Sat 9 Sep 2006
Stop Me Before I Do Something Stupid
Posted by Quicksilver under Discussion , Tactics , Trading[2] Comments
The subject of stop-losses is such an intensely difficult topic to discuss.? I’ve had many latenight debates in trading forums and chatrooms and I’ve been through every camp in my experience as a trader.? The best answer I’ve ever been able to come up with is that answer famous and frustrating for its truth: it depends.
What always bugged me about the stop-loss was the way most traders thought about it.? They basically thought of the stop-loss as a way of defining risk by itself.? These traders found a trade they wanted to be in and then by magically adding a stop-loss of a certain size could then claim, “See, my risk:reward is now 1:2 so I can enter with confidence.”? Woah there, Buddy.? As Jason laid out in his post, a stop-loss does not a trade make.
I personally think that risk management?should always the first focus of any trade.? But I don’t think that stop-losses are the only form of risk management.? In the wrong hands, a stop-loss can increase your risk by raising the probability of the trade ending in a loss, however small.? You can’t win by constantly taking small losses.? Other methods such as careful position sizing, diversification and even lowering trading costs (which give you more room to move) can all be used in various combinations with or without stops to control a trade.
The key goal is to never do anything to your trade tactically that will hurt you before the market has done enough to prove your assessment wrong, including taking profits.? This means that you need to determine what these scenarios are before you enter the trade and then determine the tactics that will best serve you.? Look for price levels for orders that have meaning (S/R, density levels etc.), not just arbitrary prices.? Think about how your orders might be vulnerable to running.? Don’t put them in obvious places.? And you need to actually assign probabilities to events, as strange as that probably sounds to some traders and investors.? If you can’t or haven’t been able to do such, then perhaps you shouldn’t be in the trade.? Oh, and add “standing aside” to the list of risk management techniques.
September 12th, 2006 at 8:10 am
The major thing that makes risk management so challenging in the world of investing is that many “investors” approach the markets with a gambler’s swagger. I’m just as guilty as the rest of the bunch. I go through a song and dance before buying, I read some books and articles, I “research” and look quizically at the charts. But at the very root I’m just logging time, letting that tasty investment marinate a bit and I’m drifting off thinking about how tasty those profits will be. Those few successful trades that stand out so prominently in my memory help fuel these little day-trader-dreams and make me think I’m a helluvalot smarter than I am.
Before anyone can craft a solid risk management strategy, they have to become more critical and lawyer like (I’m referencing a previous post here). I personally need a lot of work in this area, which is why I’m avoiding trading individual stocks for now while I focus on improving my ability to play devils advocate and sit on the other side of the trade. This takes lots of practice.
September 21st, 2006 at 12:00 pm
I just came across this at TraderFeed and thought it really couldn’t be better stated.
“In a recent post, I suggested that stop-loss points have a way of limiting opportunity as well as risk. My observation was the result of testing hundreds of trade setups with the Odds Maker program and noticing how such staples of the market literature, such as fixed price-based stops and trailing stops, severely degrade the performance of those setups.
Should one abandon stops altogether? I think not. If we consider every trade to be a hypothesis that is based upon our understanding of the marketplace, we owe it to ourselves to abandon that trade once the hypothesis is disconfirmed. The problem with most price-based stops is that they are not formulated with these hypotheses in mind. They are employed, I suspect, as much to manage the trader’s anxiety as to manage objective risk.”