Built-In Portfolio Protection

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  • on March 8th, 2011

We continue to experience chop after months of a steady trend higher.  Day to day movement is higher, actual progress lower.  Without relying on prediction, in what ways can we adapt to a changing environment?  The obvious is to step aside and wait for better conditions.  As long as one has the will to execute a plan to resume operations when conditions become more favorable, this is solution #1.  Is there a solution #2?

How about dynamic position sizing that adapts to the environment?  It won’t keep us out of losing trades, but it does allow us to “auto-adjust” to shifting conditions while still pursuing opportunity.  Consider the following graphic using the last few stocks I’ve purchased:

I use a combo of % Risk and % Volatility when sizing my positions.  These have little to do with how I’ll trade the position but everything to do with how large I’ll play.  I’d consider it a disaster to let a stock reverse an entire 1 Week ATR or slice through its 10 Wk MA before acting, but I size everything for these scenarios and manage them using much tighter parameters.  Day traders need not worry about moves of this size, but once a position is held for even 1 night we take on the risk profile of an investor regardless of some “level” seen on a chart.

To add a filter that captures increased volatility, I use the greater of last week’s ATR(Column C) and the 5 Week ATR(Column D).  I also then compare the distance from the 10 Wk MA(Column E) and take the greatest of these three(Column G), but you get the point…dynamic position sizing that forces us into smaller positions when things get volatile.  No forecast, no guesswork, no hesitation at the moment of entry; just a smaller position.  It’s a belt and suspenders approach that allows us to freely execute our ideas without unwittingly exposing ourselves to larger risk.

As far as this week’s market, it acts like more of the same.  I noted on February 24 that the levels from the Libya news were likely to be areas of debate, and 9 sessions later here we sit having ping-ponged between those initial levels of 133.86 and 130.21 on $SPY.  As we’ve seen, “chop” does not mean boring; it often means violent moves from one end of the range to the other.  The long-term uptrend has lent its support to the dips, but short-term concerns are obvious from the whippy action.

As seen by comparing Columns C and D in the graphic, I favor buying stocks whose volatility is falling as a fraction of price.  This selection filter is even more robust in risk management, as a high volatility climate reduces the chance I’ll even find candidates to enter.  Once entered, only the positions that show me a profit get another 0.2% bump in size from the initial 0.4%.  The fact that I keep finding fewer long candidates tells me to be wary, but I know my risk management approach is what keeps me engaged but protected.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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