Before we start, it is worth emphasizing that although the examples used here are options the lessons are VITAL to all trading vehicles.
After posting an ROI of 253% Hawkeye Options directional portfolio (Barracuda), my inbox was brimming with questions regard how this was possible in ONLY 8 MONTHS. For this week’s newsletter, I was asked to share some of the key tactics that may offer this sort of return. Of course this is but one of the methods used when we trade risk but we feel it is up there as one of the more important.
What really creates a sustainable return?
The aim of using Hawkeye to enter is to increase the likelihood of a high probability trade, meaning of course that we are trying to stack the odds in our favour of a move in our desired direction. Entry is the ‘sexy’ bit, the one all new investors focus upon, and win/loss ratios seem so very important.
Would you be surprised to know that the 253% was generated with a win/loss ratio a little over 1:1!
So how is this sort of return possible? Simple, it all comes down to exit!
There are two KEY POINTS:
- Even if our trade goes against us the fact we have entered a high probability trade usually means that even a one or two day move up trails the stop and reduces any potential loss even more so than our initial stop.
- We recognise the changing risk of a trade and act accordingly retaining profits.
What this has meant is that return exists because if we total the average win of ALL the trades that went for us it shows an average profit of 65%. If we did the same to our losing trades the average is -22%.
THIS is the KEY. This ratio of 2.97:1 average winning trade versus losing trade IS the major ratio you should be viewing. To ram the point home…if this is your profile it means that your win/loss ratio can drop as low as 1:3 and you can still make money!
Let us focus on the second of these two.
So how does risk change during the life of a trade?
Often on entering a trade, particularly with leveraged vehicles such as Fx, Futures or Options, we will set a profit target. This may be based on a previously established resistance (if long) or support level (if short) often identified by pivot highs or lows. As an alternative, it is not uncommon to set an x3ATR as a potential ‘line in the sand’ to exit. So we have based our decision on something solid that Hawkeye has told us.
Of course, we have a stop to cover us to the downside, so a usual profile on entry may be ATR x3 as a potential reward and 1.5 ATR as risk.
The issue we wish to highlight is when the stock approaches this profit target which you have set using your Hawkeye indicators.
See below an F (Ford) with a long trade (bought call).
With a profit target of $17.09 in the last hour on the underlying based on a 3xATR and with the stop now trailed to 1xATR, 3 sessions ago we have an upside of only an additional 5c/share and a downside at our stop of 30c/share.
The reward/risk ration profile in terms of our trading idea, has totally changed from a 3 to 1.5 (based on our initial ATR levels), to approx. 1:6.
We have two choices here; we ride it out and see if our profit target is triggered and potentially accept the new and certainly not improved reward/risk profile; or we take it off the table and retain the profit in the position 55% ROI on our original investment.
What can happen if we hang out for that extra cent or two? See what happened next. We would now be in a loss situation!
Look at a GLD (gold ETF) chart with a short (Put option) entry below.
In this case our 3xATR was not breached and so there is every chance we would still be in this trade and would have turned a healthy options profit into a just over breakeven with our close above 1xATR. In options terms we have given away a 50%+ gain for a 10% (excluding any brokerage costs)
Perhaps there is a clue to guide action with the two charts above, that may help guide your decisions as to whether to accept the changed profile and accept the increased risk to reward, or take the money off the table.
The selling volume that came in with GLD as the profit target was approaching (there is that leading indicator again!) whereas with F the following day when the 3xATR level had been tested and failed, the following day you would have seen that pivot high and could have been your clue to exit.
Time to review your trading?
So, consider your exits, recognise the changing risk of a trade while you are in it and test potential action against your trading system at the moment.
Also to finish……
- If a series on the other issues surrounding risk (there are at least 8 aspects of risk which may not be part of your thinking) would be of interest to you then email to [email protected] and we will have discussions about how we can roll this out.
- Feel free to ask questions/comment and of course if you want to look closer at what we do at Hawkeye Options then go to www.hawkeyeoptions.com where there is the opportunity to see the all our trades in action in the trade alert/portfolio service for your continued education.