Saturday, September 16, 2006

How to F*&# Up a Trade Setup

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.