PT Education Series - Maximizing trading PROFITS through proper EXPOSURE 🪜
The goal of every swing/position trader should be to maximize his profits by being concentrated in the fastest moving stocks while limiting the drawdown when the market is pulling back.
Easier said than done you will say, so how exactly could one achieve this goal?
In this article, I will cover 3 methods I use simultaneously in order to determine the optimal market exposure I should have at any moment.
Enjoy the read!
Like in sports, there are times to be aggressive, and times to be defensive. When the market is no good, you want to limit your exposure & action in order to limit the potential damages you do to your portfolio. Trust me, a couple of weeks of 2-5% drawdown quickly accumulate and you end up being in a 20-25% one before you realize it. You not only reduce your capital making it longer and tougher to get back to your equity ATH, but you also drain a lot of energy doing so and are not in an optimal mental state when the market really turns. You can still trade, but use smaller & fewer positions than you would normally do.
Determining you’re exposure should not be an ON/OFF process, you should view it as a dimmer switch where you increase progressively your risk based on the 3 methods I’ll be describing here.
First, you have to consider the general market condition. You want to trade while having the wind at your back. The vast majority of stocks move intrinsically with the market. Yes, you can pick a stock that is bucking the trend, but if you’re invested in 8-10 names and 100% exposure, you risk getting hurt more than anything else.
That’s why you want to determine if the general indices are in an uptrend, range, or a correction. To do that, I use the major moving averages & market structure to determine the market exposure I want to have at a precise moment.
10dma > 21dma = 100% exposure (or more if margin)
Price below 21dma = 75% exposure max
10dma < 21dma = 50% exposure max
10dma < 21dma = 10% max (Normally day trades OR shorts)
10dma > 21dma = I begin to build exposure up to 50% if breadth confirms a move & we got a good sell-off extension
These are the rules that I use personally, the goal is to have a system, so feel free to develop your own rules around moving averages, market structures, or anything else. BUT, have a system.
Let’s use the current market environment and see how I handled market exposure during this period.
Since the early January 50dma break, I reduced my maximum exposure below 50%, and almost the entire time even below 25% due to the fact that we never closed above the 21dma during the entire correction.
Notice also the market structure, we have never been able to make a higher high since January and making lower lows on every leg down. It is only since Friday that we made 2 important moves, a close above the 50dma & also a higher high. While not being perfect, it tells me that we’re at a full risk-on environment based on my model.
I also use market breadth & structure to gauge if the rally has legs or not. We normally want to see a broad participation
Net new high
Stocks above 50dma & 200dma
Higher high / higher lows
Lower highs / lower lows
Despite having a market-based exposure limit, you want to progressively increase your exposure in case the market pullback stops you at once on all your recently open positions. This kind of market action happens really often, that’s why you want to build your exposure gradually by using your recent trades gains to finance your next position risk.
Open heat risk
The first metric that I calculate is my current OPEN HEAT risk. This means that you sum up all the potential loss you would take if you would be stopped on all your positions at once.
OPEN HEAT (%) = (Current price - SL price) summed for all open positions / Total capital
I want to keep this open heat metric below 10% in order to manage risk properly if I were to be stopped out on all my positions.
You’ll understand that as your positions are making progress, you’ll be able to raise you’re stops based on market structure (subject for the next article :)), and then your open heat will decrease.
The second method I use here is a progressive exposure metric based on the profit I build in my current open positions. You want to use those profits to finance the risk of the next position. The goal is to protect you’re capital in case your positions are going against you.
Let’s use a basic example,
Trade #1 (1000$ position) :
Open profit = 2% = 20$
Trade #2 (1000$ position):
Risk (SL from potential entry) = 5% = 50$
In that case, you’re first trade profit IS NOT big enough to finance the 50$ risk you’ll take on your second position. You should then wait that your first position profit increases above 5% in order to finance that 2nd position risk.
You want then to calculate the overall open profit you have in all you’re positions, and determine the overall exposure you can go based on a fixed risk parameter. For me, I use a fixed 5% risk in order to calculate it.
The exact formula I use will be detailed in a future article & probably in the next version of my trading journal I’ll share soon with you folks.
Third, I also use performance-based rules to determine my ideal market exposure at any given moment. Regardless of the market condition, you also want to assess you’re current performance in case your trading is off for whatever reasons despite the market environment.
In contrast to Market & Portfolio-based exposure, I use my past performance to adjust my initial position size. In normal performance conditions, I take an initial 10% position while I’ll reduce that position size when I trade poorly.
The first metric I use is the Risk-Reward Ratio for my last 20 trades. The RRR gives an indication of the expectancy of your current trading performance. A ratio above 1 is indicative of a positive expectancy while below 1 means you’ll lose money over time.
The formula to calculate RR is:
RRR = (Avrg Win % * Win rate) / (Avrg loss % * Loss rate)
These are the rules I use to adjust my positions size based on current RRR:
RRR > 2 = Full 20% initial position
2 > RRR >1 = ½ initial position (10%)
RRR < 1 = ¼ initial position (5%)
While portfolio exposure is a complex concept, I firmly believe that in order to achieve above-average returns you need to have such a system put in place.
If you’re just beginning, you can start with 1 method at a time. Through time, you’ll be more comfortable and can add concepts/concepts one by one.
I really hope that you enjoyed this first educational article. If you did, please share it so that more folks can be reached and this Newsletter can grow. :)
I would highly appreciate it if you could DM me with constructive feedback or a new idea for that newsletter.
Also, if you have questions, don’t hesitate!