Monday, August 9, 2010

Why Risk Limits are Important: The Real World

Just back from vacation and starting off with a bang. To the downside! Well at least it could have been a bang or explosion if I did not have parameters on the amount of risk I am willing to take. Take a look at this 2 year chart of Endo Pharmaceuticals Holdings, Ticker: ENDP.

Seems to be breaking out of a long term symmetrical triangle to the upside. In fact it was a top ten pick last week for just that potential. On a retest of the downtrend line today I bought a small position at 24.87 and placed a stop just under the trend line, at 24.74. All seems well right? Now look at the 5 minute chart for today.

After trading in a tight 20 cent band all day, at 3:30 the stock plunges down to 24.58 and then rips up to 25.67 before falling back to close the 5 minute candle at 25.12. $1.09 range or 4.3% move all within 5 minutes! Volume that had been on pace for about two thirds of the normal 1.430 million shares printed over 1 million shares in that 5 minute candle alone! Obviously my stop was hit. Luckily it was within a penny of my order for a 14 cent/share loss. What happened? At 3:30 this headline hit the PR Newswire: "Endo Pharmaceuticals Agrees to Acquire Penwest Pharmaceuticals and Submits NDA For New Formulation of Long-Acting Oxymorphone Designed to be Crush-Resistant."

How could you have know that was coming right? Exactly. And that is why your trading system needs to have controls in place for the amount of risk taken. My risk controls take two forms. The first I touched on above, setting a stop loss. This should be placed at a meaningful level. You need to determine what is meaningful to you. It may be just below a key support level or some fixed percentage or dollar/share value away from the execution price. You recall my stop was just below the trendline. This determination also depends on the size of the position you have on. Since I had a small position on, the trendline at 13c/share away was an acceptable risk for me, and probably would have been even if I had on a larger position as well. The point though is that the amount of money you are willing to risk is determined by both position size and how far away your stop is from the execution price.

I lost some money today on this trade, and I do not like that, but it could have been a lot worse had I not determined how much money I was willing to risk before I bought the stock. Who knew that the price would explode or that it would stop falling? Be prepared. Determine your risk tolerance before you trade.

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