The Ultimate Risk Management Tool: Equivalent Risk (Part 1)

07/12/2010 10:30 am EST

Focus: STRATEGIES

Timothy Morge

President, MarketGeometry.com

I was asked earlier this year by several elementary schools to teach the basic of trading to their gifted students; one of the students happened to be my eleven-year-old son, Sean. The students competed in a national stock trading contest that ran from mid-January through late-April. The students could only be long stocks and each school had a team (since these were only the extremely gifted students at each school, the groups were small—three or four students per team, on average). I taught them a simple charting methodology (I called it “crayon drawing” because it was based on market structure and simple lines—no indicators were used—though the use of strict money management was featured prominently each time we met. I refused to give them trade ideas, nor would I tell them where and when to get out, profit, or loss. I would point them, using questions, to a line of reasoning that would allow them to find the answers they needed themselves. I am proud to say that three groups I helped all finished in the top ten in the country. The two in Illinois finished third and fifth, and the school system in Arizona—where I now live—has not yet given me permission to release any information more specific, but the Arizona team finished in the top ten as well.)

My first impression? We should have ten- and eleven-year-olds manage our retirement money! The three groups averaged a 12.4% non-annualized increase in the value of their trading account over that short period of time, using no leverage and only being able to be long stocks. They set their maximum risk to no more than 20% of their account on open positions, though they never approached this level of risk. One of the main tenets in my own trading, and one of the things I insist upon when I mentor other professionals is that stops are always in place the moment a position is put on, as well as logical profit targets. I taught this to the students and they practiced it religiously.

What made these students take to trading so quickly and seemingly easily? My slogan is “Master Your Tools, Master Yourself.” I believe mastering yourself and your emotions about positions and money (greed and fear, the “need” to make money) is the most difficult part of trading. I try to build simple tools to help take these emotions out of most traders’ minds, but at this young age, though the students are truly enthusiastic, they are generally not burdened by these emotions. They have no house payments and all the other burdens so many adults have when they first begin to learn to trade. These young adults also have a “clean slate.” They have not been bombarded with the unrealistic and even fraudulent claims so many vendors use when trying to sell their trading books, courses, or software. To these students, this is just another skill, like long division or expository writing, which they have to master, though I dare say the students I helped seemed a bit more enthusiastic about learning to trade than learning long division!

My son really enjoyed the experience. Those of you who follow my writings here at MoneyShow.com and the presentations I give at The Traders Expos may know that Sean has been helping me update my hand-drawn charts for several years, and has spotted several incredible opportunities that I managed for him (his sharp eyes and charting abilities led to a nice short crude oil position just above $146 a barrel and a nice long position at $35 a barrel). It's safe to say that his college fund is ready to go!

As soon as school was out this year, I got an unexpected request from him: He asked me when I started to learn about trading. Regular readers here or people who follow my writings on my Web pages know that I was extremely lucky to have an older brother who loved to speculate in the commodity markets. His interest in trading and a family friend who owned a large scrap yard in Chicago and traded to hedge his cash metals holdings led to me learning about charting and trading at Sean's age. Once I repeated the story to Sean, he immediately asked me if he could trade an account like I did when I was his age. To be honest, I felt I owed him the same opportunity that my brother gave me, so I offered him this opportunity:

  • He will trade a simulated account for a minimum of six months, though depending on the results and his ability to master essential skills, the trial may go longer.
  • He may pass; he may fail. As I tell all my students, the profession of “trader” is not stamped on your birth certificate. The key, in my opinion, is whether he can master himself.
  • If he passes the simulated account successfully, I will fund a small trading account with a $2,000 maximum stop out on the entire account, which is exactly how my brother started me out in commodities.

He's in the middle of his first simulated trade, and he came rushing into my office during one of my live mid-day mentoring sessions to tell me he got filled on his entry, so several hundred people are now watching the results of his trade live as he moves the stop orders closer. He is nicely profitable in this first trade and about to enter his first stop profit order today after the market closes.

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But besides successful simulated trading, he has to learn and master what I consider to be important tools that will give him an edge in the marketplace. For example, over the weekend, we were updating weekly commodity futures charts and cash forex charts. Of course, I never saw the question coming: “Dad, can I trade futures and forex in my simulated account?” I thought about limiting him to stocks, but I teach everyone that the repeatable patterns you should be looking for and researching come in all markets and in all time frames. Since he is in middle school, I wouldn't let him focus on short-term trading, but I decided not to limit him to just stocks.

That opened a whole new set of tools and techniques for him to learn, but I like teaching and I have all the tools pre-built for my own trading. If he was going to trade stocks, futures, and forex, one of the first things I needed him to learn was the concept of equivalent risk. Even if he only traded stocks, this is a very important concept that very few traders understand or utilize. So let's dig into this topic using some simplified examples I put together for people who have only a basic understanding of spreadsheets. (Like most people, I use Microsoft Excel.)

Many retail traders trade in blocks, meaning that they always buy 100, or 1,000, or 10,000 shares of whatever they are trading. If it goes up, they make money, and if it goes down, they lose money. But is always trading the same amount of shares exposing their account to the same risk each time they take a trade? Maybe a simple image will make the flaw easy to spot:

chart
Click to Enlarge

This trader always buys or sells 10,000 shares of whatever he is interested in, regardless of price or the volatility of the stock. This trader is trading the same number of shares each time he trades, but he is not exposing his capital to equivalent risk.

The first thing that jumps out at most people when I say the trader is not exposing his account to equivalent risk is the difference in price between the two stocks. Ten thousand shares of Apple (AAPL) was worth about $2.5 million US dollars when this was written. Ten thousand shares of Archer Daniels Midland (ADM) was worth about $260,000 US dollars. The trader would obviously have much more capital invested in 10,000 shares of AAPL compared to 10,000 shares of ADM. But that's easily fixed, right? What if the trader simply did the math so he invested in an equal face value of each stock? Let's take a look:

chart
Click to Enlarge

Let's do the math. One thousand shares of Apple was worth about $250,000, and 9,600 shares of ADM was worth about $249,600. Now that the trader is initially investing a similar amount of money in each stock, is he exposing his account to equivalent risk?

More tomorrow in Part 2…

By Tim Morge, veteran trader and trading mentor, MarketGeometry.com

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