Risk Management 4

In the last blog, we completed the formula for a normal position size and now we come to “Ebb and Flow”.

I discussed the idea briefly in the Art of Position Sizing. As Pete Steidlmayer said: “Risk is managed by knowledge – knowledge of self and of the markets”. ‘Ebb and Flow’ depends on having solid data base.

The analogy I use is to say that our plan is a beach front; the market takes the form of rolling waves that at times totally cover the beach (Flow State); at times totally withdraw (Ebb State); and at times partially cover the beach (Normal State).

The times when the waves totally cover the beach are the times when we can do no wrong. Everything we touch turns to gold – these are the results some system/seminar vendors use to sell their wares. You have read them: “Look! A 90% return in capital in only 3 months!”. The implication is this ‘golden touch’ will continue.

But of course it doesn’t. The waves start to withdraw. Our ‘golden touch’ turns to copper – with some wins and some losses. This is the normal state.

Finally the wave totally withdraws – nothing we do is right (the Ebb State). We sell and the market goes up; we buy and it goes down. Sometimes it seems the drawdown will never cease. But of course, this state also passes; and the whole cycles starts anew.

Our job as traders is to be:

  • Super aggressive during the Flow State – I use Double Normal Size.
  • Use Normal Size during the Normal State
  • Be ultra-cautious during the Ebb State – I use Half Normal Size or totally with from trading.

How do you tell in which State you are in? You need to keep a detailed equity journal and learn to look out for tell-tale signs. One point is worth mentioning – we will always be late in identifying the Ebb or Flow. We identify an Ebb State only after a series of losses and identify the Flow State after a series of profits.

Tomorrow we’ll look at Trade Management and see how this ties in with Position Sizing.

1 thought on “Risk Management 4”

  1. Ray

    I liken the Ebb & Flow you described to the Seasonality of the market.

    Just as moon phases impact tidal activity, there are consistent forces at work in the equities markets.

    For Example:

    One of the more consistent seasonal biases over time has been that surrounding major national holidays.

    The typical pattern is for market strength before a holiday as traders leave for vacations, and weakness afterwards when they return.

    Other Seasonality biases include:
    Return During Options Expiration
    Percentage of Time Positive During Options Expiration
    Days surrounding month end

    HOWEVER UNLIKE THE EBB & FLOW, WHERE:
    “we will always be late in identifying the Ebb or Flow. We identify an Ebb State only after a series of losses and identify the Flow State after a series of profits”,

    SEASONALITY BIASES are consistent.

    In the December 2002 issue of Technical Analysis of Stocks & Commodities magazine, Jay Kaeppel presented a system of being in the market only when historical seasonality is positive.

    Mr. Kaeppel used four tendencies:

    1. The two days immediately prior to an exchange holiday (New Year’s Day, MLK Day, Presidents’ Day, Good Friday, Memorial Day, July 4th, Labor Day, Thanksgiving and Christmas).

    2. The last trading day of the month and the first four trading days of the next month.

    3. November 1st through the 3rd trading day in May.

    4. The most favorable 15 months of the 48-month Presidential election cycle. This begins on October 1st two years prior to each Presidential election, and ends on December 31st of the following year.

    Each tendency gets a score of 1. When you have two or more tendencies working for you at the same time (i.e. a score of +2 or better), market performance over time is greatly enhanced.

    Therein lies the similarities and differences of the Ebb & Flow theory and the Seasonality biases.

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