Order Of Magnitude » Trading

Forex Risk Management through Position Size

wdevauld — Fri, 22 Jan 2010 23:36:54 +0000

We regularly size our forex positions based on the amount of risk we are willing to assume. To detail a feel for the steps that are gone through for each trade, we're going to go through all the steps based on a hypothetical scenario. Our situation is a young, go-get-er that is managing a ¥1M account. Because this guy understands that he's young and can take on more risk (not to mention it makes our math easier), he is willing to lose 10% of his account on any one trade (which is not recommended, you should know your own risk levels).

The trader has been looking at the USD/CAD pair, over several timeframes.

USD/CAD - Jan 22, 2010

The trader feels that the recent short term rally is pushing into over-extended territory, and believes that the long term trend will once again assert itself and push the price back down to support around 1.025. Examining moving averages, trendlines and other forecasting tools, the trader settles on a short entry price of 1.062. If the price moves against him and pushes above 1.075 then the trader knows the gig is up, the long term trend has been broken and he should be out of the trade. The total loss the trader is willing to take is: 1.0750 - 1.0620 = 130 pips.

The USD/CAD pair has all of it's profit and loss calculated in Canadian dollars. So if the trader is going to risk 10% of his portfolio of ¥1M, first determine what ¥100k would be in Canadian dollars. CAD/JPY is about 85.25, so the maximum ¥100k loss would work out to be $1,173.02 Canadian. Now, what position size would result in 130 pips, being equal to the maximum drawdown of $1,173.02ish Canadian?

The position size would be: 1,173.02 / (1.0750 - 1.0620) = 90,232.31 CAD. Now, all transactions on the USD/CAD pair are done in the base currency, which in this case is USD. So converting the 90,232.31 into its US equivalent of 85,431.04. This means that if out Japanese investor wants to cap his risk at ¥100,000, then a short position of 85,000 USD/CAD entered at 1.062 and stopped out at 1.075 would put a ceiling on the losses with the price targets from the chart.

This simple example is missing a couple of larger points, like the exchange rate between JPY and CAD messing with the total profit and loss, as well as interest charged/rewarded for the currency position. This example also doesn't take into account any margin requirements, transaction fees, spread on the bid/ask or other risk factors.

Why would this Japanese trader enter this trade, if they were only planning on losing 10% of their account? Looking at recent bottoms in the chart, the trader has determined that a price target of 1.03 is where they would close the short position, which would equate to 320 pips of profit and more than double the 10% of their account that was at risk. Of course, the price can move in any direction, and every trader should do their own research.

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Covering GLD

wdevauld — Fri, 11 Sep 2009 20:56:15 +0000

Gold as an investment is being tossed around more and more. Gold is near all time highs, and as of this writing is over $1000USD / oz. Although it hasn't yet closed over that level. If you pull pack and take a look at a longer timeframe of the continuous contract, most can pick out a multi-part inverse head and shoulder pattern. We always recommend a part of your portfolio be set in actual assets, and precious metals are easy to get and rather value dense. This time however, we're looking to use the SPDR Gold Shares ETF, which trades under GLD in New York. They shave off 0.4% every year for doing all the paperwork, and are one of the ETFs with the best correlation to actual spot gold prices.

We're never ones to just rush out and buy something, because it looks good. Right now Gold, as well as the ETF, are at a critical point.

Support and Resistance for GLD

The power of the current trend is undeniable, and we've been in this confluence of resistance before. If the H&S pattern holds, a measured move to $1200 within the measure of the head of the pattern (~ $700) to the resistant neckline (~ $1000). Although, if it turns out to be a false signal, there isn't a lot of proven support until under the $850 level. The whole world is watching, and the speculators are speculating, so we decided to check out the pricing in the options.

GLD Call Premium

GLD Put Premium

The curve is more natural than the graph depicts because the strikes start moving up by $5 instead of $1 at $100. We want to be prepared for a move in either direction. We thought we would explore selling covered at the money calls.

100 shares of GLD ~ $9870

1 GLD Jan 2010 $99 Call ~ $620

This means that our cost of out pocket is $9260 (including about $10 in fees). If we die tomorrow and the stock closes higher than $99, we'll net about 6.2% on expiration day, which is 126 days away. Annualized this play works out to 12.7%.

If you'd rather try to bring in the expiration date, to more rapidly see time decay in action. Selling a GLD Oct 2009 $99 (~$280), you'd be $9600 out of pocket (again including about $10 in fees) and a close above that would result in about a 3.1% profit over 35 days. Annualized the October play works out to 36%.

In either case, you have no downside protection, and your profits are capped. Our plan is to watch, and if the price of GLD breaks down below $90, we'll take our loss and exit the position. If the price of gold manages to hold, or remains range bound, we'll let time decay work it's magic, and roll our short call contract forward a few months closer to December. If the price breaks out and continues to trend upwards, we will wait until the premium of the contract erodes to about 2%, then close it and short another at-the-money covered call.

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Covered Call: PLD

wdevauld — Mon, 12 Jan 2009 08:21:28 +0000

The third week of the month is usually crazy, when short term pressures overwhelm logic and reason. Our weekly scan produced an interesting gem: ProLogis. Being as options expire this week, we found the bid/ask spread for the in-the-money $12.50 calls to be a bit out of the ordinary. Examining the Equivolume:

It would appear that this REIT has been going for a bit of a run and big volume appears on the right kind of days.

Now for the 50-50. We have an upward moving stock, that is due for a pullback, and in 5 trading days the options expire. PLD has a 15 trading session average true range of $1.75, which is pretty large for a stock holding the Friday's end of day price of: $14.12. Yes, 12% of current trading price.

Now, if a covered call position could be entered under these conditions, you would lay out $1412 for 100 PLD shares, and then sell a single covered call at $12.50 strike for $2.50 a share, or $250 total. If the price falls below the strike in the next 5 days, your cost basis is $10/share to offload, so we'll have a still profitable stop at $11.75 to exit the position. If the equity remains above $12.50 until Friday, you'll get called away, along with all the fees that produces. The only thing you get to take home is the premium.

So let's say your broker lets has a $10/transaction fee (hopefully you can do better). Your initial outlay is $1412 (equity) + $10 (commision) - $250 (option premium) + $10 (another commision) = $1182 (total expenses). You get called away, so you sell your stock for $1250 (minus $10 again, that broker!), and take home $1240. That mean $68 dollars in your pocket, after fees, on an outlay of cash equal to $1182 (you'll lose way more in buying power) in 5 days, if the shares stay above $12.50. If they go under, get out, and keep whatever premium erosion you have accumulated at that point. So on the upside you can get 5.7% on your money in 5 days, and there is safety net down to $10 before you start to lose money.

If your greedy, or want to take on more risk. The February call options have high volatility priced in. Have a look at our premium chart:

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Scan: Divergence from VWAP

wdevauld — Mon, 21 Jul 2008 14:26:01 +0000

The following have large relative divergences from their Volume Weighted Average Price:

Equity	Price	VWAP
Delta Airlines	6.93	5.65
Ultrashort Oil and Gas	34.20	32.02
AMR Corp	7.13	5.58
Wells Fargo	27.86	24.80

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EUR/USD Stopped Out

wdevauld — Wed, 16 Jul 2008 17:22:02 +0000

Despite all our good intentions, our trade between the Euro and Greenback was stopped out. The price action could not penetrade 1.5920, and reversed. While the moon was high in the sky, and we were walking around dreamland, the price did manage to poke above the 1.5920 range for a few hours. Then as it tested 1.5950, the price was hammered down over hundred pips in 4 short hours. I'm sure someone has a strategy to trade this currency with its recent price movements, but we're going to be staying out of any large posistions.

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The Rules

wdevauld — Tue, 15 Jul 2008 23:13:16 +0000

I mentioned earlier that some rules were broken, which resulted in larger than usual losses. At the time, adding another rule to the list, seemed like an excellent idea. At the time, I had 8 trading rules, and adding another brought the total to 9. This number is outside the total that the average human mind can keep in context at one time. As a result, I've reworked the rules down to a manageable 5.

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Spanked for Disobeying the First Rule

wdevauld — Fri, 11 Jul 2008 19:12:03 +0000

I made a terrific, novice blunder. I've been watching for a place to enter a long position on USD/JPY because it has been trending nicely for the last couple of months. A few days ago, I entered a position near near where it was apparently moving towards the bottom end of the trending channel. Expecting this to not be a day trade, but instead hang onto it for a couple days, I was rather happy last night, as I was shutting down when I was up over 40 pips, with only a single line of resistance between the current price and my price objective. In the morning:

I've been kicking myself all day for such a rookie mistake. All I could think of this morning is: Why didn't I set up a stop on this trade? Normally I play for high percentage, with the prevailing trend trades where my expected win-loss ratio is 2:1. Anything that looks like it'll reap 10 pips is game, so usually a 5 pip stop is set up; Larger stops are used, of course, if higher targets are set.

I don't claim that all my trades are winners, or that even the majority of my trades are winners, but as long as I take profits greater than half my losses, I'll come out ahead. Since this was a long term trade I had larger risk, as well as larger expectations for profit. I even knew at which point I wanted out (the red line), but with the chaos around my home last night, I turned off the platform without putting in a stop order.

This morning, I was punished for it. Had the stop been in place, I would have rolled down15-20 pips, and it would've been lost in the usual pile of bad trades for the day, but without the stop it has turned into 5 bad trades worth of losses. Talk about a learning opportunity.

Normally Risk Management is Rule number one, and I foolishly forgot about it. Now Rule number 2 is: Always follow Rule #1

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High Probability Setup

wdevauld — Thu, 10 Jul 2008 01:50:56 +0000

USD/JPY has been trending upward for the last few months. Normally it's against the rules to trade against the prevailing trend, although there was a setup today that is hard to pass up.

full sized image

There was a selloff that tested the 107 - 107.02 region. The support level held and the pair rallied over 107.60. About 6 hours later another downtrend was established with the breakdown through the 107.33ish area straight down to the previous support level. After attempting to rally a couple of times, it became apparent that the Bears were in charge and the price action showed the increased selling pressure. A profit target of around 18-20 pips was established from the height of the descending triangle pattern, and when the price dropped below 107 we entered a short position as the price ripped downward, and very quickly we hit our 106.80 price target grossing a nice and safe 19 pips.

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Way above VWAP

wdevauld — Wed, 09 Jul 2008 19:15:38 +0000

The following equities are trading above their volume weighted average
closing price:

Ticker	Current Price	Weighted Average
SDS	$67.51	$66.93
DUG	$30.98	$28.44
SGP	$20.86	$19.76
BRCM	$28.72	$27.43
MLN	$24.97	$24.96
BUD	$61.76	$61.73
MRVL	$16.79	$17.35
CHK	$61.55	$65.29

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Trade Book

wdevauld — Wed, 09 Jul 2008 08:09:02 +0000

All of the trading that was done today can be found on this July 8-9 Trade Summary. A quick summary:

¥11,300 profit
$185.75 CDN profit
€39.00 profit
$76.81 CDN in commission fees

Around here we pay our bills and buy our beer and bread in Canadian money, thus at the time of this writing if everything was converted back to CDN, there'd be a net profit on the day of $269.15 for this session of trading.

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