Risk Management: Position Sizing with Breakout Systems

This is the third method I am sharing on correctly sizing the position of each trade with proper risk management techniques. The breakout system method may be the easiest of all the position sizing calculations.

The first method is a recent volatility system which uses Average True Range as the key indicator.

The second method uses Percent Risk, either a static percent for every trade, or a percentage of the annual standard deviation of that asset.

In this post, we will explore position sizing using a breakout system method. The lookback period low will be the predetermined stop price.

Naturally, this method for position sizing and risk control pairs particularly well with a breakout box trend investing strategy.

The breakout box strategy is a simple trend investing method which has shown great results over time.

You buy an security when it makes a new high in a predetermined lookback period; you sell that security when it makes a new low in that same lookback period.

When you use a breakout box trading system, you simply move the box forward each day. When it comes to trend investing, it does not get more simple than this!

There is a growing amount of academic research into time-series momentum. We know that there is a persistent, pervasive phenomenon across asset classes where if the price of an asset makes a new high in the past 3 months to 12 months, it is likely to continue climbing for some time. Likewise, if the asset price makes a new low in the past 3 months to 12 months, it is likely to continue falling for some time.

Those time periods are not exclusive. One successful group of trend followers was rumoured to use much shorter time frames such as 20 trading days (approximately 1 month) for each market.

The chosen time frame doesn't necessarily matter if the risk control is done correctly.

By combining this research, entering an asset when it makes new highs and exiting when it makes new lows, an investor can potentially achieve outsized risk-adjusted returns.

Identifying Good Breakout Systems

Breakouts on the buy side and sell side are very easy to identify. Simply choose a lookback period that is fits your investment style based on what you want out of investing.

Generally speaking, the lookback period used should be the same across all the assets you track.

If the chosen market hits a new high within that lookback period, it is a buy side breakout. If the market hits a new low within the lookback period, it is a sell side breakout. These breakouts are your position entry and exit signals.

To develop your personal breakout system portfolio, in a disciplined way systematically track buy signals and sell signals over a long time period for a number of different asset classes you can access.

Compare the results of different timing periods and different asset classes. Performance aside, the timing period you decide to use should be one that is consistent with your personal preferences.

Generally speaking, longer time periods (such as 12 months) are likely to be much slower paced with few signals. Depending on the market, you may average less than 1 signal per year per security.

Shorter time periods (such as 3 months or less) are going to have many more signals in each market. It may not be uncommon to trade in and out of the same market several times a year in certain time periods.

A good breakout system is a system that works for your personal situation while providing a long-term positive return. It should fit your risk tolerance and your desired trading frequency.

Example Breakout Box

The price entry signal for silver (SLV) is $14.59 on February 8, 2016. That price made a new 3-month high over the previous high of $14.38.

The Stop Price on this purchase would be set at the 3-month low of $13.06.

Eight months later, silver (SLV) hit the exit signal on October 4, 2016 at $16.94 for making a new 3-month low. That's below the prior lowest price of $17.62 in the past 3 months.

Steps to Calculate Your Position Size Using Breakout Systems

These are the steps to identify all the components you need to complete a proper calculation of maximum position size using Breakout Systems.

  1. (R) Determine the maximum amount of equity you are willing to lose for each trade. This should be based on your total account equity at the time you enter the trade. (New traders should risk less than 1 percent per trade.)
  2. (P) Identify the current price of the security. I do most of my trade entries near the end of the trading day as volume tends to be higher. If you do your calculations after hours, use the closing price of the security. In this system, the current price should be a buy side breakout.
  3. (S) Identify the Stop Price. The stop price will be the lookback period low price, the potential sell side breakout. This is the lowest closing price of the security within the chosen lookback period.

The calculation for maximum position size using the Breakout System is as follows:

R/(P-S) = U (Total Number of Units)

U*P = Max Position

or, in a single, simplified calculation:

[R/(P-S)]*P = Max Position

Example

This example will be a position size calculation using the Breakout System method in silver (SLV). To demonstrate how it works, we will use the entire time period of the silver trade I shared in the example above.

  1. (R) This investor has a $100,000 investing account. His risk per trade is 1 percent. (The maximum amount of money he wants to lose if this trade goes against him is 1 percent of $100,000.) Therefore R = $1,000.
  2. (P) The breakout price of SLV on the purchase date of February 8, 2016 was $14.59. Therefore P = $14.59.
  3. (S) The Stop Price of SLV was the prior 3-month low closing price of $13.06 on December 14, 2015. Therefore S = $13.06.

R/(P-S) = U

Calculation for U: 1000/(14.59-13.06) = 653.59 units

U = 653

Calculation for Max Position: 653*$14.59 = $9,527.27

The maximum position size of SLV for this trader purchasing today will be $9,527.27, or 653 units of SLV.

The trader will enter a purchase order to buy 653 units at a limit price of $14.59 per unit. On this trade, he will allocate 9.53 percent of his account equity to SLV.

The initial stop loss price was $13.06. If the price of SLV fell below $13.06 near the close of the trading day, the trader would sell the position for a total loss of $1,000 on the trade.

Alternatively, the trader can set a Stop Limit Order and have the trade automatically executed if the price fell to this level.

In this example, the trader sold his position of SLV when it made a new 3-month low of $16.94 on October 4, 2016. The profit on this trade was $1,534.55 (less commissions). That means his profit was more than 50% higher than his initial risk of $1,000—a decent trade!

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Smith Manoeuvre: Is a Dividend Portfolio Required?

I get asked occasionally about investment options in the Smith Manoeuvre. Do you need to invest in a dividend strategy? What about ETFs? Can you use a trend portfolio?

The investment portfolio is an important component of the Smith Manoeuvre strategy. In order to have the HELOC loan interest qualify as a tax deductible expense (the whole point of the Smith Manoeuvre), you need a dedicated non-registered investment account where your borrowed money is invested.

This money should be carefully tracked at every step of the way to ensure full tax compliance. This means direct transfers from your HELOC to your Smith Manoeuvre investment account. Dividends from the Smith Manoeuvre investment account go to your Smith Manoeuvre chequing account. Both sides of your HELOC get paid from your Smith Manoeuvre chequing account.

These accounts are only for the Smith Manoeuvre process. No outside money, no mixing accounts to save a couple bucks on any account fees, and no taking money from your HELOC to pay for Mexico vacations or concrete countertops.

The structure is not necessarily simple, as you can see by my chart below. But the rewards are significant!

You can save thousands of dollars a year in taxes just for moving money through a few extra accounts once a month. This tax money can be used to pay off your traditional mortgage faster and boost your investment accounts.

Once you have all the accounts set up and understand the process, it should take no more than a few minutes of your time, a few times per month to complete the transactions.

Source: TheRichMoose.com

SM Investment Account

All of the component accounts of the Smith Manoeuvre are necessary for the strategy to work seamlessly.

As per the CRA's definition of income, every last dollar in your Smith Manoeuvre investment account (money borrowed from Portion 2 of the HELOC) must be invested in an asset that generates one of these types of income: Canadian dividends, foreign dividends, interest income, or certain forms of business income.

It's important to understand the distributions are not required to exceed your interest expenses. It is just some income that qualifies for your loan interest to be tax deductible.

Capital gains (distributed or embedded) or return of capital distributions do not count!

The direct application of income generating assets from your borrowed money is why your Smith Manoeuvre investment account must be kept separate from any other non-registered investments.

ETF Investing in your SM Account

It is certainly possible to invest with ETFs in your Smith Manoeuvre investment account and be tax deductible and successful.

As long as the ETFs pay dividends or interest, whether they are foreign or Canadian-based, they are likely to meet the standard for tax deductibility on your HELOC loan.

Although there are differing opinions on this, I would avoid most funds which are advertised as being tax efficient. This includes swap-based ETFs, T-series funds, or corporate class funds.

Compared with direct stock investing, ETFs may simplify the investing process and decision making, but they are likely to add some complication your tax situation. They are also likely to be less tax efficient compared with other options.

The problem with the vast majority of ETFs is that they distribute several different forms of income each year within each distribution.

Some forms of income are less desirable because they are taxed at higher rate, such as foreign dividends and interest. These are commonly found in international equity ETFs and bond ETFs.

Distributed return of capital, common with ETFs and REITs, causes you more work at tax time and can reduce the tax deductibility of your SM HELOC over time if not adjusted correctly.

Most ETFs and mutual funds are likely to be less tax efficient than investing directly in Canadian-listed stocks. That doesn't mean you should avoid all ETFs, but it does mean you should take this into consideration when planning your investment strategy.

If you invest in ETFs, you should prefer ETFs which are low cost, highly liquid, and pay a low distribution yield.

Avoid bond ETFs where the investment return is mainly in the form of distributions instead of unit price gains.

Investing with ETFs means you can employ a large variety of the strategies I talk about on this blog. That includes buy-and-hold investing with Vanguard Portfolio ETFs and my TADM strategy.

Stock Investing in your SM Account

Investing directly in publicly-listed Canadian corporations is a popular strategy for Smith Manoeuvre investors.

Directly holding Canadian stocks means you can design a very tax efficient portfolio that is very likely to meet the requirements for interest deductibility set out by the CRA.

As long as the company stock you invest in pays a tiny dividend or even states intent to pay a dividend at some point in the future, your SM HELOC interest will be tax deductible.

Directly investing in individual corporations also helps you avoid the potential distribution mix nonsense of many ETFs and REITs. Individual corporations distribute dividends, that's it.

Canadian-listed companies distribute dividends which are eligible for the dividend tax credit. This can significantly lower your tax bill on the distributed investment income, keeping your account tax efficient.

There are countless strategies you can use to invest with individual stocks. Trend investing, value investing, dividend growth, high yield dividend, Buffet moats, large cap equal weight, etc.

The keys to successful individual stock investing include: adequate diversification, systematic buying and selling, and cutting losses on positions when needed.

If your strategy kicks you out of a stock position, don't hold cash in your SM account. Instead, put the money in a more tax friendly bond fund like the FirstAsset 1-5 Year Laddered Strip Bond ETF (BXF.TO) or the BMO Discount Bond ETF (ZDB.TO).

Of the strategies I mentioned, naturally I'm a fan of trend investing. It's generally easy to track, requires little guesswork or "guesstimating", and can result in a pretty smooth ride.

Example

Let's look at a portfolio of ten currently popular Canadian stocks which pay dividends: Royal Bank, Manulife, Power Financial, Enbridge, ATCO, Canadian National Railway, Loblaws, Telus, Brookfield Asset Management, and Fairfax Financial.

Since 2001, if you would have run a 10-month simple moving average screen on these stocks, trading no more than once a month, you would have seen fantastic results.

The portfolio would have a maximum drawdown of 11 percent and a compound return over 10 percent per year.

To achieve that same level of risk in a Canadian Couch Potato portfolio, you would have invested in the "Conservative" model. That's just 30 percent in the stock index and 70 percent in Canadian bonds.

Your compounded return would have been around 5.5 percent per year with that approach. Still decent, but certainly not great.

Comments & Questions

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Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.