The Trader Skill Stack (part 2)

Before I begin, I want to give a quick plug for a young trader who I’ve mentored over the past few years. He’s completing his graduate degree in finance and investment and is searching for a full-time role in financial markets trading. He has the early signs for what I think makes a great trader - a hunger to learn, a go-getting attitude, and a sharp instinct for the market. He already has a couple years under his belt trading for prop desks or managing his own capital and has a strong track record. He previously worked as an analyst at a well-regarded global macro research firm, and now writes a newsletter on Substack about his views on global macro. If you’d like me to connect you with him, just reply to this email/post.

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This post is part 2 of The Trader Skill Stack, where I talk about the five components of a successful trade. You can find part one of the Trader Skill Stack here.

You’ve developed a thesis and have decided which market you want to express it in. You’ve optimized your timing and entry. Beginner traders may think their work is mostly done, but actually it has only begun. The next two skills - structure and sizing and managing open positions - are the most crucial components of trading. Screw them up and you will turn a winning idea into a loss. The following two skills are what separates analysts from portfolio managers, strategists from risk-takers, and armchair financial “gurus” from real traders.

#4 - Structure and sizing

When it comes to structure and sizing, the key decisions are whether you want to express the view via delta one (spot and futures) or options. If trading delta one, how do you manage your risk (ie place your stop)? What percentage of your capital do you want to put at risk on the trade?

I wrote a previous piece on sizing delta one trades, and here is the TLDR:

1) Decide on your stop loss level before entering a trade, because that level will determine your sizing

2) Size trades so that you can withstand ten consecutive losses.

3) If the new position is correlated to other positions in the portfolio, consider sizing it down (and vice versa if it is uncorrelated).

Personally, I risk between 0.5-2% of my total trading capital per trade, with the default sizing being around 1%. With this sizing approach, an annual return of greater than 30% is well within reach, and I’ve even had triple digit years when risking these amounts.

Ultimately, a trader has to know his risk tolerance and be able to predict how he will behave if the trade reaches his stop loss level. Getting stopped out on a trade should feel routine. If it doesn’t, your position is probably too large. Emotional hesitation at the stop level is a red flag.

Scaling in

Readers often ask whether I scale into positions or enter all at once. My default is to wait for the optimal entry and go in full size. However, there are exceptions.

1. When my technical analysis gives me a buy zone or sell zone rather than an exact level to enter a trade. In this case, I would place 2-3 limit orders across the range of that zone to enter a trade.

2. There is incoming economic data or event risk that will cause the market to gap. I might enter half a position before the market event and the other half after the event happens, after the dust settles.

3. Buying in an overbought market, and vice versa in an oversold market. The danger of sharp pullbacks is high, so I enter a partial position first with a wide stop and then brace for the inevitable pullback. After the pullback occurs, I will have an interim high or low behind which I can tighten my initial stop to. The tighter stop allows me to increase my position size if I believe that the pullback will resolve in a resumption of the trend.

Options vs spot

Options provide additional tools for structuring exposure to a market beyond a simple delta one position with a stop. What I like most about options is that it gives me additional leverage and convexity that can magnify returns if I am right and buffer my downside if I’m wrong.

I’ll structure a trade by going long options if I believe the market will move in my direction quickly and explosively, or if I believe the market is underpricing the probability of volatility in that direction. Sometimes I’ll combine futures with low delta options so that I benefit from both an orderly or explosive move in my favor. For example, back in February I bought 2 month puts on the S&P 500 in addition to shortly the futures because I believed the market was complacent about the odds of Trump getting aggressive with tariff policy.

I usually stick with vanilla calls and puts or call/put spreads. The more complex or exotic your option structure is, the more things have to go right for you to make money.

Conviction

Conventional trading wisdom says that traders should size up on trades when they have high conviction on a trade. This is dangerous advice. In my personal experience, conviction is difficult to calibrate in advance, and the obviousness of a trade can only be determined in hindsight. Some of the biggest losses of my career came from positions that I sized up too much and held on too long due to high conviction. After those painful lessons, I still increase sizing when I feel good about an idea, but now I do it through limited downside strategies such as a delta one and option combo like I mentioned above, or adding to a winner and tightening the stop at the same time to reduce my pnl at risk.

#5 Managing Open Trades

An Uber driver once told me he got into bitcoin back in 2013. My mind wandered towards the obvious question - if he bought bitcoin back in 2013, why was he still driving an Uber? Fortunately he continued with his story, sparing me the awkwardness of having to ask the question out loud.

“It turns out I bought at the high of the cycle, and it crashed 80% after that. I thought bitcoin was a passing fad so I cashed out at a loss.”

Financial markets lore is filled with the sad stories of people who got out too early or too late. The heroes are the ones who exited at exactly the right time. What you do with a trade after you enter is as important, if not more, than how you got into it.

Where to place your stop

The distance of your stop from your entry level should match your time horizon. If your time horizon is days to weeks like mine is, your stop shouldn’t be based on a level that you observe on a 5 min chart. I like to place my stops behind strong levels on the 4-hour or daily chart, and ideally outside of the current or previous day’s bar.

On momentum trades, such as breakouts and continuation patterns, you can place your stop a little tighter and inside the range that the market broke out of. If you’re having trouble finding a good place to put a stop, it probably means that you’re chasing an overextended market. Having a fine-tuned entry will making it easier to find a strong level to place a stop behind.

Placing your stops too tight will cause more of your trades getting stopped out by random noise, eroding your win/loss ratio. However, lacing your stop too far from your entry level presents another set of problems. Although the probability of getting stopped out might be lower, your risk/reward will be worse. Wider stops require you to trade smaller positions, reducing your profit potential.

Trailing stops

One key to protecting profits is adjusting your stop as the trade moves in your favor. Once a trade hits +1R, I start looking to trail my stop to breakeven or better. Nothing stings more than a +1R trade turning into a -1R loss.

Trailing your stop too tightly can stop you out prematurely. Too loose, and your P&L volatility increases. It’s a balance that depends on your strategy and the situation.

Taking profits

I usually enter trades with a profit target in mind, but I take them as rough guides. The profit potential for a trade can evolve based on new developments or unfolding price action.

One problem with price targets is that the closer the market gets to my target, the more the risk/reward deteriorates. For this reason, I trail my stop more frequently and tighter the closer the market gets to my take profit order. I call this the 1:1 trailing stop rule.

I also tighten stops when RSI gets extreme across timeframes. If you wouldn’t open a new long with RSI overbought on both the 4-hour and daily charts, why keep holding?

Listen to your emotions, then do the opposite

There are times when I’m running a position that’s well in the profit, my thesis has played out, and I’m feeling pretty relaxed. I get lulled into a false sense of complacency and stop thinking about all the things that could go wrong. That’s often when reversals happen as everyone is on the same side, creating a recipe for pain.

Learn to catch yourself when you start feeling too relaxed about a position. This is a sign that you should get out, or at least take partial profits. Every time I’ve ignored that feeling, I’ve regretted it.