Tier into Positions to Lower Your Trading Risk

Gilbert “Gman” Mendez is the Head Trader at SMB Capital.

Many traders focus on trading ideas and trading setups and forget to develop execution skills. I do not believe in just finding the setup, identifying the proper stop, waiting for the entry and bang you are done. I would even argue that with the proper execution skills you can make money on a trade setup that did not work out. Today I want to offer an execution trick I use everyday for my trading that gives me the opportunity to be wrong on a setup and yet be able to profit from it in some cases—heads I win… tails I win.

There is a linear relationship between the risk and probability of setups; normally the higher the probability of the setup the higher the risk in the play. Conversely, the risk is the lowest when the probability of the trade is fairly low. The execution “system” I propose takes advantage of this concept: Start a small position when the setup is developing or when the probability is lower and use the open profits to press on your normal entry. This allows you to have more size for the actual break, have a much better average entry price, and have a lower risk, or even no risk at all, on the play.

Let me illustrate this with an example. Let’s take a look at the following chart of LVS where we wanted to be involved if the stock got above 20.5 as it is a big technical level on the daily and weekly charts. The average trader would look pay the break and put a stop below a support area, most likely around 19.90.

The way I would look to swing trade the play is by initiating with a small position on the pullback to the trend line (around 19-19.20 area) while risking a very small amount and adding size on the actual break at 20.5. For the sake of the example let’s just make some assumptions: One, I would want to risk $1k on the break out play by paying 20.5. Thus I would only be allowed to pay for about 1600 shares. Two, I want to risk only $100 on that first trade – the buy into the pullback of the trendline. Three, my hard stop for the whole trade is 19.9 after buying the break. Four, I have to use my tape reading skills to determine the stop in cents on my initial trade to figure out how much size I can start with.

So say you pick up 500 at $19 and risk to below 18.8. If that trade holds and you get the break at 20.5 then you end up with 500 @ 19 + 1600 @ 20.5 = 2100 @ 20.14. So if the trade doesn’t work then you only lose 24c or $504 on the trade.

But what if you saw something on the tape down there and were able to spot a place where your risk would have been 5c instead of the 20c from the previous example? Then you can pick up 2k shares on the first trade and you end up with 2k @ 19 + 1600 @ 20.5 = 3600 @ 19.66 on the break– twice as much size as standard break trade and with an average price a whopping 25c lower than the stop for the entire position. If the trade were not to work out you would still end up making about $864.

You can use this concept for any other type of setup. We have one trader at our firm that does this very well and for almost every single one of his trades. Always starts by risking about $20 on a scalp trade and leverages that first entry to make $500-1000 trades. Yes he doesn’t crush that many of them but you can’t beat that risk:reward.

So there you have it a simple yet powerful way to minimize your trading risk. Yes, you will get stopped out often on the initial entry but that is why you do shouldn’t risk much on those. But the key to this is that you need to develop tape reading skills to be able to spot those places for your first entry. The better you are at identifying your risk on that initial entry, the bigger your trade will get on the confirmation. And when the stock trades cleanly and you get lucky you can really crush it while taking NO big risk. For the record I legitimately hit the bottom below 19 in LVS but was able to get back in MUCH smaller above 19.5 and then pressed above 20.2 and 20.5. That was a little chipper.

Happy trading!