# Portfolio Heat: will it save your bacon?



## Zaxon (7 August 2019)

I'm increasingly aware of the need to consider portfolio heat when you hold stocks.  So let me set the scene, and then I'll pose some questions to you.

*What is Portfolio Heat?*
If you hold 10 shares, each with stop-losses and the most you'll lose is 1% per share, then if the market nosedives you could lose 10% of your total portfolio.  Your portfolio heat is 10%.

*Who understands this?*
Traders.  By contrast, investors will usually limit their risk by diversifying across a range of shares (share specific risk), by then won't protect themselves against whole market risk.  "Time in the market" approach.

I'm of the opinion that if you set stop-losses (or price related exits) on individual shares at all, then you should also be factoring in your total market exposure.  These concepts go hand-in-hand.

*Questions:*

*Can we agree on the definition?*
@peter2 uses two terms: *Portfolio heat* is your total money at risk in the market, and *Capital at Risk* assumes that whenever a position's stop reaches break even or above, that money is now risk free (at least I think that's his definition).

However, when I google "portfolio heat", I see some commentators who exclude positions that are above BE, and others who include them.  There doesn't seem to be a consensus. How do you people at ASF define portfolio heat?  And if you include all open positions, what term do you give to the risk where you exclude BE positions?

*What do you do with your cash?*
Portfolio heat "theory" has you setting a limit on your amount at risk, say 5%, 10%, etc.  Once a position moves past break even, you can then open a new position.  But in the meantime, you've got all this cash waiting there.  So what do you do with it?

1) The most obvious thing is to keep as cash (say in a HISA, in AAA ETF etc) OR
2) You could park your cash in less volatile securities, such as bonds.  But given that the value of bonds can drop, wouldn't you also have to factor your bond exposure into your total portfolio heat? OR
3) Park your cash in an index fund.  This is crazy talk if you're trying to protect against market crashes.  However, if you asking yourself: "Does my new trading system outperform the index in practice?  I don't know.";  then hedging your trading system risk by keeping the unallocated cash in an index fund, could make sense.

So what's the best place to store you cash as you're waiting for your portfolio heat to cool down to open your next position?


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## aus_trader (8 August 2019)

I keep my unused cash in HISA and only plan to move money into Gold related or Bonds type of investments if I don't need to take it back in the medium to longer term. I don't see the added complication of short term gains/losses from Gold/Bonds adding any value.

So money transferred between HISA and stock broking account for share trading. Longer term investments such as Gold/Bonds to be left alone.

That part is easy.

What's not so easy is to answer the thread question regarding portfolio heat. I don't have an exact answer but I also limit damage by scaling into the market rather than being fully invested at the first sign of bullish sign after a sell off. When I say 'scale in' I mean buy a few stocks at a time and allow them to rise with the market for a bit before buying more stocks and so forth. Yes, that means I am very late into a bull market before fully invested but I tend to tread on the cautious side.


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## Zaxon (8 August 2019)

aus_trader said:


> I keep my unused cash in HISA and only plan to move money into Gold related or Bonds type of investments if I don't need to take it back in the medium to longer term. I don't see the added complication of short term gains/losses from Gold/Bonds adding any value.



That make sense.


aus_trader said:


> I don't have an exact answer but I also limit damage by scaling into the market rather than being fully invested at the first sign of bullish sign after a sell off. When I say 'scale in' I mean buy a few stocks at a time and allow them to rise with the market for a bit before buying more stocks and so forth.



That's in keeping with the principles of portfolio heat: make your existing shares in the market become profitable before putting in new money.  Particularly in a high volatility market, that's an excellent way of protecting yourself.


aus_trader said:


> Yes, that means I am very late into a bull market before fully invested but I tend to tread on the cautious side.



That is the cost, for sure.  People will quote statistics like "the market made most of its gains in just 4 days.  If you weren't in, you missed out".  So it's definitely a risk mitigation vs potential reward equation here.  The other side of that coin is where the market starts to recover...but it's fake...and has another drop.  A cautious investor, like yourself, wouldn't have that many positions at that point, anyway.


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## $20shoes (8 August 2019)

Zaxon said:


> I'm increasingly aware of the need to consider portfolio heat when you hold stocks.  So let me set the scene, and then I'll pose some questions to you.
> 
> *Questions:*
> 
> ...




I use these two in my trading and Portfolio Heat is your open exposure to the market. The greater the gap between price and your trailing stop, the higher the Heat (more open profits can be lost in a downswing to your stop). As prices fall and close in on your TS, the smaller the Heat. This doesnt factor in if your trades are in the black or in the red.

I always take Capital At Risk is my OPEN capital position +cash; essentially my total open exposure to the market regardless of if I'm in the black or not, PLUS cash position. 

Someone might adjust their trailing stops, as market conditions dictate, to maintain their portfolio heat tolerance. A real example of this might be that your current heat level won't allow you to take another position (or perhaps force you to take a reduced position). Or even that you may need to aggressively tighten stops to reduce your heat to such an extent that you can now place a new open position in the market.


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## Zaxon (8 August 2019)

$20shoes said:


> I use these two in my trading and Portfolio Heat is your open exposure to the market. The greater the gap between price and your trailing stop, the higher the Heat (more open profits can be lost in a downswing to your stop). As prices fall and close in on your TS, the smaller the Heat. This doesnt factor in if your trades are in the black or in the red.



Interesting.  So you share the same definition of Portfolio Heat: the risk of all open positions, but you have a different definition of Capital at Risk.  I'm not surprised.  Google "capital at risk", and everyone uses it informally to mean whatever they want.  Do you have a term for portfolio heat - positions above break even?


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## systematic (8 August 2019)

It's not a relevant concept to me, as I guess I consider my capital 100% at risk, however I have always heard traders refer to portfolio heat as the current aggregate risk of total capital based on current stop levels.
Simply, if you are risking 2% of capital per trade and you have 5 trades open, your portfolio heat is 10%.  This is continually monitored to keep trades within your desirable portfolio heat.

It's another area for testing - i.e. the same system (entry, stop and exit rules) will produce different results based on portfolio heat.


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## peter2 (8 August 2019)

Portfolio heat is a term that represents the downside exposure of your portfolio. As *systematic* mentions it could be 100% as the market can close at any time. Yes, the ASX has closed for short periods of time and the US markets closed for a few days after the 9/11 terrorist attack.

The amount of downside exposure that we select is an arbitrary amount because we can never know what our actual selling price will be. In periods of increased volatility prices can drop below our exit trigger and combined with thin bid volume we may realise a much bigger loss than planned.

It's important to know two things about you and your portfolio heat.
(i) What's your own risk tolerance? How much downside exposure are you comfortable with?
Individual shares and the whole market can drop quickly.

(ii) How much portfolio heat does your system need to operate effectively?
If you're uncomfortable with the amount then it's highly likely that you won't allow the system to operate normally and you'll get sub-standard performance. You''ll blame the system but it'll be your fault.

edit: Whatever level of downside exposure (portfolio heat) that you select, be prepared to experience it multiple times during your trading/investment journey.


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## Zaxon (8 August 2019)

peter2 said:


> Portfolio heat is a term that represents the downside exposure of your portfolio. As *systematic* mentions it could be 100% as the market can close at any time. The amount of downside exposure that we select is an arbitrary amount because we can never know what our actual selling price will be. In periods of increased volatility prices can drop below our exit trigger and combined with thin bid volume we may realise a much bigger loss than planned.



This comes from your post.  How are the Capital at Risk and Total Portfolio Heat percentages calculated here?


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## peter2 (8 August 2019)

From the pic posted above.

*Portfolio heat* is the sum of open EOD P&L - current trailing stop (exit stop) for all trades.
ie (0.6-0.5)+(1.7-0.3)+(0.4-0)+(0.6-0)+ . . .   = 4.1% (= Total downside exposure)

*Capital at risk* is the sum of all trades where there's still some original capital at risk.
ie 0.5+0.9+0.7+0.6 = 2.7%  (four trades at the bottom of the table).
The cap risk limit in the pic is 5% so that leaves 2.3% to use. This means I could start another 3 trades risking 0.8% each.

Once a trade has it's exit stop above BE there's no initial capital at risk (unless there's a huge gap down).
I use the Capital at risk parameter to control the number of trades that I start. It's easy to get carried away by all the buy signals and end up starting too many trades at a time when it would be wiser to be cautious. This is one of the modifications I use to avoid a 10% DD when using a system that has regular 20% DDs. Other modifications include the application of a market filter and some active management guidelines


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## Zaxon (9 August 2019)

peter2 said:


> From the pic posted above.
> 
> *Portfolio heat* is the sum of open EOD P&L - current trailing stop (exit stop) for all trades.
> ie (0.6-0.5)+(1.7-0.3)+(0.4-0)+(0.6-0)+ . . .   = 4.1% (= Total downside exposure)



Interesting.  I'll do some math to try and replicate your figures.

Using DTL from your above table, I get


or 9.1% profit.

Your table has 0.6% profit for this entry (DTL).  I'm therefore assuming that is the 9.1% / initial portfolio value (or something like that).  Digging through your P2 Weekly thread, I see you started out with $222k.

So redoing the math, (I don't know whether you're still using the original $222k or if you're using the current portfolio net worth, but I'll go with the original for now) we get:




which agrees with your 0.6% in your table.  Is that your math?


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## peter2 (9 August 2019)

Looks like you've reverse engineered that perfectly.


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## peter2 (9 August 2019)

Will knowing your portfolio heat, save your bacon? NO 
Portfolio heat is the downside exposure that you're comfortable with in order to earn the rewards you seek. 
Most people overestimate the amount of downside exposure that they're really comfortable with. Think back a few days, did you worry when the market fell solidly for two days? How will you feel if the market continues to fall? A few people commented on how they were going to handle their portfolios after the second down day. Were they worried? No, because they've seen it before and expect it to happen. 

Whenever I start a new trading plan the first question I ask is what is the expected downside exposure for this plan? Can I handle that? Will I continue to stick to the plan when I find myself losing? 

Then, I consider, is the reward worth it?


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## Zaxon (9 August 2019)

Alrighty then.  I will convert this into formula type language that could be useful when putting together a spreadsheet, etc.

Portfolio Heat (per share) =
 ((share_price - stop_loss_price) * num_units_held) / total_portfolio_value * 100

Capital at Risk (per share) =
  if (stop_loss_price >= entry_price) then 0
  else ((entry_price - stop_loss_price) * num_units_held) / total_portfolio_value * 100


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## Joules MM1 (10 August 2019)

*



			Chris Weston
		
Click to expand...


*


> ‏ @*ChrisWeston_PS*






> Aug 7
> 
> 
> 
> ...



https://www.traderfest2019.com/home?utm_medium=social&utm_source=twitter&utm_campaign=trader-fest


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## Newt (11 August 2019)

Portfolio heat, or the sum of profits above stop loss for all your holdings, is also useful to help your mindset around monitoring open profits.  I've found focusing on open profit adjusted for "open risk" helps me deal with the inevitable rapid market falls into drawdown.   As a systematic trend trader, its no use getting excited over long periods of climbing profits if you blow your cool after a few down days.  

Its no fun seeing open profit evaporate quickly, but they're never really your profits until you book them and you usually shouldn't be doing that until price closes below trailing stops (thinking weekly trend following here).


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## Zaxon (11 August 2019)

Newt said:


> Portfolio heat, or the sum of profits above stop loss for all your holdings, is also useful to help your mindset around monitoring open profits.  I've found focusing on open profit adjusted for "open risk" helps me deal with the inevitable rapid market falls into drawdown.



"profit adjust for open risk" - can you explain what you mean here?  And what percentage portfolio heat do you allow in your portfolio?


Newt said:


> As a systematic trend trader, its no use getting excited over long periods of climbing profits if you blow your cool after a few down days.
> Its no fun seeing open profit evaporate quickly, but they're never really your profits until you book them and you usually shouldn't be doing that until price closes below trailing stops



Agreed.  It's very easy to give those profits back.  And the market doesn't even have to go down. If it goes sideways for a while, and the market is volatile enough, you can get whipsawed out.


Newt said:


> (thinking weekly trend following here).



Weekly, OK.  What's your average holding period?


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## willoneau (11 August 2019)

I think portfolio heat has to be taken in consideration with the type of risk management you are using.


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## willoneau (11 August 2019)

Is your stock selection governed by max stocks you can hold or max risk to Capital you are trading.
The way I see it with Peter2 if I'm correct he will continue to add stocks while his portfolio heat remains under certain %. So he will in theory have no limit to the number of stocks he can hold in a bull market the way I see it.


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## Zaxon (11 August 2019)

willoneau said:


> The way I see it with Peter2 if I'm correct he will continue to add stocks while his portfolio heat remains under certain %. So he will in theory have no limit to the number of stocks he can hold in a bull market the way I see it.



Not quite.  Portfolio heat ignores whether a position is in profit or not.  So if you factor that in, you'll hit a limit fairly quickly.  Capital at risk allows you to remove any portfolio heat that is in profit.  So as each position becomes entirely profit, you just keep adding more.


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## willoneau (11 August 2019)

Why does portfolio heat ignore if a position is in profit?
What is it measuring?
If all your positions are in profit and your trailing stop is above your entry price what is your portfolio heat?
are you including paper profits as capital also at risk?


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## willoneau (11 August 2019)

I did read some were that a % of heat has to be added to positions above BE to allow for some risk or you could get the scenario of unlimited positions.


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## willoneau (11 August 2019)

30 positions no stop 100% portfolio heat.
Add a trailing stop and heat is reduced.
I think the question is do you consider open profits as yours or only closed positions in bank?


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## Zaxon (11 August 2019)

willoneau said:


> Why does portfolio heat ignore if a position is in profit?
> What is it measuring?
> If all your positions are in profit and your trailing stop is above your entry price what is your portfolio heat?
> are you including paper profits as capital also at risk?



Should the market crash tomorrow and all your positions be stopped out, there's two separate things you'd want to know.
1) How much outright loss from my current value would I endure?
2) Of my positions which aren't a guaranteed profit (stop < buy-in price), how much would I lose?

Most people call 1) portfolio heat.  We're calling 2) capital at risk.


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## willoneau (11 August 2019)

Unfortunately black swans carn't be managed.


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## Zaxon (11 August 2019)

willoneau said:


> I did read some were that a % of heat has to be added to positions above BE to allow for some risk or you could get the scenario of unlimited positions.



You will.  There's several ways people are using the term "Portfolio heat".  That's why I specifically started this thread, to try and hash out a consensus on exactly what they mean.  The definitions that have arisen from this thread is that portfolio heat doesn't factor in BEs.  Capital at Risk does.  But don't be surprised if you see different people using them, but be meaning different things.


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## Zaxon (11 August 2019)

willoneau said:


> 30 positions no stop 100% portfolio heat.
> Add a trailing stop and heat is reduced.



That's correct.


willoneau said:


> I think the question is do you consider open profits as yours or only closed positions in bank?



For sure.  That's why we've come up with two separate terms, and given them specific meanings.  One factors in profits, the other doesn't.


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## Zaxon (11 August 2019)

willoneau said:


> Unfortunately black swans carn't be managed.



Yup.  Stops are a best case, loss minimization scenario.  They can always be gapped or blown through.  That's why you need to be not too generous in setting your risk levels.  Because the reality can have slippage and missed stops.


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## willoneau (11 August 2019)

Zaxon said:


> Yup.  Stops are a best case, loss minimization scenario.  They can always be gapped or blown through.  That's why you need to be not too generous in setting your risk levels.  Because the reality can have slippage and missed stops.



Not sure what your implying here?


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## willoneau (11 August 2019)

I think you have decide as an individual if open profits are real or not same as open losses.


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## Zaxon (11 August 2019)

willoneau said:


> Not sure what your implying here?



A few days ago, the market went through a rapid drop.  I had stop-losses in place, a number of them fired as Limit Orders, but the shares didn't sell because the current share prices just fell right past them.  I was forced to manually go on and sell them at a price below my original stops.




Common wisdom is that shouldn't risk more than 1-2% of your portfolio.  Let's say that you, personally, are comfortable with 2%.  But because we know that stops aren't guaranteed, I'd say set your stops at 1% (or maybe 1.5%).


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## willoneau (11 August 2019)

Zaxon said:


> A few days ago, the market went through a rapid drop.  I had stop-losses in place, a number of them fired as Limit Orders, but the shares didn't sell because the current share prices just fell right past them.  I was forced to manually go on and sell them at a price below my original stops.
> 
> View attachment 96721
> 
> ...



I also had a number of stocks that went below my trailing stops but because I only put sell orders in when price closes below my stops on Friday I still have those positions.


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## Zaxon (11 August 2019)

willoneau said:


> I think you have decide as an individual if open profits are real or not same as open losses.



And I think that comes down to your trading length.  If you're a short term trader, then you probably always reference back to the amount of money you put in the market originally.  "I've opened 5 positions it cost me $50k, I want to know my risk relative to that."  But if you're an investor (or longer term trader), then you probably think of losses relative to your current portfolio's value.  "I put $50k in the market, I've held it for a few years and it's now $100k.  I want to protect that wealth".


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## willoneau (11 August 2019)

Not sure what your getting at here?
that comment was in reference to portfolio heat calculations.


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## willoneau (11 August 2019)

Take SRG I hold at moment my stop is at 0.465, that is a close below that on Friday will force me to close position.


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## Zaxon (11 August 2019)

willoneau said:


> Not sure what your getting at here?



Which part don't you understand?


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## willoneau (11 August 2019)

Zaxon said:


> And I think that comes down to your trading length.  If you're a short term trader, then you probably always reference back to the amount of money you put in the market originally.  "I've opened 5 positions it cost me $50k, I want to know my risk relative to that."  But if you're an investor (or longer term trader), then you probably think of losses relative to your current portfolio's value.  "I put $50k in the market, I've held it for a few years and it's now $100k.  I want to protect that wealth".



are you saying you put in $50,000 and you have $50,000 in open profits?


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## willoneau (11 August 2019)

Zaxon said:


> Which part don't you understand?



sorry I edited it to give more information while you were replying.


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## Zaxon (11 August 2019)

willoneau said:


> are you saying you put in $50,000 and you have $50,000 in open profits?



Correct in scenario 2.  Scenario 1, the open profit wasn't mentioned, but presumably was much smaller.


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## willoneau (11 August 2019)

How is trading length referenced to portfolio heat?


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## willoneau (11 August 2019)

5 positions 50k cost , risk is distance of stop.
Now is that the portfolio heat?


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## willoneau (11 August 2019)

I believe portfolio heat is not relevant with fixed fractional risk management.


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## Zaxon (11 August 2019)

willoneau said:


> How is trading length referenced to portfolio heat?
> 5 positions 50k cost , risk is distance of stop.
> Now is that the portfolio heat?



Portfolio heat is defined the same in both short and long trading styles.  The difference is how they see Capital at Risk.


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## Zaxon (11 August 2019)

willoneau said:


> I believe portfolio heat is not relevant with fixed fractional risk management.



To some extent that's correct.  It's capital at risk that matters most.  But some people also place an upper limit on portfolio heat.


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## willoneau (11 August 2019)

Totally agree, Capital at risk is either with open positions value or not.


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## willoneau (11 August 2019)

Zaxon said:


> To some extent that's correct.  It's capital at risk that matters most.  But some people also place an upper limit on portfolio heat.



I would say those that probably don't use fixed fractional risk.


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## willoneau (11 August 2019)

% Capital risk would, also very relevant if that % risk varied between positions.
I would be watching portfolio heat if I was scaling in.


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## willoneau (13 August 2019)

I believe portfolio heat only has relevance if you use open position Capital Valuation to determine your next entry size, IMHO.


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## Newt (13 August 2019)

Zaxon said:


> "profit adjust for open risk" - can you explain what you mean here?  And what percentage portfolio heat do you allow in your portfolio?
> 
> Agreed.  It's very easy to give those profits back.  And the market doesn't even have to go down. If it goes sideways for a while, and the market is volatile enough, you can get whipsawed out.
> 
> Weekly, OK.  What's your average holding period?




Hi Zaxon,
Re-reading Pete's posts, what I'm calling Open Profit-Open risk sounds like what he's calling Portfolio heat (open profits/loss versus current trailing stop).

I try to focus on profit/loss of my trailing stop values rather then get excited if open profit suddenly spikes - its a psychology thing.  Its not currently an integral part of my system.

Average holding period is just under 6 months for winners.  I'm fussy about entry criteria and prefer to hold on for long term trends rather than jumping in and out a lot.  There are tax benefits too if you can't get a nice profit held >12 months.  Once the trend has clearly failed, I'm out though.


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