to do with the decision to enter with a ~$9,000 position rather than the Grow_Up strategy. The question then is, is Guppy recommending to use 1/3 * 2% for the initial buy? During my own trading, I find it hard to stomach an even 1% loss in capital from a position, hence I am leaning towards having a 0.5% limit instead for the initial buy, which is close to his 1/3 * 2% example.
Anyway, my notes on the book are captured below so you get to enjoy the fruits of my digging.
How to Protect Capital: The Zero Cost Averaging Strategy
- Sell what is required to recover the original capital, and leave only profits at risk in the market.
- Best applied in bullish markets where prices have increased by at least 30%, and is most suited for fast-moving momentum stocks or stocks in strong, sustained up trends.
- This protects trading capital, and the opportunity cost if the market goes up further is the cost of insuring against the market falling.
- The original capital can be applied to other stocks or to the same stock again, considered as a separate new trade.
- This is better than strategies involving scaling down the position (e.g. sell half) as the stock moves up, because the original trading capital would still be at risk.
How to Capture Profits: The Profit Dollars At Risk Strategy
- Put a stop-loss on open profits, of the same amount as what you are prepared to risk on a trade entry (e.g. 2% of trading capital). E.g. if trading capital is $10,000, 2% = $2,000, so you should limit the loss on open profits to at most $2,000 from the most recent high.
- Christopher Tate in The Art of Trading recommended using an exit point of 2 x Average True Range below the most recent high. This is not ideal for fast-moving stocks because the stop loss lags a long way below the highest high.
- This strategy works better for fast-moving volatile stocks compared to slow-moving trends because slow-moving trends can shake you out with an exit too early.
How to Pyramid: The Grow_Up Strategy
- Adding constant position size (i.e. same number of shares) uses too much capital as the up trend continues, resulting in low return on capital. Adding constant dollar amount does better but requires significant capital to be allocated to a single stock.
- Stages of a trend
- Stage 1: Young trend, immediately after breakout from a downtrend, rallies and explosive up-moves with trend line of 45-60 degrees.
- Stage 2: Robust trend, well-established with trend line of 30-45 degrees.
- Stage 3: Mature trend, consolidation patterns develop, rounding tops, head and shoulder patterns. Some trends break out to continue, most collapse.
- Stage 4: Trend collapse
- The pyramiding strategy should match trading exposure with the changing risk. Risk is high at the initial portion of Stage 1 because you are not sure the trend has changed, risk then drops as the trend develops, and then increases as the trend matures because of increasing probability that the trend is ending.
- Pyramid strategy
- Stage 1: Young trend
- 1st entry: Signaled by close above count back line (CBL) (see below) indicating a trend change. Position size determined by maximum loss of 1/3 of 2% with initial stop loss set using CBL.
- 2nd entry: When the CBL trailing stop loss rises above the initial entry point, our confidence that the trend has changed increases, hence we add the same dollar amount as the 1st entry.
- 3rd entry: When the CBL trailing stop loss rises above the CBL ‘no chase’ line (set when determining the 1st entry). Add the same dollar amount as the 1st entry.
- Stage 2: Robust trend
- 4th entry: Signaled by the price bouncing off the 10-week EMA on daily charts, which should be above the 30-week EMA. Add position equal to 1/2 the dollar amount of the 1st entry.
- Guppy uses his Guppy Multiple Moving Average (GMMA) to generate buy signals, which broadly match those using 10- and 30-week EMAs on daily charts.
- Generally 1 to 3 positions can be added in the robust trend stage.
- Stage 3: Mature trend
- Entries during this stage will be 1/3 the dollar amount of the 1st entry.
- Generally 1 to 2 positions can be added in the mature trend stage.
- Stage 1: Young trend
- If a trailing stop-loss is hit, all open positions (from the different entry prices) should be closed.
Using the Count Back Line (CBL) to Identify Trend Changes
- Designed to follow the existing short-term trend and to confirm when the trend changes. It uses the ranging activity of the price to establish a hurdle which must be overcome before we believe the current up-tick is really a trend break.
- Enter on a breakout trade when the closing price is above the count back line.
- Use the CBL only after a straight trend line has been broken, to verify whether the trend has indeed changed. If the CBL hurdle is met but the straight trend line has not been broken, it is a false signal. Guppy noted that he only uses CBL after a trend line break and a GMMA confirmation.
- Calculating the count back line (details in his Share Trading book)
- Select the most recent low in the current downtrend.
- Move to the top of this bar, then travel left until you intercept the next bar (which may not be adjacent).
- Move to the top of this bar, then travel left until you intercept the next bar.
- Move to the top of this bar, the value at the top of this bar is the count back line value.
- Project the count back line value to the right. If prices close above this count back line, we assume the trend has changed.
- When moving left, price bars of equal height are ignored, as are intervening days with lower highs. Price gaps are ignored by moving up to the next bar in the current trend, i.e. it is as though there is no gap, you close the gap by bringing the upper and lower bars together, so when you move left, you will get to the adjacent bar which was previously higher. For example, if there is a price gap between middle bar and the bar immediately to the left of the middle bar (label the bar immediately to the left as Bar A), the left-most bar in the count back line will be Bar A, so the left-most bar and the middle bar are adjacent bars.
Setting Stop Losses and Maximum Entry Price with Count Back Line (CBL)
- To set a maximum entry price.
- Calculate the distance between the most recent low to the CBL, project that same distance up from the CBL to get the maximum entry price. That defines the ‘no chase’ line, so the entry to capture the young trend should be between the CBL and the ‘no chase’ line.
- If you didn’t enter before the price went above the ‘no chase’ line, wait for the next pull back or consolidation.
- To set a trailing stop-loss
- Same method but reversed. Start from the most recent high, move down, left, down, left, down. That defines the count back exit line.
- If there are 2 recent highs that leads to 2 different CBLs, choose the one that gives the highest CBL.
- Exit on the next day following a close below the count back exit line.
- Use this only after the close breaks below the straight trendline support. Guppy noted that he only uses CBL after a trend line break and a GMMA confirmation.
- To set initial stop-loss
- Same way as trailing stop-loss.
Allocate Portfolio Based on Volatility of Stocks
- 4/7 of a portfolio allocated to large-cap, trending, low-volatility blue chip stocks.
- 1/7 to small-cap, fast-moving, high-volatility speculative stocks.
- 2/7 to mid-cap stocks.
- Diversify risk based on volatility is better than diversifying across sectors.
- By spreading risk across stocks with different volatility profiles, it reduces the probability of all open trades being closed at the same time, hence the effective risk would be much less than 2% * number of positions.
How a Novice Trader Should Start
- A novice trader would have poorer analysis skills in picking in the right stocks at the right time, and managing exits, hence having a lower success ratio.
- To improve the chances of success, take just one trade at a time in each sector based on volatility (e.g. low volatility, high volatility). This gives time to manage the trade, analyze the reasons for its failure or success, before moving on to the next trade.
- With less open positions, the cumulative risk is lower, which gives more time to learn and survive.
Portfolio Management: The Swiss Roll Strategy
- Stock selection (funnel)
- Membership in the top 100 stocks (size and reputation)
- High dividend yield (funnel down to 10 stocks)
- Price trending upward, preferably in a young trend
- Reasonable volatility to deliver capital gains (funnel down to 5 stocks)
- Portfolio stop loss
- Chart the total portfolio equity value including cash.
- Set a stop loss at 2% below the most recent high point of the portfolio equity value line.
- When the stop loss line is hit, examine each of the open trades, identify the weakest, and sell it.
- This is mostly triggered in a weak market, and forces capital to be preserved earlier, compared to taking multiple losses with individual positions.
Active Trading with Range Indicators (Alan Hull)
- Use the Average True Range to create an envelope around the price.
- Stop loss zone is set below the lower band. Buy zone is set between the lower band to the price line. Hold zone is set between the price line to the upper band. Profit take zone is set above the upper band.
- Entry criteria
- Stock price’s annual Rate of Return >= 25%
- Buyers support seen: A rising week with a close higher than the previous week’s close.
- Price is in the buy zone.
- Sell rule
- Price closes at the end of the week in the stop loss zone, close the position.
- If rate of return falls below 25% per annum, close the position.
- To limit total portfolio risk even with the 2% risk rule, limit the number of open positions by being more selective in the stocks.