The 10 percent solution

An interesting trade-management compromise between the low-probability, (potential) high-reward method of scaling up into a position and the high-probability, low-reward technique of scaling down into a trade is something I call the 10-percent solution, which I picked up from a trader on one of the FX trading bulletin boards.

Let’s suppose once again we would like to short the EUR/USD pair at 1.2500. For simplicity’s sake, we are willing to risk 100 points and seek a 100-point target on the trade. In other words, our stop is at 1.2600 and our target is at 1.2400.

Let’s further imagine we will trade 10 mini-lot contracts with total notional value of 100,000 units. We place our short at 1.2500. However, here is the rub. Instead of stopping out at 1.2600 with the whole position, we place stops at 10-point intervals for 10 percent of the position. So, if the trade moves against us by 10 points we would sell one mini lot, leaving us with nine mini lots (90,000 units) in the trade.

If the trade moves 20 points counter to our entry we would sell one more mini lot, leaving us with 80,000 units — and so on, until the price reached our ultimate stop-out value of 1.2600, at which point we would only have to liquidate one mini lot left in our inventory.

On the opposite side we would maintain our target of 100-point profit regardless of how many lots we had left, so if we got stopped out on three mini lots but prices then turned in our favor we would harvest a 100-point profit on the remaining seven lots.

Think about the implications of this strategy for a moment. In the original trade we risked 100 points on 10 mini lots or a total of 1,000 points (100 * 10 = 1,000). Using this compromise stop-out approach we were able to winnow down the total loss from 1,000 points to only 550 points if the trade became a complete bust.

However, if the trade turned in our favor at any time before reaching the eighth stop-out, we would still have been able to bank a gain. The attractiveness of this approach is twofold. It automatically reduces risk if the trade moves against you, but it allows the trader to partially remain in the trade up to the very last moment. Not only is this a good practice of risk management but it is also a very clever way to get the trader to actually accept his stops. Just like a mother who feeds her baby medicine in tiny little portions in order to make it more palatable, this technique forces the trader to do what is best for his account with minimal psychological damage.

Steve Cohen, probably the greatest trader in the world today — so good that he is able to charge 50 percent of gross profits in his multibillion-dollar hedge fund STC Capital — once said in an interview with Jack Schwager in Stock Market Wizards (Harper-Collins, 2001), “What happens when you are short a stock that is moving against you, and there is no imminent catalyst? I always tell my traders, ‘If you think you’re wrong, or if the market is moving against you and you don’t know why, take in half. You can always put it on again.’”

When I first read that comment it went in one ear and out the other. But upon further reflection, I realized Steve Cohen was practicing just this type of risk control methodology for all of his trading.

The 10-percent solution strategy is only a template. We need not scale out at every 10 percent of the distance to the ultimate stop. We could use 20 percent, 25 percent, 33 percent, or any other type of ratio that makes sense. The strategy can also be refined further to enhance the probability of success, though at a cost to profitability.

For example, instead of keeping the profit target at a static 100 points from original entry, we could adjust the target in response to price action. If the price moved 10 points against our position we could reduce the profit target by 10 points, so that instead of 1.2400, we would decrease the profit target for our short to 1.2410; if the price moved 20 points we would decrease the profit target to 1.2420. It shows what happens when the system is adjusted in such manner.

Note that while the profitability of each trade is somewhat reduced, the probability of the success for each trade is likely to be better as it needs to travel less and less distance in order to reach the profit target.