• Close a half position if the stock falls back below the breakout level.
• Sell a half position if the price drops below your entry price.
• Close your position after the prices goes sideways directly after the breakout for more than 10 days.
• Sell a half position if the relative strength is going down or sideways although the price is going up!
• Close your position if important support levels are broken or it closed below the EMA 21 or EMA 65.

These are just examples, but they help you to remove emotions from trading.

I have a clear goal: I want a small average loss over all my trades. The smaller the average loss is, the larger my profit. If you sum up all your losses and divide that by the number of losing trades, you calculated your average loss. That should be much smaller than your average profit.

The opposite to holding losing trading positions is holding your winning positions. The larger the gains, the more you are tempted to take profits. But this is not the right strategy! You must have small losses and really big winners. That means: Letting your profits run!

My rule is: As long as the stock behaves right, does what I expected and no sell rule if fulfilled, I don’t touch it! If the stock reached new all-time highs, pulls back to natural reaction levels and shows high relative strength, I leave it alone. If the stock starts to show weakness, I am watching the price behavior closer. The more weakness a stock shows, the faster I sell it. Here is the link between selling weak and holding strong stocks.

To do this you need a different mindset and that will not appear over night. It takes many years to develop. You have to work on your mindset every day until it changed and became a natural behavior. Set up rules, backtest them to build up confidence and follow them with discipline. That help you to cutting your losses short and letting your profits run.

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7 things I am monitoring actively

1. I do my analysis of stocks and the general stock market everyday. I go trough my watchlists and ask myself: Are the stocks I am monitoring strong? Do they lead the market? If yes, it’s a good sign that my stock selection process is working.
2. How many stocks do I have on my watchlist? Am I adding new stocks to my watchlist everyday or every week? If I add a few stocks every week to my watchlists, it’s a good sign because the chances increases to catch a good winner.
3. How do the leading large cap stocks look like? Are they close to all-time highs or are they broken down without any recovery? If all charts look like a catastrophe it shows me that nobody is buying glamour, large cap stocks (like $AMZN, $AAPL, $NFLX etc.).
4. Do the indices show a bottoming pattern? If yes, it’s a good sign. Especially if the updays show higher volume.
5. Are the indices in a long-term uptrend? You can have a look at the weekly and monthly chart. If you have a solid uptrend, the odds are higher for a continuation instead of a reversal. Maybe a correction is just a small pause in a long-term bull market.
6. I monitor the % of stocks above the 50 MA and 200 MA. They gave me clues about the broad trend of the markets. In a strong bull market, everything is above the 50 MA and 200 MA.
7. Are the indices in synch with each other? You always want to see a broad market trend. That means small and mid caps should lead. Use the Russell 2000 for an analysis. This index should be in synch with the large cap indices like Nasdaq and S&P 500.

Make sure you look from different angles at the market. But most important for me is my own watchlist and my stock screener. If everything on my list looks good, the chances are high that I can make money. That’s my niche and I try to know my niche as best as nobody else.

Buy small test positions first

Don’t jump back into the market with both feet! Always buy small test positions and increase them if they show a profit:

• If you normally buy 10% positions, buy 5%.
• After they show a profit and moved up a few percent (f.e. 3%), add another 5%. Now you have the full position.

Of course you pay a higher average price, but see it from the risk side: If the market is ripe, you will save a lot of money because your losers are smaller. Often it takes multiple attempts to get back into the market and reducing losses is the key. Lose small!

Don’t underestimate the psychological side

As I wrote above, sometimes it takes multiple attempts to get back into the market. If you have 5 losses in a row it will have an impact on your confidence. The smaller the losses you have to bear, the less the damage of your confidence as a trader. Losing 0,5% of your capital is better than 1% or more.

Do everything to secure your “mental capital”. It’s much more important as your monetary capital. If the odds are increasing to make money, you must be able to pull the trigger again. In that situation your mindset must be in a good shape.

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First understand the chance-risk-ratio concept …

To identify low risk entry points you first have to understand the chance-risk-ratio. The concept is simple:

Possible profit / planned loss = chance-risk-ratio.

The possible profit is the money you will win if your trade works as expected. To get this number, you must subtract the target from your entry price. Example: $70 target – 50$ entry price = $20 profit.

The planned loss is the amount of money you are risking. It’s the difference between your entry price and stop loss. Example: $50 entry price – $45 stop loss = $5 planned loss or risk.

Now you have all you need. Here is your chance-risk-ratio:

$20 profit / $5 planned loss = 4.

If your trade reached the target, the return will be 4 times of your initial risk. That’s a good chance-risk-ratio.

Why is the chance-risk-ratio important?

You should only risk money if it’s attractive. Don’t place bets where you only get a small return. Of course it depends on the hit-rate but you want to calculate for the worst case.

If your hit-rate decreases, you need a higher chance-risk-ratio. Because it’s very difficult to maintain a high hit-rate over time, you want to consider this. Try to reach higher chance-risk-ration instead of having a high hit-rate. Then you have build-in a buffer for failure.

What’s a good chance-risk-ratio?

That depends on you and your trading style. If you are a long-term trader, you often have a higher average chance-risk-ratio. If you are a short-term trader, you mostly have a lower average chance-risk-ratio and a higher hit-rate.

The same is true for trading styles. Trend followers often have a high chance-risk-ratio because they are following a trade for a longer time. A swing trader often has a lower chance-risk-ratio because he works with targets.

I personally don’t work with targets. Instead I apply a more trend following style. If a trade will return 3-5 times my initial risk, it’s a good trade. My best trades will return 10-20 times my initial risk.

Paul Tudor Jones famously said, that he will at least aim for a 5 times chance-risk-ratio.

What’s low risk entry point?

It’s simple: The smaller your planned loss or initial risk, the lower is the risk at the entry point.

Don’t think that a trade with a low risk entry point has a smaller risk to fail. That’s nonsense. In the short term every trade has the same odds: 50%. It can be a winner or loser. Only over a large number of trades you will generate a hit-rate and edge.

Focus on trades where you can place a stop loss very close to the entry point. That’s only possible if you select an entry where you see quickly if your trade works or not.

3 examples of different entry points

How to select a valid stop loss level?

I could write a whole own blog post about selecting stop loss levels. But remember: A stop loss level should be your insurance. It should show you clearly that the trade is not working and you have to exit immediately.

I personally only select trades where my stop loss level is less than 7% away. Often I exit a trade or sell a portion of my position at a drop of less than 5%.

If I select a good entry at the right time, the price will never come back to my entry price. Therefore something must be wrong if a stock drops 5-7% after my entry. I give enough room for daily fluctuations but not for corrections!

A simple and clear entry signal and a technical level close to the entry price are important. I mostly use simple chat patterns like flags, triangles or multiple tested resistance lines. For a stop loss I used the last low or a moving average like 10 or 20. That’s it.

If a trade is not working, you can’t do anything. Get out and try it again at a later point. The more important thing is that you have a close stop loss. If the trade is working instead, you have a great chance-risk-ratio.

A low risk entry point needs discipline

If you select a value for your maximum stop loss level, you created a rule. Every rule needs discipline to apply it. If you don’t do that, the rules is worthless.

I personally stick to my rules. I never open a position where the stop loss level is more than 7-10% away. 10% is the maximum I only allow for very volatile stocks. If a stop loss is more than 10% away I skip the trade and wait for a better entry.

A low risk entry will not help you if you don’t have sound rules to select great stocks. You need rules to select potential winners which will generate a good chance-risk-ratio. If you created you rules for a maximum stop loss level, you can start to optimize your selection criteria for stocks. That will increase you hit rate over time.

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I got the idea from my two mentors I am actively following or where I attend their programs: Trader Steve from UK. He taught me to track the closed equity and interpret it. Olivier Tischendorf who wrote a very good article about that. In addition he called my attention about what type of equity curve I wish to have.

What is an equity curve?

If you look at a stock chart you see the up and downs of the price. One share is one piece of the equity of a company. So you say that you are monitoring the equity curve of a company if you look at a chart.

The same is true if you look at the price chart of a mutual fund or ETF. In that case you look at the up and downs of a portfolio of stocks.

Now look at your trading. If you trade a portfolio of single stocks, you have the same situation as a mutual fund or ETF. You have multiple positions and with that you can create an overall equity curve. It’s the same as in the scenarios above.

So your own equity curve is the picture of all price movements in your portfolio. It shows the total value of your portfolio.

How to build an own equity curve

To create your own equity curve you can use a spreadsheet (f.e. Excel). Everyday you write down the following values:

1. Closed equity: The value of your trading account without open profits/losses. This is the amount of money you have in your account. It shows the development of your closed trades. Everytime you close a trade, this value will go up or down.
2. Open profits/losses: This is the sum of all open profits or losses in your trading account.
3. Open risk: Here you summed up all risks of all single positions. This shows you the amount of money you can loose if all positions will be stopped out.

I also recommend to gather the number of long/short positions. With that you can track the number of open positions and evaluate how often you change your portfolio.

Now you can build some sums. These sums will create different curves on a graph:

1. Closed equity with open profits/losses: This number is your current equity curve. It shows you the worth of all positions if close them immediately.
2. Closed equity curve with open risk: Here you can see the “worst case scenario”. You can see what will happened if all positions will be stopped out in one moment.
3. Percentage change: That number shows the change of your portfolio in percentage. F.e. +1% or -1%.

Creating the graphs

Now you can take your spreadsheet and create a graph. I recommend to track two different graphs:

1. Development of your closed equity: This shows you the development of your closed equity without any profits or losses. This gives you a much more clear picture without the daily fluctuations of your portfolio positions. It is the most important graph. If this graph is falling, you are in a clear draw-down.
2. Development of your closed equity with open profits/losses: In this graph you included the profits and losses of your portfolio. You can follow how your portfolio value is changing over time and you can see the impact of daily fluctuations of your trading positions. It helps you to see if you are too aggressive or too conservative. You can compare it to the market indices.

In addition I would recommend to add simple moving averages to the graphs:

1. 10 day moving average: This is the fast moving average. In good time your equity curve should be above that.
2. 20 day moving average: This is a slower one. It should rise the most of the time.

Depending on your trading time frame you can choose different lengths of the moving averages, f.e. 20 and 50 or 50 and 100.

Interpreting your equity curve

If you created the table with all the necessary values and graphs, you can start to follow your equity curve. After some time you get a feeling how your trading is mirrored in the graphs.

All your decisions will be displayed in the graphs, f.e.:

• If your timing is correct and your trading produces profits or losses.
• If you should be more aggressive because your equity curve is rising.
• If it’s time to be more conservative or sell positions because your equity curve is falling.
• If you are positioned to heavily in one sector because your equity curve is dropping heavily if one specific sector is falling.
• If one of your trading positions has a big impact.
• If it’s time to go to cash because the moving averages are crossing.

I would recommend to follow your equity curve for some moths. After that you get a good feeling how you trade and what are possible rules to manage your risk and equity curve.

Creating a rule set with your equity curve

I made the experience that you can create a rule set for your equity curve. This helps you to manage the volatility and risk better. It’s always my goal to reduce the fluctuations to the down side.

After tracking my equity curve for some month I create some rules which I tested. These are just examples and you have to create your own rules.

1. Equity curve drops below moving average 20: This is a first danger sign! Something is wrong in your portfolio if this happens. Mostly the dropping will continue and a draw down starts. If this happened I immediately check all my positions. Often I start to sell the loosing positions and maybe reduce winner. I start to build up cash.
   Often I made the experience that a single position is too big. If this is the case, I reduce it so it has a lower impact on the equity curve.
2. Equity curve climb above moving average 20: Now it’s time to be more aggressive and open new positions. It could be that your equity curve will drop below the average 20 for one or two days. If it recovers immediately this is a good sign.
3. Moving average 10 crosses below moving average 20: This is a clear sign that something is wrong. In that case you should consider to go to cash. After being in cash you should make very small commitments and wait until your equity curve is rising again.
4. Moving average 10 crosses above moving average 20: Good signal! You are on track again. It’s time to be more aggressive.

I do not found the optimal rule set for me, but I am always experimenting and learning. But I found this is a great method to manage risk actively.

Additional observations

Besides the rule set you can observe some more thins in your equity curve. Over time you create new rules to manage that. Here are some observations I made:

1. The biggest down-swings comes after the biggest up-swings. I observed that my equity curve will dop immediately if it climbs steep before. F.e.: If I have a big up day (2-4% in one day) it will go down the next days. It could be a sign that it’s time to take some profits.
2. There are chart patterns in your equity curve: I found double bottoms, head and should, trend lines, horizontal resistance, false break-outs etc.
3. Always try to reduce the down side. It’s very dangerous to let losses run in your equity curve. The better you manage the down side the easier it is to reach new highs. Start to manage your risk and exposure actively. F.e.: It your equity curves creates a new lower low, start to reduce your exposure.
4. Take crossings of the moving averages seriously. In the beginning I just follow my equity curve. I didn’t had any rules. But I quickly observed that there are clear visible trends in my equity curve. If it starts to dop and the moving averages are crossing, it will to continue. Only reducing your position size will help.
5. Losses will bring new losses – profits will bring new profits. It’s the same as with number 4. If your equity curve starts to drop, it will continue to drop. F.e: If you have a down day of 1,5% or more, the next days will be loosing days, too. You must define a maximum for you. What will happen if you equity curve drops 3% in a day? Or 4% over 5 days? You should react to it.

Recommended books

Here is a small list of recommended trading books about this topic.

[amazon box=”1119371872,007135980X,007147871X”]

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