Categories
The Basics

Some Not-So-Great Tips for Using Stop Orders

Stock Trading to Go posted 10 Great Tips For Using Stop Loss Orders Successfully the other day. I’ll give the listing a middle grade. There are some good suggestions, but there’s also some stuff which range from perhaps too narrowly focused for general use all the way to just completely wrong.

First of all, I don’t agree with the idea put forth before the list of tips that stops are like insurance. Insurance makes you whole on losses suffered. Stops only provide a measure of assurance that they don’t get too large.

Here are the tips I’m good with:

2. Watch for hidden fees.
3. Never assume a stop loss order has been filled successfully.
6. New investors should use only stop market orders.
7. Use stop loss orders to setup a profit vs loss ratio.

In the case of #2, it’s a case where some brokers charge extra for non-market orders. And of course traders should always confirm all order entries and executions, which is #3.

In terms of #6, the comparison is against stop limit orders, which is where when a stop price is reached a limit order is activated rather than a regular market order. The difference is that a limit order will only be executed at the specified price or better. That means your order may not get filled, which you absolutely don’t want happening.

As for #7, I’ll go along with stops enforcing discipline and can help to better trade selection.

Now here are the ones I take issue with.

1. Never use stop loss orders for active trading.
4. For the original placement always give the stock at least 5% of space to avoid market maker abuse.
5. Don’t use stop loss orders for large positions.
8. Keep an eye out for after hours trading gaps.
9. Set the trigger price at common price increments.
10. Use with stocks that have high average daily volume.

Long-time readers of this blog know that I am not a fan of anyone using always or never in terms of trading rules, so you can guess my reaction to #1. That aside, the author is suggesting that because you’re in front of the screen watching the market you don’t need the stop. My contention is that stops help enforce discipline, and what happens if you are distracted by something while you’re trade is on?

Tip #4 is one that doesn’t fit many people’s trading. Short term traders, for example, may never expose themselves to a contrary move that large. I do, however, agree that stops should account for normal volatility.

Now for the really big problem for which I’m going to lump tips #5, #8, #9, and #10 together because they are all based on the same error in understanding. It’s one that appeared in the prior post that’s referenced at the outset of this one. The blogger is under the mistaken belief that a stop order will not get activated unless the market specifically trades at the order price. That is just flat out wrong, as this Investopedia definition indicates (italics mine):

What Does Stop Order Mean?
An order to buy or sell a security when its price surpasses a particular point, thus ensuring a greater probability of achieving a predetermined entry or exit price, limiting the investor’s loss or locking in his or her profit. Once the price surpasses the predefined entry/exit point, the stop order becomes a market order.

I tried to correct the blog author via comment when I saw the initial error, but it never went through (apparently). That site is one with a pretty large amount of traffic, suggesting the perception of authority, so I’m really surprised to see that kind of error being made.

Categories
Trading News

Another Rogue Trader

If you were completely out of touch Thursday you might have missed the adventures of our latest rogue trader. And this one’s a biggy. He puts Nick Leeson to shame. How about $7bln+ in losses for his employer, French bank Societe Generale. Inexplicably, he’s vanished. Imagine that!

Let’s just say someone didn’t practice very good money management. 🙂

By the way, a lot of folks are blaming this guy for the market insanity this week. He apparently had gotten very, very long (read tens of billions worth) in European stock index futures, especially the DAX. The unwinding of that position, which Soc Gen only found out about on Friday, was a major contributor to the global sell-off.

Rogue Trader - Nick LeesonIn case you never heard the Nick Leeson story (he’s the guy who sank Barrings Bank about a decade ago) you should definitely read his book – Rogue Trader. If you can get beyond the questionable ethics of helping a guy who caused the loss of over $1 billion and the death of Britain’s oldest bank make a few bucks based on his experience doing so, then it’s a interest read. The film version starring Ewan McGregor is ok, but lacks the real depth of the story as Leeson tells it in the book.

Another good read if you’re into the kind of “inside Wall Street” type of book is Black and White on Wall Street. This one is an autobiography written by Joseph Jett, a former Kidder Peabody fixed income trader who was accused of improper trading or accounting or something (it’s a bit unclear) which resulted in substantial losses. Unlike the Leeson book in which he admits to his wrong-doing, this one is an attempt by Jett to tell his side of the story and clear his name. There are some complex financials issues discussed in places, but they don’t really hinder things when you read it.

Categories
Trading Tips

Risking Something Other Than 1-2%

The idea that you should only risk 1-2% of your trading account is a bit of advice which is thrown around a lot in trading circles. It’s become trading dogma. I am not a big fan of hard and fast rules and this one falls into that category. While those percentages might work for the majority of traders – and certainly some very prominent figures in the markets have cited them – they are not necessarily appropriate at all times or for all systems.

The question was recently asked “When you can reasonably estimate the average % of trades as drawdown, the average % in profit ( per week/month) do seasoned traders increase their % risk from the recommended 1-2% of capital?”. The short answer is “Yes”.

It all comes down to testing. Backtest with different risk percentages and see what happens when you use larger risk ones. You may indeed find that 1-2% is the right area to be in, and you may not. Your position sizing should be a function of your system and your risk tolerance, not some rule you heard from another trader or read in a book.

Also note that there is the question of increasing the size of trades which are moving in your favor. That too is part of risk management and should be another element of the testing process if your trading strategy is one which is suitable for adding to open trades (trend trading, for example).

Categories
Deep Posts Reader Questions Answered

Money Management Question

I recieved the following from one of my list members yesterday: 

Hi John,

The most important question that I try to answer(with help from other traders, courses and books – your excellent book including) is:

How to keep as much of my earned profits as possible?

Today I know that the most important part of my strategy is money management(I use Fixed Ratio). I chose FRatio because I trade systems that are always on market. So there are no stop orders. So I have to use a money management strategy that uses system’s drawdown.

I had many situations when I had deep drawdown periods after nice profits. Unfortunately, in drawdown I had more contracts(because of earlier profits) so even if my losses in points per contract were similar to my earlier profits, my net loss was bigger because of the biggest amount of contracts at the beggining of drawdown periods.

Is there any smart way to improve results of my money management method?

Two years ago I tried to take out of the market a part of my profit from every profitable trade(usually half of it) and didn’t reinvest that part, but it doesn’t work good…

I think my question should be:

Is it possible to improve a profit factor of my money management strategy? 

Best regards,

K.D.

The whole concept of risk and money management is something that I’m finding to be perhaps the single most misunderstood element of trading – not just for new traders, but for experienced ones alike. There is a strong tendency to think of it only as protecting one’s self against outside losses, but that’s only part of the picture. I’ve actually decided to begin working on a very intensive educational program on the subject. I’ll keep you posted on my progress.

The short answer to K.D.’s question is “Yes”. In the end, money management comes down to position sizing. When you can optimize (or nearly so) your position-sizing you can improve your overall trading performance. The primary drawback to fixed ratio sizing is that while drawdowns tend to be shallower, they also take longer to come out of because of the smaller trades during the trough periods. What K.D. might want to look at is a stepped type of approach as I discuss in my book. It’s a sort of mix between fixed lots and fixed ratio.

Categories
Trading Tips

Close stops do not lower your risk

A lot of new traders fall in to an insidious little trap. Because they hear from those who they consider better, more experienced, etc. that your stop defines your risk, they draw the conclusion that closer stops mean lower risk. Sadly, this just isn’t the case.

Are you thinking something like this right now?:

A closer stop means I lose less money if the market goes against me than a stop put further away. Smaller losses mean less risk.

If so, you are only looking at one side of the equation.

The risk you take on a trade combines not just how large a loss you might take, but also the probability of taking one. As I think we can all agree, markets very rarely move in straight lines. Then tend to wander around a bit as different forces push prices back and forth, especially as you move toward the short-term time frames.

Because of that movement, as you put your stop closer and closer to current price you increase the chances of that stop being hit. A higher likelihood of your stop getting taken out means an increased probability of taking a loss. Sure, the loss might be smaller than it would be if you put the stop further away, but you’re going to take the loss more often. At some point you reach a threshold whereby the tighter stops, because of their increased likelihood of getting hit, offset the smaller losses taken when compared to the wider stops.

As an example, let’s assume we have a market which has a 20% chance of moving 10 points and a 50% chance of moving 5 points during our trading time frame. If we do ten trades that would mean the wider stop gets hit twice, costing losses of 20 points. The tighter stop would get hit 5 times for a total of 25 points in losses.

But that’s only part of the equation. There are two other elements at work here. First, having close stops that are within the market’s normal trading range not only means more losses taken, it also means more of those awful trades where the market goes against you enough to take out your stop, then reverses and goes profitable. Having the tight stops, therefore, means you miss some potentially big winners.

That’s pretty hard to deal with. For some traders, though, losing at a high frequency is even harder. It can become significantly destabilizing to one’s trading confidence. Not good.

My own personal philosophy on the placement of stops is to put them at a point where if the market reaches them, the move I expected to unfold probably isn’t going to happen.

I never place my stops based on how much I’m willing to lose on a trade. I set my position size based on where my stop is going to be and what that implies in terms of position risk.

Does all of this sometimes mean that you take smaller positions to keep your per trade risk level? Absolutely! It’s been my experience that most traders trade too big, though, which usually means bad news at some point. Cutting back on your position size, therefore, shouldn’t be seen as a bad thing.