Market Reactivity System

Commentary by Al Gietzen

There are a number of factors involved in managing your money in a trading account; most fall into the category of managing risk.  Here I’ll discuss the two most important aspects to managing risk; stop-loss orders and sizing of the position (number of contracts) to trade.  For a more complete discussion; find a copy of my book, ADVANCED CYCLE TRADING.  It’s out of print now, but there are used copies available.

Stop-loss Orders

I’ll bypass the discussion about whether or not it is a good idea to place stop-loss orders.  I have found that, overall, it is the best thing to do; but it should not be done in some arbitrary manner.  Stop-loss points should not be some fixed dollar amount, or how much of a loss you’re willing to take, or the size of your account; or any ideas that are not directly related to market behavior.  It’s not about you or your account balance – it’s about the statistical evaluation of the short-term volatility in the market.

The range of price in a given time interval has a distribution of values, so we’d like to know the average range and the normal deviation from that range.  We can then extend the midpoint from the previous interval, and using the statistical standard deviation, compute a range within which the market can be expected to vary without a change in trend. Or put another way, determine the point at which there is a high probability the price will continue beyond the range.

This analysis is built into the Market Reactivity System. It always gives you the stop-loss point for the next interval for either a long or short position.  It is integrated into the strategy so that hitting the stop-loss is taken as a trade signal in the opposite direction; the point to reverse the trade.

Sizing Your Position

The number of contracts you trade in a given instrument is obviously strongly related to the balance in your account.  But since the risk is based on a combination of the market volatility, and the dollar value of a point move in the particular contract you’re trading, clearly the number of contracts to trade must consider those factors.  If you are trading multiple commodities it must also consider the number of positions that you may have open at any one time.

A good measure of the volatility is already built into the computation of the stop-loss point described above, so the distance between the long and short stops is a good guide.  The point value of each commodity is easily found; you know your account balance; and you have an idea of how many trades you are likely to have on at any one time.  And there is something else – how confident are you about your ability to rigorously execute the trading system – the confidence factor.

Putting it all together gives a suggested number of contracts to trade, N, as:

N = B * F_c / P * V * (S_s -  S_l)

Where B = account balance

F_c = the confidence factor

P = likely number of open positions (# of commodities which will have open trades)

V = the point value for the commodity

(S_s – S_l) = the difference between long and short stops. (Best to use an average of about the last 20 days).

The confidence factor is self-assigned; but I generally recommend a value of 0.5 for an experienced trader with reasonably good discipline.  Perhaps 0.3 for a relative novice, and 0.4 for someone somewhere in between.  I consider 0.7 to be about the top of the scale – very risky.

There is generally a gain in profitability for diversification up to trading about 5 different commodities in different groups, so P should generally be greater than 1.

Here is a simplified way for you to calculate a suggested number of contracts to trade for the commodities given below. Take your account balance and multiply it by your confidence factor.  Divide that result by the number of positions you’d expect to have open at any one time – considering that you may be standing aside in one or more due to conditions you don’t like. We’ll call that you’re your Trade Allocation, TA.  Then divide your TA by the number given in the table. Round your result the nearest whole number.  If the result is zero, it suggests trading a lower risk commodity.

The values given in the table (March 30, 2012) will change based on market conditions, and will be periodically updated.

The above procedure allows determining roughly equal risk, and equal profit potential, for each commodity.  There is a natural tendency, for example, to simply look at margin requirements in deciding the size of a trade, or to limit exposure by trading just one contract in each commodity that you track. But following the above procedure makes it clear that the risk is very different from one commodity to another. An extreme example, for instance, would be noting that trading one contract of Copper is roughly the risk equivalent to trading 22 contracts of Eurodollars.