Thursday, January 19, 2006

Stop Theories

The most difficult question in trading for me is deciding: Where is my Stop. Use a small Stop and you might die the slow death of a 1000 stops, use a wide stop and a few Stops in a row have the power to really hurt you.

The Stop should not be determined by your account size. Imho it needs to be a logical Stop determined by your charts and your trading plan. You have to decide in advance: Where am I wrong. At what pricelevel will my tradesignal no longer be present.

It all boils down to something not very appreciated in our fast instant gratification world: Screentime.

Know what you trade...really know it.
It's one of the reasons I left the stockworld and now trade futures. There are just a finite number of futures worth trading. And after a time you know them. Sure they still can surprise you, but usually they behave within their personalities, which allows you to decide in advance, what Stops are appropriate to trade a specific futures contract at a certain time of the day.

Taking a Stop means your account goes down, because you have to admit you are wrong, that the position was a failure, that you lost and admitting that we are wrong is something humans are not good at. Sometimes I have the feeling, that women are better traders than men just because they are not as stubborn as men when it comes to admitting failure.

Now there are different ways to deal with Stops:
1. There are the traders, who use no Stop at all.
2. Some traders use very small Stops (2 to 6 ticks)
3. Some traders use dollar-based fixed stops. EG the Stop is always 10 ticks or 125$/contract
4. Other traders determine certain Support and Resistance levels and place the Stops around (usually outside) of these levels.
5. Or Stops might be calculated based on a certain percentage of invested capital respectively based on a Risk : Reward calculation.

Is any of these methods wrong? Just the first one most of you will agree. But nonetheless it?s the method implemented by most of the traders around the world.

Trading with no Stop
Markets fluctuate. It was none but Alan Greenspan telling this truth about the markets when asked for the reasons for the Black Monday.
And there is a lot of truth in this statement. If markets fluctuate, if they swing back and forth there is no reason why you should lose in the Stock market. Unless you happen to be the unlucky trader who picked the Top or Bottom prices will return to your position and you will be able to get out with a profit.

Just as an example of so many Stocks maybe you remember JDSU

JDSU was a 1 digit stock and is now again a 1 digit stock. Nothing happened. If you went short at 10$ in 1999 and covered last summer around 1.50$ you made 8.50$ / 1$ invested in the short. 850% not a bad return for a 7 year investment. Of course you saw your short going to above 153$ in between. Markets can remain illogical a lot longer than you have capital to finance it.
But this example is great to show you, why you need to use Stops. Your capital was frozen in the short for 7 years. During that time a Stop/Reverse strategy could have made a lot more out of the same capital invested.

Take a Stop at 20$, go Long for the ride up, cover and reverse when the double Top was in place and make not 850% but

Short at 10$, cover and reverse at 20$,
Long 20$, cover and reverse at 100$ for +80$
Short 100$, Cover and Reverse at 1.50$ for +98.50$

Total: -10$+80$+98.50$=168.50$ or 16850% increase on the invested capital in the same 7 years

Btw. If you happen to think GOOG is expensive right now, take a look at the frenzy just a few years back. JDSU as a lot of other stocks made it from 1 digit stocks to 3 digit stocks. GOOG started around 100$ and quadrupled until today. That's like JDSU or another stock going from 10$ to 40$, something which was common place in the second half of 1999

Trading with small Stops
It has some appeal. You risk maximum 50$-75$ per contract, if you give your position 4-6 ticks room. But unless you have extraordinary good entries, you will face a lot more Stops than Winners. Also you will see quite a lot of trades go your way after being stopped. 4-6 ticks is less than the intrabar range on 1 minute bars of most of the futures I trade.
Of course, if you trade for a profit of 4-8 ticks, then a 4-6 tick Stop is reasonable. But you can?t expect 40 tick winners regularly, if you are willing to risk just 4 ticks. The markets take care of that. Most traders trading with small stops will therefore face the death of a 1000 Stops. 50$ here, 75$ there (plus commission of course), might not sound a lot, but with a 60% loss rate, it can and will make sure, your account will go down to zero sooner or later.
You have no 60% loss rate. Great! But most traders trading with small stops usually will have it, as timing the entry so good, that you usually hit the top or bottom with 3 ticks room is nearly impossible. Trading requires taking financial risks and to make profits, you will have to accept, that your positions go a few ticks against you during the trade.

Trading with fixed Stops
It has the big advantage, that you always know exactly, what you are willing to risk in the trade. And if the amount is set in a way, that you won't get wiggled out of your position by a small movement against your position, there is nothing to argue against trading with a fixed Stop. Just one thing. Take your entries in a way, that your Stop will be the other side of a clear support or resistance line.

EG: If you trade Eur/USD with a 10 tick Stop. You go long at 1.2005, Stop 1.1995 as you know, that 1.2000, being a nice round number, will provide support in case Euro tests this level again. On the other hand an entry at 1.2012 will place your Stop at 1.2002 something to be avoided as we all know that the market likes to test round numbers, so it might hit your Stop and immediatly reverse to goto your target at 1.2025. Something really frustrating and to be avoided by better trade planning in advance.

Stops around Support and Resistance levels.
That's the Stop which makes most sense to me and a lot of other traders as well, which is actually a drawback for this type of Stop. Because the market knows where the Stops are clustered and will try to take them out just to turn and rally right after taking them. Still, if you have a clear Support/Resistance and you take the trade on the presumption that this S/R will hold, placing the Stop on the other side makes the most sense to me, as when hit not only your signal failed, but also the S/R on the chart is broken and you might in fact look for a reversal trade.

Stops calculated to be a certain percentage of invested capital:
The Stop being a percentage of the invested capital makes sense on the one hand, as it makes sure, you have enough left, when the trade goes against you. But it faces the problem, that the Stop might not be the most logical choice, if you use charts and technical analysis. Consequence is, that you need to consider your Stop, when you take your entry and that you can't take some signals your system is giving you.

Stops calculated on a Risk:Reward basis
Trading literature suggests you should not trade unless you expect a 1:4 Risk:Reward outcome of the trade. That means for every 100$ you risk in a trade, you expect to earn 400$. Literature and reality differ, at least for me and most of the daytraders I know. If you get a 1 : 2 rate on average you are good, 1 : 3 is exceptionell and 1 : 1 or worse is the reality for most. You can still be profitable with a 1 : 1 rate, if you have more winners than losers, but it's getting difficult.
Let's look at a common example:
A trader trading the Russel 2000 futures. On a 3 or 5 minute chart the ER2 has a 9 - 10 tick wiggle range, meaning on average a 3 or 5min bar is 9 - 10 ticks. A reasonable stop on the ER2 should be outside of this wiggle range or you risk getting stopped on a valid signal due to the volatility of the contract. Say you use a 12 tick stop, so based on the above you should enter only when you expect 24 or 36 ticks profit. Unfortunatly most ER2 runs go just 20 or 30 ticks before you see it stalling and reversing. The move might continue or the move might really turn. You can't know it in advance. As most of the signals don't get you in at the low or high and the same goes for exit signals, you have 10 to 17 ticks potential profit in your trade before you have to expect a reversal. 10 to 17 ticks profit calls for a 5 to 8 tick stop, if you use a 1 : 2 ratio trading ER2. For me, that's too small as my entries aren't so good to allow these small stops on ER2. There are traders who can trade with these stops but most I know use 10 to 12 ticks and are happy to take 5, 10 or 15 ticks in their trade. So in effect they trade with a 1 : 1 ratio and know or hope, that they have significantly more winners than losers.

Does that mean: Forget about Stops based on Risk : reward. No. But you need to know the timeframe you trade and know, what you can expect from the trading vehicle you trade. The longer the timeframe the easier it is to use a Stop based on Risk : Reward.

EG: A Euro trend run goes 100 to 120 ticks. It takes as long as it takes, but usually no more than 24 hours. So based on this knowledge, you take your signal, use a 20 or 25 tick stop to give the euro enough room to work and go shopping. Take look again tomorrow and see, if you were Stopped or not. It takes conviction to trade this way, but take a look at the 2 hour chart below. I marked the big runs. Give them 15 ticks for the entry and 10 ticks room for the exit, so you take 75 ticks for the winning trade and 25 ticks for a Stop. 1 : 3 ratio working nicely in this case. Use a daily chart and you can trade with a 1 : 6 ratio successfully, using say 50 tick stops and 300 ticks profit.

3 comments:

SwingTrader said...

Excellent post about stops.

You said you moved from trading stocks to trading futures so you get more tuned to their personalities (the way they move). I was wondering if you have considered MAE (Maximum Adverse Excursion) based stops. If yes, what do you think about the idea of using MAE stops? Assuming a trader is using a single strategy consistently, his winning trades would have a small adverse excursion (when compared to his losing trades). So stops placed just beyond this MAE level would probably be good stops. Do you think this would be a good idea?

Globetrader said...

I've tried doing a statistic about my winning setups and calculating the MAE looking at the winning and losing trades. But unfortunatly with most of the setups I trade the results were not so clear as I liked them to be. Maybe I did not enough research, but I ended with something like a winning trade will not go more than say 10 ticks against you on average, while losing trades obviously go farther against me. Still there were good trades going 20 ticks against me as well and I found, that regardless of the entry pattern, it usually was a retest of Support or Resistance on the chart, which provided the reason for the move against me.

What you might use is the previous bar's High or Low, add a tick or two and use that as Stop, because winning trades usually test but do not break the previous bar's low (on a long) or high (on a short). There are exceptions of course, but that is the reason why I say, you need to know the contract you trade.

Akuma said...

Great article, I just finished an article on the same topic, I have linked to this article, hope you don't mind :)

Cheers
Akuma99
(http://akuma99.blogspot.com)