The financial markets cycle through many phases of opportunity and danger. With this in mind, it doesn't make sense to trade a healthy uptrend or persistent downtrend using the same strategy as a choppy or uncertain market. Collaring recognizes these behavioral shifts and adapts the trading strategy to match short-term risk characteristics.
At its core, a trade collar is just like the one you stick on your dog to keep him in check. Put the market on a tight leash when risk is high and opportunities are tough to find, and conversely loosen the collar and let your positions "run free" when the market is trending sharply, with the single-minded goal of getting from one level to another
The collaring process works best when traders make small adjustments each morning in response to that specific day's reward/risk profile. But longer-term collaring is just as important in building the right exposure to major position trades and even multiyear investment portfolios.
The collar signals when to let profits run and when it's the worst thing you can do. It also defines the right instruments to trade at any point in time. For example, go ahead and play volatile small-caps when the collar is loose and the market is printing money, but then stick with slower moving blue-chips when visibility is low and whipsaws are the rule of the day.
Applying the right collar in a particular session goes well beyond simple index analysis. For starters, is the pre-market setting up a big gap against your open positions? Losses incurred by overnight movement require a defensive collar even if everything else is firing on all cylinders. In a nutshell, the glowing red numbers that morning are saying that you're wrong about the market.
And whether you like it or not, you'll open that session sitting on losses, which will detract from your narrow focus on other trading opportunities. The best path when caught on the wrong side of the tape is to take a deep breath and deal aggressively with the matters at hand. After the fires are put out, reconsider how you want to collar the rest of that session.
Execute your collaring strategy by adjusting position sizing, scaling and holding period. These three elements will handle just about any type of environment -- from a raging bull market to a midsummer chopfest. Of course, each one affects the risk attributes of your overall portfolio or trading account, as well as the positions picked up that day or week.
Risk increases as a function of your time in the market. The odds you'll lose money increases geometrically the longer you hold onto a position. With this in mind, the most relevant time-control decision you can make in this tough June market is whether or not to hold a position overnight.
That's especially important as we head into this afternoon's FOMC rate decision. The day after a
meeting routinely triggers a reversal of the trend that closed out the prior session -- usually through an opening trap. This market bias heightens risk on positions bought or sold today in anticipation of a beneficial move into the end of the week.
Position sizing and scaling also comes into play when initiating collaring strategies. Specifically, your risk exposure needs to adjust dynamically to the evolving ticker tape. Trade large-size when risk is low and opportunities abound and small-size when confusion and conflict control the ticker tape.
Limit total positioning to just one-third of account equity in bad markets when a defensive collar is utilized. Your two goals during those periods are simple: Make a little money and avoid losing a lot of money. Alternatively, ratchet up exposure to 90% of equity in good markets and increase holding period at the same time. These elements work together, with the wind at your back, to "make hay while the sun shines."
Supportive markets favor two common scaling strategies. The first builds the position in three to four pieces, each smaller than the one preceding it. The decreasing size serves two purposes. First, it keeps the average entry price close to the risk target. Second, it allows the market to take you out, with a smaller loss, if price action after your first entries fail to support the trade setup.
Note how each entry into this
example is smaller than the one preceding it. This scaling strategy lowers the average entry price to just a point above the trendline breakout, which lets the trader place a stop-loss at a price that won't break the bank if it gets hit by an unexpected selloff.
The second strategy trades three to four equally sized pieces, but only after calculating the intended average entry price and total loss you're willing to take on the position. This method provides less control than the first because more things can go wrong trying to establish an average entry price.
Scaling strategies in adverse markets are relatively simple because the defensive collar precludes heavy exposure. In a nutshell, just keep it simple and limit yourself to two pieces applied at the right time. Each of these segments should also be smaller than usual, in deference to the increased danger.
The first entry follows the pattern: buying or selling a narrow range, pullback or momentum break. Then buy or sell an equal number of shares when the position moves into a profit. Here's the tough part: Sit on your hands if the stock moves in your favor again, even though you're salivating like Pavlov's dog. Remember, your defensive collar is on and it makes no sense to turn a winner into a loser.
Alan Farley provides daily stock picks and commentary with his "Daily Swing Trade" newsletter.
Know What You Own: Other copper companies include Southern Copper( PCU), Sterlite Industries India (SLT) - Get Report, Encore Wire (WIRE) - Get Report, Madeco (MAD) and Taseko Mines (TGB) - Get Report. For more on the value of knowing what you own, visit TheStreet.com's Investing A-to-Z section.
At the time of publication, Farley was long had no positions in the stocks mentioned, although holdings can change at any time.
Alan Farley is a private trader and publisher of
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