Watching the pennies

It is a common error among amateurs that they set stop-losses that are very distant from their entry price. The reason for this is usually a psychological block when it comes to admitting an idea was wrong. Successful professional traders do not make this mistake, instead placing stops that are close to market.

But why limit losses to a maximum of 2 per cent? In the unfortunate event that you manage to pick four losers in a row, you will still have 92 per cent of your original funds. And if you repeat this losing streak a further three times, your account will fall initially to 84.6 per cent, then 77.9 per cent and finally to 71.6 per cent.

Think about this for a moment. Even though you've made 16 losing bets in a row, you still have more than 70 per cent of your starting capital left in your account. Remember, you are risking just 2 per cent of your total account size each time, with a maximum of four bets simultaneously.

Professionals frequently risk tiny amounts, with 1 per cent often touted as the optimum bet size. Of course, if you wish to bet on more than four positions at once, then the risk amount should be reduced pro rata, so that the total risk of all positions held is limited to less than 8 per cent at any one time.

For example, say that Rio Tinto's shares are trading at 5,920p and you make a £10-a-point long bet, placing a stop-loss order at the first support level at 5,830p (see chart 1 below). A 90-point drop to that line will result in a loss of £10 x 90 = £900.

Chart 1: Rio Tinto

Although placing the stop with reference to a support level is a perfectly reasonable technique, it does not take into account the volatility of the shares. Specifically, it ignores the potential for a move even lower if the price gaps through the support level.

The goal is to place bets on the market that allow you to control your potential betting losses (in the knowledge that you could cope with the odd disaster) and second, get the most out of your equity growth.

This can be achieved by assessing the natural volatility of the share and then using this information to manage your risks on the trade. By doing this over a number of bets and restricting the total risk on all your trades at any one time, you will build up your account balance, allowing you to make progress without losing your shirt.

An effective and easy-to-use technical indicator that is available on any decent charting package can help give you a decent estimate of the potential losses in any 24-hour period if the price of the instrument moves unexpectedly. The average true range (ATR) measures day-to-day volatility, which can be used to inspire an advanced money-management policy.

ATR was a creation of the legendary technical analyst Welles Wider and introduced in his book New Concepts in Technical Trading Systems, which was published in 1978. Welles intended it for use in the commodity markets, as those prices were very volatile at the time. Thirty years later, we find ourselves at a similar juncture in the market.

Calculating ATR is a little complex. Summarised simply, though, the 'true range' takes the greatest of: (i) the prior day's close less the current high or (ii) the prior day's close less the current low, (iii) the current high, less the current low (see diagram above). All results are absolute and negative signs are ignored. The ATR or average true range is calculated by smoothing the true range data over a number of days, in the same way as a simple moving average.

The ATR method takes into account historic price movements of any traded instrument acting as an estimate of the largest expected movement in the next 24 hours, either higher or lower based on the most recent data.

You can think of ATR as being an advanced average daily range number with the additional benefit of including overnight movements. This gives a fairly realistic day-to-day price movement from a betting perspective. In the example shown in Chart 1, five betting days have been selected for the ATR and this number is commonly used in the market as it represents a week’s worth of trading.

To understand how to apply ATR readings for money management in spread betting, there are a number of observations for Clarkson’s shares in Chart 1. Spikes in volume on the chart will often be followed by an increase in the volatility in the stock causing the ATR to rise. Large price movements will normally occur on heavy volume days. Notice that the ATR seems to peak at 68p. Also observe how the blue lines represent periods where the ATR is pulling back and this is followed by a breakout in price on two occasions. This is why the peaks in the ATR are used for money management and not the ATR itself. In some cases the ATR can act as a lead indicator for a breakout.

Having taken note of this behaviour, we will deploy our insight within our betting strategy by using the ATR figure to decide the correct bet size to be placed. The key here is to have the correct money-management technique combined with a high-reward bet. Anything can happen in a 24 hour period in the financial markets and being prepared is more important than reacting to unexpected movements. It is too late to change the money management policy after the event if you failed to put the correct one in place to prevent such losses.

In table 1, we use the five-day ATR to define losses for a portfolio of stocks. This will help

to limit the impact of a large capital loss on our account due to a big losing bet. The same process can be used to create realistic profit targets. Capital allocation is set at 2 per cent of the cash on account for each trade. The potential overnight risk is the current share value minus five-day ATR high over the past 12 months.

By using this method, we can estimate cumulative losses for a portfolio of bets if we have a sudden meltdown. Think of this as the 'overnight risk'. Unfortunately, there is no way to prevent the losses, but a money-management plan will certainly help to contain them.

Table 1: ATR for a portfolio of stocks