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Brief lessons in basic risk management

Firmly breaking out above resistance of their 50-day moving averages and the previous week's "swing highs," the major indices kicked off March with a solid session of gains. After gapping higher on the open, stocks continued higher throughout the morning session, then consolidated in a narrow, sideways range for the remainder of the day. Led by impressive strength in the Biotech and Semiconductor industries, the Nasdaq Composite jumped 1.6%. Blue chips showed a bit of relative weakness, limiting the Dow Jones Industrial Average to a gain of 0.8%. The broad-based S&P 500 rose 1.0%. Small and mid-cap stocks resumed their leadership roles, as the Russell 2000 and S&P Midcap 400 indices advanced 2.3% and 1.7% respectively. Each of the main stock market indexes closed near its intraday high.

Total volume in the Nasdaq increased 10% above the previous day's level, enabling the Nasdaq Composite to score a bullish "accumulation day" that followed through on the recent reversal off the lows. However, 22% lighter volume in the NYSE was disappointing because it tells us mutual funds, hedge funds, and other institutions primarily confined their buying operations to the tech-related industries. In both exchanges, advancing volume exceeded declining volume by a margin of only 2 to 1. Such a moderate adv/dec volume ratio confirms the relatively narrow breadth of yesterday's session. Broader-based sector participation, such as at least a small gain in the KBW Bank Index ($BKX), would have been better.

Most of the time, our daily commentary of The Wagner Daily focuses on technical analysis of the broad market and specific ETFs. However, today we will shift gears by diving into something different -- a discussion on basic risk management. Over the nearly eight-year period since we first began writing The Wagner Daily, the model portfolio account of the newsletter has had many winning months, as well as many losing months. The long-term performance of The Wagner Daily speaks for itself; overall, the model portfolio presently has an overall cumulative percentage gain that is nearly four times greater than the benchmark S&P 500 Index during the same period. We believe the biggest reason for the newsletter's long-term outperformance of the S&P 500 has been a strict discipline to follow sound risk management guidelines, rather than a huge percentage of winning trades. As such, we were quite concerned when a subscriber e-mailed us yesterday, telling us about a big problem with risk management in his account. Upon reflection, we decided new traders could benefit from some tips on risk management, while the same discussion would serve as a friendly reminder to experienced traders as well.

This particular subscriber e-mailed us after UltraShort Nasdaq 100 ProShares (NYSEARCA:PSQ), an inversely correlated "short ETF," sold off to trigger our protective stop price yesterday (to refresh your mind, we bought PSQ as the Nasdaq bumped into major resistance of its 50-day moving average and 61.8% Fibonacci retracement from its January high to February low). While PSQ hit its protective stop, our long position in iShares Xinhua 25 China (NYSEARCA:FXI) cruised to a sizeable unrealized gain yesterday. Because we were intentionally hedged with only one short position and one long position going into yesterday, there was no harm done to the bottom line of our model ETF portfolio account. Nevertheless, we received an e-mail from a frustrated subscriber, complaining that because of the PSQ position hitting its stop, along with other losing trades of the past month, his trading account had "taken a beating." Now, this was most surprising to us, as the model portfolio was actually net profitable last month (with four winning trades and four smaller losing trades). Therefore, considering his account was apparently down, while the model account was up, a bit of probing was necessary to find out what was causing the sharp profit/loss divergence.

Upon further e-mail communication with our subscriber, we quickly learned the reasons his account was showing a loss, despite The Wagner Daily showing a gain over the past month. Specifically, two major problems jumped out at us. The first, and most alarming, issue was that he was sizing each position for an approximate capital loss of 8% of total account value if a trade hit its stop price. This was way out of line, as most professionals advise risking no more than 1 to 2% of account value for any given trade, depending on one's personal risk tolerance. In the model portfolio of The Wagner Daily, we typically size each trade for a maximum loss of 1% (about $500 for the $50,000 model account). Furthermore, we always take overall market conditions into account, which sometimes causes us to reduce risk even further, such as by taking "half" positions in indecisive or choppy environments. But with risking a whopping 8% per trade, it's no wonder our dear subscriber was distressed. With just four losing trades, his account was down more than 30%! Obviously, taking such crazy risk is a surefire way to make one's account quickly disappear when the law of averages inevitably turns negative (ie. a temporary losing streak).

The second issue plaguing our subscriber was his inability to maintain a consistent capital risk from one trade to the next. Excepting the occasional adjustment for unusual market conditions, we size all positions to take approximately the same risk of 1% per trade. We don't play favorites and take greater risk on one trade than another just because we think "this is the play of the century." Quite frequently, the trades we have the lowest expectations for at the time of entry go on to be the biggest winners. Conversely, trade setups that look "perfect" at the time of entry often become nothing more than duds. As such, we learned a long time ago that picking and choosing the amount of capital risk per trade is not a winning strategy for our methodology. Rather, we take the same risk for every trade, and just let the law of averages work in our favor year after year. Our average winning ratio (batting average) is only around 50%, but the dollar amount of our average winning trade is roughly 1.5 to 2 times the size of our average losing trade. Over the long-term, such math simply leads to a proven system of profitability, albeit one we continually strive to improve upon. In the case of our subscriber, he was haphazardly guessing which trades to have "heavy" share size and which to have lighter size. As such, he unfortunately took the most risk on our biggest losing trade last month (EWJ - loss of $615 in model account) and had the least risk exposure on our biggest winning trade (UUP - gain of $1,343).

Combining his lack of consistency in risk exposure with an extreme capital account risk of 8% per trade, it became very easy to see why our subscriber's account printed a substantial loss, even as our model account showed a gain for the month. But the good news is he assures us he now "sees the light," and his account can still be turned around with a bit of discipline. Hopefully, we have helped set him on the path to undertaking trading as a professional business, rather than a roll of the dice or spin of the wheel. For those who just want to gamble, there's always Vegas and a myriad of other places to blow your dough. However, it's to people who are serious about long-term profitability with a disciplined system of controlled risk that we dedicate every day's issue of this newsletter.

Open ETF positions:

Long - FXI
Short (including inversely correlated "short ETFs") - (none)

The commentary above is an abbreviated version of a daily ETF trading newsletter, The Wagner Daily. Regular subscribers receive daily updates on all open positions, as well as new ETF trade setups with detailed trigger, stop, and target prices. Intraday Trade Alerts are also sent via e-mail and/or text message, on as-needed basis. For your free 1-month trial to the full version of The Wagner Daily, or to learn about our other services, please visit morpheustrading.com.

Deron Wagner is the Founder and Head Portfolio Manager of Morpheus Trading Group, a capital management and trader education firm launched in 2001. Wagner is the author of the best-selling book, Trading ETFs: Gaining An Edge With Technical Analysis (Bloomberg Press, August 2008), and also appears in the popular DVD video, Sector Trading Strategies (Marketplace Books, June 2002). He is also co-author of both The Long-Term Day Trader (Career Press, April 2000) and The After-Hours Trader (McGraw Hill, August 2000). Past television appearances include CNBC, ABC, and Yahoo! FinanceVision. Wagner is a frequent guest speaker at various trading and financial conferences around the world, and can be reached by sending e-mail to deron@morpheustrading.com.



DISCLAIMER: There is a risk for substantial losses trading securities and commodities. This material is for information purposes only and should not be construed as an offer or solicitation of an offer to buy or sell any securities. Morpheus Trading, LLC (hereinafter "The Company") is not a licensed broker, broker-dealer, market maker, investment banker, investment advisor, analyst or underwriter. This discussion contains forward-looking statements that involve risks and uncertainties. A stock's actual results could differ materially from descriptions given. The companies discussed in this report have not approved any statements made by The Company. Please consult a broker or financial planner before purchasing or selling any securities discussed in The Wagner Daily (hereinafter "The Newsletter"). The Company has not been compensated by any of the companies listed herein, or by their affiliates, agents, officers or employees for the preparation and distribution of any materials in The Newsletter. The Company and/or its affiliates, officers, directors and employees may or may not buy, sell or have positions in the securities discussed in The Newsletter and may profit in the event the shares of the companies discussed in The Newsletter rise or fall in value. Past performance never guarantees future results.

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Reproduction without permission is strictly prohibited.


Disclosure: Long FXI