Risk Management for Speculators & Trend Investors

Risk management is the absolute key to success for speculators and trend investors. If you can limit your losses and downsides, the upside will take care of itself.

Here are a number of rules to help you reduce risk in your trend investing portfolio.

1. Divide your total portfolio equity into equal sized portions.

Ten portions is good to begin with and you can expand to twenty equal portions as your portfolio equity grows and you gain access to more markets. Unless you are managing millions, there is no point into dividing your portfolio further. Keeping your portfolio equity portioned will help with setting risk levels and stop losses for each position later. It is also a good way to help you determine the number of markets you should monitor and trade.


2. Only put up to one portion of your portfolio to work in any one asset.

By limiting your bet size on any one asset, you are ensuring your portfolio stays manageable from a risk perspective and properly diversified for broad return potential. You never know which markets are going to make you your profits, so don't bet the ranch on just one or two assets. Cash, or short-term bonds, are a default holding so nearly your entire portfolio may be in cash if markets are not trending.


Example Assets Only

3. Trade diverse markets that provide returns which are independent of each other.

Trading only stocks and bonds will not provide you with a broad range of returns. Instead, monitor a range of uncorrelated and liquid assets: stock indices, currencies, precious metals, real estate, and bonds. If your account is larger and you have access to futures markets, include energy, grains, and industrial metals.

A lot of these assets can be traded with ETFs, but be careful to pick the right ones. You want liquidity and reasonable costs.


4. Determine the size of each position, including leverage, based on volatility.

Leveraging up your position can help increase returns on each position, but it also increases your chances of hitting a stop loss quicker than you need to. This can increase your whipsaw costs. Use Average True Range or Standard Deviation to measure the volatility of an asset. The asset's stop loss price should be a low multiple of ATR or SD.

Your stop loss price will help you determine an appropriate size for each position once leverage is factored in. Based on this formula, a highly volatile asset might be purchased with no leverage, or maybe less than a full position. Many assets can be leveraged up 2x to 5x or maybe more.


5. Never risk more than 2% of your current portfolio equity on any one asset.

Regardless of the size of the position and the amount of leverage used, the maximum loss of any trade should never be more than 2% of your portfolio equity. Newer and more cautious investors should start with a 1% maximum risk per trade. In dollar terms, if your portfolio equity is worth $100,000, your maximum equity loss on any of your positions should not be greater than $2,000. Limiting losses is the key to long-term success.

Source: Flickr - DoD News

6. Enter a Stop Limit Order on every trade set at your maximum risk.

To ensure your emotions don't get in the way of your trading, always place a stop limit order on every position. The stop price should be set at or near your maximum risk. Assuming you are risking 2% equity per position on a $100,000 portfolio, your stop price will never allow your total equity loss on any position to exceed $2,000. Move your stop loss up as your position becomes profitable, but never move your stop loss down.

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Canadian Dollar Impacts

You may have wondered in the past few weeks why the global stock markets seem to be recovering but your investment accounts are not getting any bigger.

Since the beginning of April, stocks have been doing quite well. The S&P 500 is up around 5%, the Nasdaq 100 is up a bit more than that, the MSCI EAFE index is up around 4%, while the Emerging markets are more or less flat.

However, this gets completely turned around once we take a look at markets in Canadian-listed products. While XUU.TO and XEF.TO are basically flat, VEE.TO is actually down so far this month. What is going on?

The answer boils down to one factor... the value of the Canadian dollar has been climbing. This fits with the common themes we have been seeing from the Canadian dollar in the last few years. When the stock markets do poorly, the value of the Canadian dollar falls as well cushioning investor accounts from the full impact of the markets. The inverse is also true.


Source: Yahoo Finance

The chart above is the Year-to-Date movement of the Canadian dollar relative to the U.S. dollar. The Canadian dollar fell in value quite a bit from the end of January though the middle of March before suddenly changing direction.

From the beginning of April, our dollar has leaped up around 2.5% against the U.S. dollar, jumping above the short term moving average I like to use: the 10-day EMA. The 10-day EMA is a great indicator of shorter term market movements. This is a big, solid move for any currency including the secondary currencies (Canadian dollar, Australian dollar, New Zealand dollar, Hong Kong dollar, Singapore dollar, and the Swiss franc are in this group).

The CAD/USD relationship directly impacts Canadian ETFs which hold U.S. stocks. My favorites include XUU.TO, ZSP.TO, HXS.TO, and XDU.TO.


Source: Yahoo Finance

The direct impact of a falling currency on stock portfolios can be seen in this chart. I compared XUU.TO (dark blue line) to its currency-hedged version XUH.TO (light blue line) from the recent market peak on January 29 to the recent low on April 2. The unhedged version with the full impact of the falling Canadian dollar during this time declined approximately half the amount of the underlying market!

The currency impact translates to the muted overall effect on your portfolio as mentioned above.

CAD vs. Euro

Source: Yahoo Finance

The Canadian dollar has also increased approximately 1.5% against the Euro since the beginning of April. This is important because the Euro is the largest currency component of the MSCI EAFE index.

Other larger currencies represented in the EAFE index are the Japanese yen and the British pound.

Currency Impacts When Investing

The question of currencies is always an important one when considering your investment strategy. It's also a topic that gets a lot of investing commentators very fired up.

Currency is an important consideration for Canadian investors precisely because we are a secondary currency market. Our currency sees large swings in value which are largely driven by resource market conditions.

Commentary surrounding currency hedging by U.S.-based personal finance folks should be ignored. It's like comparing apples to oranges. The U.S. dollar is by far the largest impact and most important currency in the world--setting the global prices for nearly all commodities and a significant volume of industrial trade. U.S. investors should rarely hedge their portfolios for precisely this reason.

As a trend following investor, I generally just invest with the longer-term trend including currency trends. This makes the decision about hedging easy. I pick a hedged version of international index ETFs when our currency is trending up and a standard index ETF when our currency is trending down. It's impossible to catch all the trends perfectly, and it's not possible to hedge effectively with Emerging markets, but this strategy largely serves the purpose.

For more static investors, I believe the answer is to mix products to get varied currency exposure. Buy bond ETFs that hold Canadian bonds where possible. When buying international bonds, use hedging to minimize currency impacts.

When purchasing stocks, generally stick with ETFs which are not currency-hedged. This gives you exposure to the major currencies like the U.S. dollar, Euro, Japanese yen, and British pound.

If your portfolio is large (seven figures or more) with a smaller than typical bond allocation, consider currency-hedging a portion of your stock ETFs. Targeting between one-third and one-half of your total portfolio in Canadian dollars is not a bad choice if you primarily spend Canadians dollars.

Alternatively, you can invest in a Leveraged ETF Strategy. By increasing your bonds (held in Canadian dollars) and using U.S.-listed leveraged ETFs, you can have a high Canadian dollar exposure providing interest income as well as full stock exposure in international currencies. Not only are your long-term investment returns likely to be higher than a boring Couch Potato portfolio, your risk levels are actually lower.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

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