Thursday, January 07, 2010

Managing Trading Risk: Time is Size

The recent post addressed the issue of adding to trades following adverse movement. Here is a trading faux pas that has cost me in the past: I don't add size to a trade that's in the red, but I have added *time*.

In other words, a trade will move a bit my way, then a bit against me, then back to scratch: back and forth for a while. Often this occurs in slow markets.

Normally, my trade ideas include an estimate of time: I should see the market move my way within a matter of minutes from my entry. If that doesn't happen and I stay in the trade, it's been a pretty good predictor of a losing trade.

One reason for that is that adding time is like adding size: it increases the variability of returns. If I turn a short-term trade into an intraday swing trade or an intraday swing into an overnight hold, I've effectively added to the size of the trade. Instead of adding risk on a promising trade, I'm adding it to one that has fallen short of promise.

Equally important, every trade idea with a target and time frame is assuming a particular level of market volatility. If the trade has not moved much in the allotted time frame, it means that the estimate of volatility may be off, which in turn suggests that market participation has declined. Again, this is hardly a good reason to add risk.

Some of my worst trades occurred when short-term trades turned into miniature investments. You don't have to add size to a losing trade to add risk; in the market time *is* risk.