Saturday, August 02, 2008

Risk Management in Trading: Where to Place Your Stops

I recently received a couple of emails from traders asking me about placing stops. Should they use stops? Should the stops be 1% away from their entry point? 2%?

I'll provide my perspective on the issue, but also welcome comments from readers and other perspectives.

My quick response is that stop loss exits are necessary; without them, trades lose any favorable risk/reward edge. You can only make money in one of two ways: by ensuring that your winning trades are meaningfully larger than your losers and/or by ensuring that you have meaningfully more winning trades than losing ones. Without clear stop-loss levels and profit targets, it's very easy for the average size of winning and losing trades to converge or even turn unfavorable. That puts a lot of pressure on a trader to be right much more often than wrong.

I think that asking whether you should risk $X or Y% on a trade is useful for general risk management, but not the right question to be asking for the placement of stop-loss levels for specific trades. It gets back to the idea (see link below) that every trade reflects an underlying hypothesis. You stop yourself out when objective evidence tells you that your hypothesis--the idea underlying your trade--is not being confirmed.

I've illustrated this above with one of my own trade setups from Friday's trade. Note in the top chart how we came sharply lower in the early morning in the Dow Jones Industrial Average (DIA), hitting a low around 9:08 AM CT (first light blue arrow), bouncing, and then making a new low around 9:25 AM CT (second light blue arrow).

I had no thoughts of buying the market on this first bottom: all major indexes were participating in the decline, and many more stocks were trading at their bid price vs. their offers (bottom chart). Catching those falling knives and trying to call bottoms before market action confirms a turnaround is a perilous occupation.

By 9:25 AM CT, however, the market's situation changed considerably. As the Dow moved to marginal price lows (top chart), the S&P 500 Index (SPY; middle chart) failed to record new lows. We also failed to make new lows in the Russell 2000 (IWM) and NASDAQ 100 (QQQQ) indexes and their respective futures contracts. Volume (dark blue arrow) declined significantly as we made the new low, suggesting that large market participants were not joining the downside. At 9:25 AM CT also, we had many fewer stocks trading at their bid vs. offer (NYSE TICK; bottom chart). In short, the Dow was traveling alone; nothing was confirming its weakness. This is one of my key setups for a reversal trade.

The hypothesis behind this trade is that selling is drying up and that we should see buyers come into the market and produce a healthy bounce. My initial price target is the set of price highs we made during the bounce between 9:08 AM and 9:25 AM; my next targets are the price highs around the 9:00 AM period before the market's selloff.

I want to enter the market as close to the hypothesized lows as possible so that my trade has a favorable risk/reward profile. I want to make more money on a winning trade than I would lose if I were stopped out. For that reason, I want to enter the trade as soon as I see buyers coming into the market, lifting offers out of the unconfirmed lows. I don't try to catch the exact low; I wait for buying to surface and quickly join in.

So now the question of where I put my stop becomes clear: I stop the trade out if we make new lows in the indexes that had been non-confirming, such as SPY. I stop the trade out if we make new lows in NYSE TICK. I stop the trade if the initial buying out of the expected lows leads to a reversal on enhanced volume. In other words, I stop the trade when my idea is not supported: when the unfolding evidence of the market is not meeting the expectations of my hypothesis.

It is in the sizing of the trade that I ensure that I am not risking an undue proportion of my portfolio on any one idea. In my own trading, if I'm risking the equivalent of 3 S&P points as the distance between my entry and my stop-loss, I'll size the position so that the loss of the 3 points won't draw my portfolio down by more than a fixed fraction of portfolio value. That fixed fraction is determined by the amount of portfolio value I'm willing to lose in a day, which is determined by the amount of value I'm willing to draw down in a week and a month. Each trade should risk a fraction of what you're willing to risk in a day; each day should risk a fraction of what you're willing to risk in a week; etc. That gives you the opportunity to battle back when your hypotheses are disconfirmed on one trade after another.

What I hope is clear is that setting stop loss levels is not a simple matter of saying, "I'll risk $1000 or 3 points on this trade." The stop-loss level is integrally tied into the clarity of the trade idea; the execution of that idea to maximize reward-to-risk; and the trader's overall risk management. When you're clear about your trade ideas, it's easier to be clear about stop loss levels, and that makes it easier to keep losses small relative to wins.


Trade Like a Scientist