Q. Dear Sandy, I heard the saying “don’t get married to the market”. What does this mean?
A. We’re not talking literally here, surprisingly enough. In the current market environment where the FTSE 100 recently declined 6 per cent some traders were said to be married to their positions.
What does this mean? As a trader it is easy to enter a position hoping it will move in your favour forever. But at some point the market will turn and you may find yourself holding on for dear life wishing that your position would turn from red to black.
Q. So what should I do in these circumstances?
A. One of the problems for traders is the market mantra “buy and hold”. Sometimes people believe that you buy a stock and simply hold on to it forever. That may be fine if the stock just happens to go up steadily. But the reality is that all markets experience ups and downs. The key to long-term success is knowing when you should cut a losing position. One way is to consider a fixed percentage. This involves deciding that you will never lose more than a certain percentage of your account on any one trade. You could also consider using support and resistance levels where prices have previously either accepted or rejected key levels. These often mark the line where price will either gravitate towards or move away from. This way you are at least able to see if your percentage stop loss will be adequate.
Q. What is the best way to play?
A. This depends on your risk tolerance. Personally I like to employ a dynamic method, which uses a technical indicator known as ATR (average true range). You take into consideration the market volatility and see if the volatility factor is suitable for your risk tolerance.
You calculate the ATR by noting the difference between the high and low price on the market. Let’s say the FTSE moves 89 points one day and then 73 points the next, followed by 94 points. You can calculate that the market’s mean ATR is 85 points over this period. Knowing this, if you enter at a suitable level then your stop should be just over 85 points away. As the market moves in your favour you continue to note the ATR and adjust accordingly. Of course the ATR does not account for shock moves and can stop you out like any other method.
Ultimately whichever method we use the key point is to manage risk and not to fall in love with our positions. Our objective is to trade simply, safely and successfully for profit.
Learn more about technical analysis with Sandy at his free City Index seminars.