Which Signals to Trade?
SPI • NIKKEI • TAIWAN •
HANG SENG • DAX • FTSE • NASDAQ
Although IndexALERT™ covers eight indices not every subscriber will wish to, nor possibly be able to afford to, trade all index markets. Accordingly this section is designed to assist people in determining which markets and signals they would like to follow.
Depending on your preferences you can either follow the signals on just a single market or you could trade all signals across seven markets. The choice is yours. To help you determine which markets you would like to follow and to determine the account size required I've constructed a number of portfolio combinations* below for your review.
These portfolios follow a simple accumulation rule, adding a contract to the portfolio as markets open around the world, following their respective time zones.
Now there are a few basic approaches people can consider when determining what account size they should have to trade IndexALERT™.
Please note that any method you use to calculate an appropriate account size MUST allow your account to be large enough to fund both a contract's deposit margin and a trade's expected risk.
Lets look at the contracts' deposit margins.
What this tables shows us is that if we place an order for the SPI which is triggered the Sydney Futures Exchange will automatically debit AUD1,750 from our account to ensure that we will be able to honour our trade. If we place an order for 5 x SPI contracts then AUD8,750 will be debited from our account while our trade remains open (note if the trade goes adversely against us the Exchange will debit a margin variation from our account). So as you can see a trader's account must be large enough to fund the contract's margin.
Please remember contract margins do change as Exchanges measure market volatility so be sure to regularly ask your Broker for the latest contract margin requirements.
Lets now look at a few approaches people might like to consider when working out what account size they should have to trade IndexALERT™.
1. Individual
Trade Risk: Account Size = Individual Contract Margin + Individual Trade Risk.
The first approach simply says that traders should only consider those
signals whose estimated risk is within their risk parameters. IndexALERT™
calculates an estimated dollar risk for every trade signal. Traders could just
take those signals that have an estimated risk within their limit. This dollar
risk could either be
-
A fixed dollar amount or
-
A fixed percentage of their account balance i.e. 1%, 2%, 3%, 5% etc.
Fixed
Dollar Amount
A
trader may prefer to risk not more than a fixed dollar amount of say AUD500 on any one trade regardless of
their account balance. Accordingly
they would only place orders for those signals who's estimated risk is equal to
and less than their AUD500 limit. If this approach was chosen the trader's account size
would have to be sufficiently large enough to fund both the contract margin and
the estimate dollar risk. For example if IndexALERT™ generated a trade
signal in the DAX which had a an estimated risk of AUD450 then the trader's
account size would have be equal to or larger than AUD15,278 (AUD450
+ AUD14,828) assuming the trader is not holding any other open positions.
Fixed
Percentage of Account Balance
Alternatively a trader may prefer to only risk a certain fixed percentage of
their account balance on any one trade. Lets say a trader has a AUD30,000
account balance and prefers to only risk 2% of their account balance on any one
trade. Accordingly the trader would only follow those IndexALERT™
signals whose estimated risk was equal to or less than AUD600 (2% x
AUD30,000). As the trader's account balance grows or declines so would their
estimated dollar risk since the 2% risk per trade is "fixed". With this
approach the account size and percentage risk level dictates which trades are
selected.
As you can see with these two approaches traders basically will pick and choose their signals according to their preferred risk levels.
While these approaches look at the "individual" risk to chose signals the next approaches take a "portfolio" view. They look at a portfolio of markets and then estimate the level of capital required to trade.
2. Portfolio
Risk: Account Size = Portfolio Contract Margins plus Portfolio Drawdown
This first "portfolio" approach simply says an account should be large
enough to fund both the portfolio's contract margins and the portfolio's worst
accumulative loss, or drawdown. Under this "portfolio" approach traders follow
ALL signals and DO NOT pick and choose.
With this approach the trader will determine their preferred portfolio. It may consist of one, three, five or seven markets etc? Traders need to determine the number of markets and contracts they would like to trade and then ensure their account size is sufficiently large enough to trade them.
When determining the number of markets and contracts to trade and the account size required under this approach a trader should, as a minimum, take into account the following factors.
-
Drawdown? Straight away you have to focus on the RISK. Believe it or not trading isn't so much about making money but managing your risk. Always think defense, defense and more defense! You have to ask yourself what has been the worst historical loss so far for the portfolio of markets you would like to trade? Is it likely to occur again? I would say yes, as our worse drawdowns are always in front of us! So to be conservative you should consider increasing the "Maximum drawdown" by a certain percentage (i.e. 30%, 50% or 100%?). You then have to ask yourself whether you would be comfortable experiencing that level of drawdown? If you don't then either you shouldn't trade or you should consider a smaller portfolio with less markets and less risk.
-
Margins? Remember each time you trade a contract the particular Exchange in question will debit the contract's initial margin from your account. Your account will need to be able to fund both your contract margins and expected worst drawdown. The larger your portfolio of markets the larger your account size will need to be.
Lets take an example.
Lets assume I would like to trade an Asian Portfolio consisting of the SPI, Nikkei 225, Taiwanese Index and Hang Seng. I like the 55% expected return (positive expectancy) and I'm comfortable with the worst historical drawdown of -AUD10,636. I like the frequency of signals where I'll expect to be trading on average 10 times a month.
Now the question I need to ask myself is what account size should I have to trade this portfolio?
As an aside please remember this is only an example and is not personal advice. You should, with or without the assistance of a licenced advisor determine whether your calculated account size is appropriate for you given your financial situation, particular needs and investment objectives.
Now back to the example. I've determined that I only wish to trade a single contract for each signal and that I would be comfortable with the Asian portfolio (4 markets). I know my worst drawdown is ahead of me so I will increase the Asian portfolio's worst drawdown by 50% to -AUD15,954 (AUD10,636 x 150%). Now I'll round this up to -AUD16,000.
Finally I need to add my portfolio's contract margin requirements to my expected drawdown.
We'll take a look at the following contract margin table to see how much money would be required to fund contract margins in the Asian portfolio.
According to this table I would
require AUD25,171 to simultaneously hold one contract in each market in my Asian
portfolio.
To calculate a possible account size I simply add the contract margin requirements to the expected draw down.
Accordingly, under this approach I would need AUD41,171 to trade the Asian portfolio (AUD41,171 = AUD25,171 + AUD16,000).
The second "portfolio" approach looks at determining an appropriate account size that will limit the portfolio's drawdown to a predetermined percentage level.
3. Portfolio
Risk: Account Size = Limit Portfolio Drawdown to Percentage of Trading Capital
Like the previous "portfolio" approach traders need to trade every signal generated by
their portfolio. There is no picking and choosing. With this approach traders
need to determine an account size which is sufficiently large enough to limit
their expected drawdown to a certain percentage level of their trading capital,
say -20%, -30%, -50% etc? When determining
the number of markets and contracts to trade and the account size
required a trader should, in addition to examining the portfolio's worst
"Drawdown" and "Contract Margins", take into account their,
-
Personal Risk Tolerance? Another factor you should consider is the level of percentage drawdown you would feel comfortable with? The previous "Drawdown" above looked at the actual dollar amount, not the percentage of your trading capital. You have to ask yourself what percentage loss of your capital would you be prepared to suffer before you stopped trading i.e. -20%, -30%, -40%, -50%? Remember the lower the percentage drawdown the larger the account size required.
Lets look at the previous example with this approach.
I know that I would like to trade the Asian Portfolio consisting of the SPI, Nikkei 225, Taiwanese Index and Hang Seng. I liked the 55% expected return (positive expectancy) and I was comfortable with the worst historical drawdown of -AUD10,636. I determined that I only wish to trade a single contract for each signal and that I was happy to increase the Asian portfolio's worst drawdown by 50% to -AUD15,954 (AUD10,636 x 150%) which I rounded up to -AUD16,000.
OK, I now have to ask myself what percentage loss of my trading capital would I be comfortable with? Let's say that I'm happy to suffer a -30% loss.
Well, if I wish to limit my expected worst loss of -AUD16,000 to 30% of my trading capital than I will require an account size of AUD53,333 (AUD16,000 / 30%).
Finally I need to determine whether this proposed account size would be large enough to not only allow me to suffer my worst drawdown but to also fund my contract margins?
We'll take another look at the contract margin table to see how much money would be required to fund the contract margins in the Asian portfolio.
According to the table I would
require AUD25,171 to simultaneously hold one contract in each market. Lets see
if my estimated AUD53,333 account size would be large enough?
Well if I experience my worst expected drawdown of -AUD16,000 some time in the future while at the same time placing an order for the SPI, Nikkei 225, Taiwanese and Hang Seng (AUD25,171 in margin) then I should be ok as my AUD53,333 account is large enough (AUD16,000 + AUD25,171). If I was in this situation I would still have AUD12,162 in my account (AUD53,333 - AUD16,000 - AUD25,171).
Summary
Well as you can
see traders can either look at Individual Trade Risk or Portfolio Risk to
determine which IndexALERT™ signals to trade and the necessary account
size required. By no means are these
approaches exhaustive however they will give you a start.
If you have any questions please do not hesitate to contact me at bpenfold@tpg.com.au.
Warning
*These
portfolio combination performance figures are hypothetical only, showing the results of trading 1
contract per IndexALERT™ signal. The following estimates were used for brokerage
and slippage.
Please be aware
IndexALERT™ only provides general advice. It can only offer general advice as it
does not take into account subscribers’ individual needs, financial situations
and investment objectives. Subscribers need to determine, with or without the
assistance of a
licensed financial adviser as to whether the trading opportunities identified by
IndexALERT™ are appropriate for them given their particular needs, financial
situation and investment objectives. Subscribers also need to be very aware
there is RISK of loss in futures trading. Hypothetical, historic or actual
results do not indicate future success.