Friday, July 24, 2009

Risk in the SPY

Risk is the most important part of trading and investing. For a trader the question is: How much am I willing to lose in order to have potential for gain? For an investor, the question is at what price am I able to get an attractive return to compensate for the uncertainty of future cash flows in a company.

The chart below tells me when the market is "risky". All of my investment decisions are made by entering a market when risk is low and exiting when risk is high. The zero line on this chart is considered low risk while the positive and negative extremes are considered high risk. Currently, my position is long, however I reduced my position size yesterday because of what is historically a relatively high amount of risk. I will return to full investment when risk is lower.

What is counterintuitive is that I could reestablish a position at a higher price but my % at risk could be lower. Such is the case with dynamic position sizing in a reversal based trading system.

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