Success in trading requires discipline and risk management, right?
We should always establish and honor stop losses, right?
But what if stop losses consistently minimize the profit potential of promising trade setups?
In the Trading Psychology Weblog the past couple of days, I've taken a look at the Odds Maker program from Trade Ideas as a way of establishing market regimes. You can think of regimes as the set of rules that the market has been playing by over the recent past. The Trade Ideas program screens the market for various patterns; Odds Maker tells you if those patterns would have been profitable if held for user-defined periods with user-defined stops.
For example, over the past three weeks, it has been consistently profitable to buy SPY after a break below the 30 minute opening range. That gave us 8 winning trades in 11 opportunities, with the average win size ($.46) exceeding the average loss (-$.04). Trading those opportunities provided the SPY trader with net winnings of $3.54 per share. That's with no stops and a holding period of 60 minutes.
Suppose, however, that we want to add a stop to our setup to limit our risk? We decide to exit any time the market moves against us by making a 15-minute price low after our entry. Now we have 4 winning trades in 11 opportunities, with the average win size ($.48) exceeding the average loss (-$.11), but overall profitability of $1.49 per share compromised.
Fine, let's widen the stop and exit if we make a 30-minute low. That really F*&#s it up. We have 2 wins in 11 opportunities. Yes, the average win of $.63 is fine and we've limited the average loss to -$.08, but now the net winnings are down to $0.96.
Indeed, in my work with Odds Maker I find it amazing how just about any configuration of stops degrades a trade setup. Not just for this pattern, but many others across different stocks and time frames.
Maybe--horrors!--the common wisdom has it wrong. Maybe it makes sense to limit the capital you assign to any single trade idea, properly diversify your ideas across time frames and trading vehicles, and contain your risk that way. Forget about stops, take the losses like a grown man or woman when they occur, and have the integrity to stick with your ideas.
At the very least, test your stops out in advance and determine if they're managing opportunity more than risk. I think you'll be surprised.
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7 comments:
Dr Bret,
Great blog and I find your books to be very enlightening, informative and good reads!
My personal experience (limited to 12 months now as a full time trader and historic data hound) confirms today’s blog.
In a mean reverting vehicle (vs a trending vehicle) (preface statement with IMO) it is better to keep broad stop limits and use time limits or limit risk in other ways; Think approaches (and the thought processes) of Todd Harrison at minyanville and those of Adam Warner.
As a newbie trader I appreciate your work and any bones you throw.:).
On the topic of understanding the players in the market: It seems that at time Europe's opinions of what should happen in US equities for the day differs from the home player(s) opinions. This is an exploitable condition perhaps. When do traders from other time zones show up, when do they leave; Are they big players or small? How is their home markets trading? All areas of interest to me that I thought I would share.
I urge everyone to weight my opinions appropriately as they are the opinions of a green trader still putting the pieces together.
Thank you for all of your work!
jjc
I have similar mixed feelings about stops. Here's my thoughts on them.
I read your blogs often and enjoyed them. Thanks.
Hi jjc,
Thanks for the note. Your observation about how markets trade during the premarket (European hours) and during the U.S. day session is right on. Very much of the US market's directional trade has occurred between sessions (during Asian and European hours) and not during the usual US day session. It's almost like two different markets.
Brett
Thanks for your observations, wincity. It is interesting how most traders are far more discriminating and rigorous about entries than exits. So many times, exits are unplanned and based solely on trades hitting a trader's maximum pain threshold. So many of those exits turn out to be the worst points to get out!
Brett
Hi Brett,
As a trader I have also experienced a period where my stops were so close that the market just had taken them and went in my direction. That's is why keeping statistics of trades is very important /essential/ for traders. Such a statistics is MAE, or Maximum Adverse Excursion, which is tha maximum heat a trade endures before it goes to green. I keep MAE statistics for the different patterns I trade during different market condition and set my stops in such a way so that the probability of getting hit is minor, when patterns work.
Krasimir
Very, very good point, Krasimir. If you know the average expectable drawdown for a trade setup, you have some rational basis for establishing a stop loss exit beyond that point. What I find is that traders often don't know how much heat is taken by good trade setups, which leads them to stop out trades prematurely and lessen opportunity as well as risk. I'll post more on this topic shortly. Thanks for the observation.
Brett
Linda Bradford Raschke's testing has always shown that stops reduce the edge of profitable patterns.
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