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The New Paradigm in risk management

dates back 100 years


“You have to minimize your losses and try to preserve capital for those very few instances where
you can make a lot in a very short period of time. What you can’t afford to do is throw away your
capital on suboptimal trades.” -Richard Dennis

Almost everyone’s approach to trading is forecasting


price direction, and calculating risk and reward, full
stop.
The new paradigm is direction neutral; it looks at
context first to judge risk and reward, based on market
dynamics.
There are many ways to successfully apply this method
based on your personal risk/reward personality or your
fund investment policy. I will only focus on one here
because I use it. Personally, it is dramatic in its results
and used by an aggressive self-trader or a hedge fund
trader.
There are many reasons why no one else talks about
this method. For one, not many others have this set of
tools, in a phrase I’m writing the book.
The method is not transactional motivated, so it does
not get the attention of the Sell-Side of the industry, nor is it a liquidity provider, based
on you have to be in it to win it.
Getting your head around that meaning puts you miles ahead of the majority.
To understand the method it does not matter if you trade mechanical strategies or trade
a plan based on advisory and visual indicators. The only difference is who (or what) is
seeing the data stream.

With all of that in mind, here is what I mean by “direction neutral.” The trader
determines if the market can get carry over after hitting the entry signal. If yes, the
strategy is allowed to take the trader into the position, no matter if the signal is up or
down.

To drive home the significance of this idea you need to contrast it to the industry
benchmark. One of the pioneers of systems trading -Robert Pardo - in his original text
said the following:

"Let us consider the plus side of the discretionary trader. It is quite simple. The
biggest plus is that, to date, I do not believe that a systematic strategy has yet been
created that equals, let alone exceeds, the performance of the greatest discretionary
traders."

I accept this as true that a robust trading system or a static plan will not make anyone
rich, and that may be one of the reasons why you trade visually with discretion and not
with systematic signals.

In other words, a trading plan or a system – at least the way Bob developed
them – are statistically robust and in practice generic. They are designed to
deal with all the major conditions in the markets going back over the longest period as
possible. They are meant to provide the trader with an average winning trade each time
he takes a position on a regular basis over the long term.

This goal of a trading plan or Algo-strategy is the heart and soul of the system trading
school of thought. The industry is happy with this, and many system’s traders do well.
Furthermore, it is possible your goal to make an average amount of money each day or
week to supplemental income, and the use of automatic systems is a meaningful factor
in achieving that goal.

But as Bob says himself in so many words about system trading, it can be good, but
not “GREAT.” He goes on to point out the following:

"Proof of this concept is available by the mere consideration of a short list of some of
the household names of the greatest discretionary traders. This short list of the greatest
would include legendary billionaires such as George Soros, Paul Tudor Jones, Bruce
Kovner, and T. Boone Pickens."

Well, in my opinion, you can’t argue with that.

One of the legends I study is Stanley Druckenmiller, and it is his notion of risk
management that I set out to understand and replicate. As it turns out he did not have a
corner on the idea. The proper idea of risk management goes back hundreds of years. In
my professional life, it years cuts across all of the legends.

Ideally, “the best risk management is not to take a risk at all.” If you are a poker player
or an experienced investor/trader you know this: you don’t bet on the “if come,” you
only place a wager when you have a circumstance that you know you can win without
anything else occurring to send it on its merry way.

Traders like Jesse Livermore spoke about his first principle that making big money is by
the sitting and the waiting, not the trading. They are waiting until all the factors are in
favor of his trading strategy before making the trade.

The modern-day hedge funds control risk by not taking a risk, but once everything is
100% correct based on their comprehensive system or trade plan checklist,
they enter the markets and, in the words of Druckenmiller, “go for the jugular, they
leverage up throughout the series to maximize profits. This is exactly what the Turtle
Traders do with their trend following systems.

This New Paradigm is easy to understand, once you cut through what the retail industry
and the media publish every day. They overlook the above idea of waiting, ignoring or
considering it trash. The financial media and part of my industry even see investing or
trading only from an act now, happening now, breaking news environment making it
transactional and Vegas type of gambling, which is the opposite of taking no risk!

Everything the legends do is just the opposite of what many in the industry promote, in
their idea of a trading plan where you have to be in it to win it. They only pay lip service
to the great ones and use it to take Social Media polls. But once you take to heart what
the legends say and what it means to implement their wisdom you have advanced your
capabilities beyond the majority.

The key rule of risk management is to avoid risk, do not take on a position until
everything in your model is in your favor. A key rule of opportunity management is once
you are in a position, you go for the gusto; you leverage up systematically to maximize
your profits. Lastly, your forecast and strategy are based 100% on price. The profit trail
is after the fact and has nothing to contribute to your next trade.
To execute these two key rules, you need a strategy to get you in and out of the market
profitably, the basic trade plan if you will. We have all seen strategies that work. There
are many, hundreds of them that are sound with better than average profits; and they all
have periods of profit run-ups and drawdowns.
So this is where your risk management model comes in to tell you when to trade the
strategy and when not to trade it. It will tell you if it is a good time or a bad time or a
great time for the strategy. That makes the New Paradigm a comprehensive investment
or trading SYSTEM.

Long Volatility Strategy just one example

Regardless of how it is measured volatility reflects the difference between the market as
we imagine it to be and the market that exists. It is that tension our model seeks to
measure at its extremes for its outcomes.
If above average performance is achieved moving between short and long volatility
exposure, we will only attain that edge if we relentlessly search for nothing but the truth.
Otherwise, the truth will find us through volatility.
Here is an example of waiting for the 100% set up. The overarching model
for strategy engagement is our Technical Event Model (TEM).
One reason why a few will ignore this idea is they
doubt they will ever find a method that gives them
100% certainly before they get into the market.
This doubt is imbued into all interested parties no
matter what side of the desk they are sitting. It is
in every sales and marketing stripe provided to
salespeople and the foundation of what is feed the
financial media to hit the airways.
The 100% certainly makes the point but in the
real world mark it down to 99% or whatever level
gives you supreme confidence in the strategy you
know works most of the time. Now you’ve got it.
These numbers to the left will make sense relative
to the above approach using TEM. The annual
results are from a short only breakout
scalping system that implements the Turtle money management method.
No one, I mean no one, would give this strategy a second look because they expect to see
year in and year out consistency profits, because you have to be in it to win it, right?
It is easy to see that the strategy had two good years 2008 and 2018, and we all know
they are both high volatility years. But what few people know is that both years preceded
by signals provided by TEM that indicate the year was going to be a high volatility one.
(See our MarektMap January 2018 Newsletters link here.)
In the 14-year history shown above, there is a $53,000 drawdown. So, if one uses
negative thinking and assumes poor timing, then the drawdown is a certainty. Given the
drawdown, a capital manager would need $1,000,000 in funds to have the risk limited
to 5% +/-. So let's assume you have to be engaged the strategy all of the time, and you
can’t know or be confident of a high volatility year.
So Again, taking every trade, you would expect to pick up at least one year in ten of
$182,000 or an 18% return on the account.
However, what if you have a Macro Filter like
TEM that tells you when to engage this long
volatility strategy?
Going into 2018, TMT’s January 18 MarketMap™
suggested the use of this exact system. Here is how
2018 through October would have performed after $32.00 a trade cost to achieve the
$243,528.00, through October, and December not shown was great.
The first thing a risk manager sees is the loss in May, on a million-dollar account, that
amount is a palpable 1.6%.
However, the successful fund manager needs more than one opportunity a decade;
rather he needs to isolate one or two a year? Or, something to fit the trader’s style or
corporate investment structure and policy.

ContraryThinker’s job is to provide the opportunities for its professional's


advisors and managers. To teach traders and advisors what to look for
and how to use the tools we provide. To provide plug-in strategies to use
to take advantage of the setups for all liquid markets and any style or
investment policy.
I look forward to working along with you. Contrary Thinking starts here.

Real Time Example of System Management with TEM


Trader's can manage their money without their profits and losses managing them.

It's easy, use TEM for the clue, the signal that a market condition is about to become profitable
for your strategy, apply it to the market; AND stop trading that strategy when the model is
telling you conditions are about to change into something that is not liked by the strategy.
TEM for the stock indices on a ST basis, the daily bars, had a %C spike January 4 calling for a
trend with HV already expanding, so a period of daily range expansion was expected.
In this chart, I have the iCahnTrade system, which does not have TEM in its code. I trade it with
the visual filter. During that advance, it hit 5 out of 8 for a net $5,175.00.
When the TE#3 hit, I stop trading and avoided three losses in a row, that would have cost me
over the 5k it made with a loss of $4,680.00 in today's trade.

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Great and Many Thanks,

Jack F. Cahn, CMT


A Thinking Man’s Trader Since 1989,
Copyright 1989-2018
Individuals and Family Capital Managers Visit: www.thinkingmanstrader.com
Capital Managers and Professional Investment Advisors visit:
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