Post by tradeviper on Mar 22, 2015 at 6:25pm
Stop In The Name Of Alpha
Of Mice And Stops
I recently ran into someone who had read some posts on an internet board, and of course you can believe everything you read on the internet, anyway, they told me that someone had developed a “system” that trades without stops. My first question was “how are they hedging their position”, his response was the cocked head of a dog hearing a high pitched whistle. I then said, “Well you either have to hedge, have fixed stops based on price, technical aspects, or possibly both”. Of course he said “no, you don’t need either one, the internet guy says if you use stops, you will die the “death” of a thousand cuts” and he finished by saying “if you get in with a good system, all you have to do is wait, and price will move back in your favor and even better, wonder of wonder of wonders, he/she has designed such a system,”. I could go on with more of his verbal diarrhea, but you get the picture. I finally told him, “PLEASE, save yourself some money and heartache, trade this thing on a sim for 6 months, and follow this “system” genius at the same time and see what happens, the market will always be there, and if it works, good for you, all you have lost was some time”. Well he decided to sim it for a while, (truth told, his wife decided he would sim it for 6 months) After only two weeks, low and behold, his sim account was dead (he’s dead Jim). Fortunately for him he lost some time but no money, and the no stop guy, well he kinda disappeared, something about Illuminati, G. Soros, and the need for an aluminum foil hat.
This experience, has motivated me to tackle the subject of stops. Understand that these are my opinions and observations, I am not setting out to prove anything or am I an expert. But, when I see folks struggling and giving up, I just cannot walk away. Mrs VIPER says it is a weakness, and I am wasting my time, I sometimes wonder if she is related to Ayn Rand, hehehe, but “I Ams What I Ams”. It takes time and effort to put this stuff together, that having been said, I learn from this also, looking at a subject from different angles, when one is removed from the consequences of the action taken, allows a clarity that is hard to find when one is in the middle of a morass of emotions.
It also is obvious that this subject is controversial on trading boards, in fact the discussions can get to be down right nasty at times, which, in and of itself, shows that something is not quite right with either side of the issue. The fact that people cannot just say “well I disagree with that” and not descend into insults and name calling, shows that those involved are not mature in a trading or emotional sense. Since this is the case, I really wanted to take a look at it from a psychological view, but in doing so there will be some Risk and Technical aspects to clarify the discussion. So without further adooooooo heeeeeeeeeeeeerse da VIPER
Protecting your capital is the first thing a trader should think about.
This brings us to;
Psychological stop Issue #1
“Stops And Capital Preservation Are Boring and Negative”
Yes, talking about preserving capital is boring and so are stops, they are nowhere near as fun as talking about high percentage gains, positive expectancy, and the power of compounding. Capital Preservation is to an immature trader a “Debbie Downer” conversation. The emotionally immature trader does not want to talk about losses, it scares them, makes them think they are losers. The thought of this disrupts their fragile egos, so they use “denial by avoidance”, looking for someone to validate their feelings, they gravitate to anyone who will tell them they do not need stops, or anything else losers need, because they will be winners.
Stops Are About Capital Preservation.
You will not be able to defend your account from your own mistakes, sudden unexpected market moves, or just plain being wrong, without stops. If you cannot see this or understand it, you will not be successful in your career as a trader. Of course this does not mean you cannot trade, or you do not have the “it” factor. It just means you have to be willing to change, adjust and apply.
Psychological stop Issue #2
“I don't want to die the death of a thousand cuts”
We have all seen this, play out time after time on public forums, the trader starts out taking stop after stop and eventually runs out the account. They become emotionally devastated, having lost possibly thousands of dollars, so anger and depression set in, and at this point the trader is no longer thinking clearly due to the psychological pain they have suffered. In this unbalanced state the Stop becomes a convenient scapegoat for the failed trader. This psychological condition is so common one would think that it could appear as a separate section in the DSM. Of course others read this and believe what the failed trader is saying, and so the legend of a “thousand cuts” continues to grow.
Stops Can Only Function IF The System Being Used Has Positive Expectancy
There are only Three types of market movement, Up, Down, Sideways and your system has to either function in these conditions or keep you out when it is not working. You cannot expect a system of stops to make up for a trading system that does not have positive expectancy. If the trader does not understand this they will, without doubt, die from “a thousand cuts”.
Psychological stop Issue #3
“The Price Always Comes Back In My Favor After My Stop Is Hit”
This illusion is at the heart of many account blowups, and traders giving up. What a coincidence that price moves against you, hits your stops and then moves back in your favor. Some begin to view this action as a reason to not use stops. Of course it's not, in general, your broker hunting stops, it is just a function of price discovery. Here is where the psychology comes in, a trader may decide that trading without stops makes sense with this kind of action, they jump into a strong trend market, each trade is with the trend, and since the trend is so strong there are only small retraces which eventually come back to the traders favor, so with each trade they are more and more profitable. Unexpectedly the trend bends back, and price starts a long hard retrace, at this point all the trader has left is hope, of course we all know that will not work. Finally he/she draws up the courage to close out, with most of his/her account gone. Again, devastation, death and destruction.
Stops Are You Friend
A famous man once said “how can you have any pudding if you haven't eaten your meat”. My friends, truer words were never spoken. Also, another famous guy once said “You can't trade unless you have money in your account”. Please, I am beggin y'all to think again about this. HOW do you get out of a trade that has moved against you before it burns your account to the ground? You cannot believe you will never have a loss, whether due to unexpected market movement, error in execution, or being on the wrong side, you will have losses, and again I ask, how do you ensure these moments do not bow you up, without using some form of stop? There are those who would disagree with these statements, and the internet is littered with the financial bones of those who will tell you not to use stops. For your own sake's please remember this, Stops are like seat belts, the financial life you safe might be your own.
Stops are not one size fits all, the following are some basics on how to choose Stop placement. These are not original ideas, but just a hodgepodge of stuff I have learned over the years, stuck here in one place.
A. If it is not at least 60% don't even bother
The “you can make money at 50% with proper money management”, is nonsense, it's a nice theory, and I have seen it done, in theory, but in reality, the 50% system fails 50% of the time. So that means, 50% of the time your account will blow up, hehehehe.
a. To clarify, I have recently experimented with this, and have changed my mind from being in the pro
50% expectancy crowd to anti.
B. Account size
- This is the hard part, it takes time to figure this out and you really have to know your system. Take for example a 40% loss ratio, how many trades in a row you can lose before your account blows up taking X amount of loss per trade.
a. To do this you need to know how many trades you system will generate given a specific time period, then figure the 40% of those are losers, it gives you a rough start.
b. If you want to take a conservative view (ooooooo I used the “C” word) Do this backwards, and figure all 40% in a row, now that will put hair on your chest, hopefully not our Lady traders. So (account size needs to be X before trading Y system), so you would be fitting the account size and margin to the system, and not the system to the account size.
c. Risk – Reward. It would be nice to say 2 to 1, one risked to 2 returned, but markets are dynamic, and not fixed, so figure at least 1.5 to 1, any lower than that and your fees start to become a larger factor in profitability.
d. If you are using technical stops, these have to fit into your account sizing and expectancy figures.
e. Longer time frames require wider stops, which means generally a larger account or lower margin
So Thanks for reading
The Ever Wearing His Seat Belt VIPER