Many discussions about irresponsible trading in unsustainable assets revolve around the problem that most parabolic rallies in hyped-up areas of the market come crashing down eventually. “This will end badly” is a very common comment, which has always sounded a bit non-sensical to me – the only traders that are likely to stick around until the end are the ones without a plan! At the same time, many of these bubbles contain significant opportunities for life-changing profits as they inflate, because they can go on for quite a long time – making prudent traders look on with suppressed FOMO wishing they were participating.

In current markets a lot of extreme exuberance is visible and we all know that that is dangerous – fingers will get burned eventually. But plenty of people aren’t resisting the urge to buy 2x leveraged MicroStrategy ETFs (just to pick a popular example), based on a company that is a leveraged Bitcoin vehicle in itself, which again is an extremely volatile asset with similar characteristics to a 3x leveraged Nasdaq ETF – leverage upon leverage upon leverage, which, of course, cuts both ways. 

In my mind there is a simple, practical workaround to the problem of trading hyped-up-assets if speculative trade ideas are implemented purely from a risk management perspective: A position is opened with clearly defined risk and, once it successfully shows a profit, the position size is increased. From that moment on a break-even stop loss protects the initial capital. It is important to not get sucked into the narrative of a bubble security, but stick to following price with an agnostic stance. There is no “this will end badly,” because in that case the position would simply stop out early without a loss and we can start with a fresh idea.

Now the only thing left to do is to go out and find great speculative ideas with an edge!

Pyramiding Positive Positions

This technique enables traders to ramp up exposure in speculative trades without taking excessive risks of loss of capital. I use this method whenever my analysis points to a decent chance of an extended trend in an asset or security, because outsized positions can occasionally lead to very high profits. It is possible to participate in a strong macro environment, hype or bubble that may turn on a dime, because the opportunity is allowed to unfold, while the trade is managed by controlling risk.

Take care of the downside, and the upside will take care of itself.

1. Entry: The key idea when opening a position is to find a setup that allows for a meaningful position size with tightly controlled risk via stop loss, which defines the trade’s maximum loss of initial capital in case it doesn’t work out. The commonly used rule of thumb to risk around 1% of capital (0,5%-2%) per trade works very well in practice. The size of the initial position is defined by the distance of the stop loss from the entry price:
   Position size (number of shares) = 1% Capital / (Entry – Stop)
   A variety of technical setups that enter in the direction of a major trend using a close, logical stop loss exit can be used. For example, a re-test of a support level or moving average, volatility contraction pattern breakouts, as well as other methods work well.
   Many setup structures can have an edge, if they enable a stop loss that is close to the entry price, but has a relatively low probability of being hit (this relative probability can vary greatly in practice, depending on the trade’s reward-to-risk ratio – there are highly successful traders using super-tight stops with win rates as low as 25%). Identifying such setups with an edge is the job of a good trading strategy.
   Leveraged instruments can be used to enhance capital efficiency, which permits to trade several ideas in parallel. Their use also allows low-volatility assets to be viewed as equivalent opportunities to fast-moving, volatile securities by adjusting leverage factors to asset volatility (a concept similar to risk parity).
   Take care to never exceed your risk limit on each trade and mind the potential correlation of simultaneous trades. I limit myself to 2-3 uncorrelated ideas at a time, allowing myself to add more trades only when successful positions have reached their break-even point.
2. Trailing Stop: After the entry, the stop loss level is trailed up as soon as the trade becomes profitable. Good, common sense levels for stops are below higher lows or below a significant moving average (e.g. the 10, 20 or 50 dma).
3. Pyramiding Entry: As soon as the trailing stop has moved up to a profitable level that allows an increased position to exit at break even using a logical stop loss point, we can pyramid the position size. The parameters can vary according to individual sizing preferences, which influences the timing – I personally like to increase positions by 50% at a time. A new setup can be used to add size, for example at a breakout after a minor consolidation or using a pullback to a short-term moving average.
   The crucial point is that the entire trade should never be allowed to end in a loss from this point on. The trailing stop must result in exiting at break even or better. Our initial capital is now protected, because the most we can give back are unrealized gains before stopping out. It pays to analyze gap risks when trading individual securities or assets prone to large gaps, because outsized overnight gaps against open positions are a risk that remains beyond our control.
4. Repeat: One can pyramid repeatedly until a desired position size is reached. The final position size should end up to be somewhat worrying, but not cause sleepless nights, which ensures it is meaningful yet stays manageable. I tend to add twice in the initial phase, doubling my position, if the trade goes my way, before looking to book some profits. 
5. Profit Taking: As a rule of thumb, I will try to minimize potential regret by realizing some profits along the way, while holding on to the trade’s potential for outsized gains. To achieve this, I aim to keep the final position size constant – i.e. I will sell 10-25% of the position for every 10-25% it gains in value. Often my trade setups will come with profit targets to implement this basic rule.
   As the trade progresses, new setups can show up at higher prices, which I may use to add back to the position. With an increased book-profit buffer, I give the trade more room by loosening the trailing stop, which effectively increases the time horizon of my trade. While the initial setup is usually short-term (it may even be intraday), the time frame moves to medium- to long-term, when the trade works well.
   However, with increasing gains, I want to make sure that my trailing stop will also lock in a rising profit by gradually moving it further and further above break even over time.
6. Exit: Very often the trailing stop loss will take care of the exit. But at major medium- to long-term profit targets, I look to significantly decrease my position or exit altogether. In my mind, the risk of a consolidation period, which might easily hit my trailing stop, rises significantly at well-placed targets. Once a deep pullback has passed and new setups present themselves, I can always enter a new trade. Profit targets can be derived by looking at the upper ceiling of trend channels, historical precedents (the length of past trends), measured moves of breakouts from significant structures (e.g. bull flags, cup-and-handles, etc.), or other methods.

Bitcoin Example

To visualize the concept, let me go through a Bitcoin trade that I still have on currently. I like this asset as an example, because it polarizes like few others. Many opinionated pundits tell you it is bound to go to zero, while others target a price of several million dollars per Bitcoin, as if this were inevitable (spoiler alert: nothing is ever inevitable in financial markets).
No matter your position, or if you just spot an opportunity without a decisive opinion, it simply does not matter for the trade’s implementation. You may remain completely uncertain about the asset’s long-term future and merely follow a strong trend, or be extremely convinced by a bullish thesis, just as long as you heed price and act according to a plan.

My initial entry was taken at $67,600 after a breakout above a falling trendline within a multi-month consolidation area provided multiple entry opportunities with a well-defined stop loss point below a recent low at $58,660. These two points determine my position size, as my initial risk is $8,940 per Bitcoin. For a hypothetical $100,000 portfolio a 1% risk thus translates into a buy order of 0.112 Bitcoin amounting to $7,571. You can see that due to the high volatility of the asset and a wide stop the position size is relatively tame at roughly 7.5% of available capital – it aims to be a low-stress, multi-month trade. 

After a while, Bitcoin begins to move up and breaks above the high point of the consolidation. A second position, half the size of the first, is added at $74,600 with a combined break-even price of $69,933. This is the point in the trade where it is most likely to get stopped out, because the break-even exit is only $4,667 below.

However, Bitcoin quickly moves higher and I begin to trail my stop up via the 50-day simple moving average. Around $90,000 a small consolidation forms and I add a third position above the consolidation, again at half the size of the first, at $91,900, which brings my average entry price to $75,425 for 0.224 Bitcoin amounting to an expense of $16,895.

I now own a sizable position of roughly 17% of my initial capital, which most traditional portfolio managers would consider imprudently large for such a volatile asset, but my trailing stop ensures a slowly rising profit with minimal risk to my stake. Of course, by using a tighter initial stop, this trade could be run even more aggressively, while still controlling risk diligently!

During the rise above $100,000, I trim my position by 10% for every 10% Bitcoin gains in value to pocket enough profit to make the trade worthwhile even if the trend should suddenly turn. This keeps the position size constant at around $17k. At my first major target at $111,000 I plan to reduce the trade for a nice profit and no sweat despite its size.

Trade Philosophy

The big picture idea is to participate in a strong trend with an outsized position, while minimizing regret should it fizzle out prematurely. By definition, major trends come around only every so often and those times are hard to predict. The purpose of this technique is to be in a trend, that coincidentally turns out to be a major move, with significant size. The expectation is that small losses, restricted to around 1% of capital or less, will happen often, as will small gains, but life-changing profits that occur seldom make all the difference. This results in a divergent, positively-skewed return profile, which counterbalances the many convergent, negatively-skewed risks that dominate most portfolios.

I think, such a risk-managed approach using tight stop losses in a trade setup with an edge is the secret sauce that actually makes many momentum-based trading styles so successful. The momentum factor provides the basic edge honed by individual entry setups, while outsized profits are purely a function of very large position sizes with a laser-focus on minimizing the risk to lose capital. Arguably, risk management is the most important element of such a trading strategy, much more so than the entry setup.

Psychologically, employing a rigid plan to deal with speculation serves as a crutch to tame FOMO and control risk using some mental accounting: Risking only unrealized profits makes it much easier to take losses when speculative assets suddenly draw down from their highs – the open P/L is not quite the same as real money in our mind.

The entire process automatically gives a portfolio positive structure, as only profitable positions remain on the book. This is a huge advantage, because loss aversion often leads to a portfolio salad – it is littered with deeply-red legacy positions that are psychologically difficult to purge. The downside is that such a strategy always carries the potential that big, unrealized profits will be given back, because it looks to capitalize on outsized trends, which are rather rare.

But isn’t that an easily tolerable risk, as long as your initial capital is protected?

Good luck with your investments, and thank you for reading!

David

This is not financial advice.
These are my own views, as I may implement them in my own portfolio.
Please do your own due diligence!

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