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RE: Gap risk = critical?



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> I guess my real question should be is a 2% risk on a
>position practical on a stock that can easily make a 10% move in a day?

Good q'n John, the answer is NO unless the "in a day" problem is taken out
using some combination of active trading and passive volatility knowledge.

Bottomline, volatility is a critical part of the equation. The lesser your
intimacy to current price action, the wider the P&L swings one needs to
allow for. A couple of days ago I think Al Taglavore had a comment about 50
day ATR.  That is a useful statistic - as are other period ATRs, and as is
Historical Volatility (which gives a one standard deviation move for the
historical lookback period chosen).

The wider the P&L swings one expects, the lesser the $ commitment to the
trade so that overall impact on the portfolio is muted/equal to a PFE where
the same 10% move may happen over a 3-5 day span.

This is how I traded YHOO:

a. Entered at 103 7/8 (bid ask spread was actually 1/64th) - see lower of
the attached chart for why.
b. I added in the after market at $105.50 because the Daily bar had put in a
key reversal, with volume confirmation.
c. I am still long it but at $125 I have hedged my exposure with some
premium moves which now make me direction-neutral for the next $15 either
way.

$15 above current price clears the 50/200 ema hurdles and I get longer as
price goes higher.
$15 below current price clears the low of the bar before the Key Reversal
Bar, and I get shorter as price goes lower.
Within the $15 range I make/lose some money but nothing like the move from
104 to 125.

On my first entry the stop was below the congestion at $102.50, below the
flag pattern highlighted on the lower chart.
On my second and therefore position entry the stop was the low of the Daily
bar.
For gaps below $100 I went long put butterflies that buy me time to adjust
my stock position.

Critical summary answers to your q'n:

- Volatility needs to be part of the equation. A 10% move in PFE is not the
same as the same 10% move in YHOO, because PFE takes 3 days to move 10% and
YHOO takes 3 minutes (ok, 3 hours) - and yet, both have the same P&L impact
on the portfolio so trade size becomes a function of volatility. We
discussed % of capital to commit to a trade, but other than Al I don't
recall seeing anyone discussing volatility.

- A lot of creative ways are available to enter and exit trades, this is the
value the individual can add to the system of choice. One can use price
targets, retracements, ATR is maxed-out so exit, one can use option premium
after such a move - and so on. Someone commented that it is not the entry
that counts - it is the exit. Well, a good entry is often a good leg up to
designing a good exit strategy because the focus changes from loss control
to profit protection. One is a defensive stance, the other is an offensive
stance. The former assumes negativity attached with losing on a trade, the
latter clears the slate for using the benefit of coming from a position of
strength into the exit decision.

It is therefore - in my belief - shortsighted to marry oneself to some
equation or rigid set of inflexible rules while being closed to dynamic
humint input. Markets change, we have to change our trading strategy with
that given the constant set of instruments we trade.

I guess I view trades as a continuing game of chess or cricket or tennis,
others view it as a stop-go-stop-go affair. This is why I have no problem if
I have concentrated all my resources in the energy market if that is where
the action is - or on B2B stocks if that is where the action is. After a
certain comfort level is achieved, you can actually make lack of
diversification work for you without violating the lines in the sand that
define risk.

Gitanshu

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