LarryCan stops depress returns? You bet, and that's a problem if you have a perfect system.

If you don't have such an approach — and feel it might be to your advantage — to not wipe out your account (been there done that, it is depressing) then stops of some sort are the only tool at a trader's disposal.

[A blog referenced by a reader] so stupid and upsets me so much — geez these guys will insure their house but not protect a trade… it takes only one — just one — trade to kill you; the loser you held.

Happy trails to all.

Dr. Williams is the author of The Right Stock at The Right Time, Wiley, 2003

Bill Rafter replies:

Dr RafterPermit me to play Devil's Advocate, and in the process insert philosophy into the exercise of making money.

Some people use stops because they cannot decide when a trade has gone bad. That is, they admit that they cannot forecast the future of that trade, so they put a stop on it, solely to save money (or so they think). However the very act of doing so is in fact a forecast. Thus the conflict: they know they cannot successfully forecast, but they forecast anyway.

Other people use stops and place them at particular points specifically because they know that statistically if the price goes to point A, the odds are very small that it will revert.

My contention is that the latter person will be successful and the former will not. Thus I encourage those who use stops to question themselves as to the reason for the stop.

Our own situation is illustrative of knowing your weaknesses and circumnavigating around them. We know that we cannot forecast individual asset prices. We get reminded of that daily. Consequently we never use stops. We can however forecast the outcome of a basket of assets with some reliability. Many have been the times where we lost say 20% in an individual stock, but redemption has been found in the basket.

Dr. Rafter is the author of The Moving Trend, TASC, 2002





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1 Comment so far

  1. George Parkanyi on August 10, 2008 2:47 pm

    I agree with both Larry and with Dr. Rafter in their respective contexts. If you have a highly focused, leveraged trade, you simply cannot afford to have that go against you substantially, ergo the need for a stop.

    The negative effect of stops in a concentrated position can also be mititaged by scaling into a trade. Say a first lot on the break-out and then maybe 2 or 3 more additions into the rise as someone like Jesse Livermore would have done. If you get stopped out on your first entry lot, no big deal. You’re taking a small loss on only part of the intended capital allocation. If you start out of the gate with a small profit cushion, then more choices become available to you. For example you can now protect a long futures position with corresponding puts, and get a “free” trade for at least the life of the option. This is a technique our own Jeff Watson uses and has blogged about.

    If you are patient, and have a diversified non-correlated portfolio, then, as Dr. Rafter points out you don’t need stops. My own approach is the latter. I really like the new 2x leveraged commodity and equity ETFs. You get a little leverage, both directions (long and short), and importantly - continuity. (You don’t have to worry about expiring futures, options, and rollovers.)

    For example, in March I inititiated “naked” short gold and short oil ETFs (I went both long and short in grains and natural gas, so was far less exposed there), reasoning that these markets were already pricey. I was early. They both went against me substantially in the May-June run-up, but I was able to ride it out because these securities were part of a diversified portfolio, and only 2x leveraged. Now the gold short (it’s actually a basket of gold shares, not bullion) is up 29% and the oil down only 10% (it was down 45% at the peak). No stops required, back on side.

    So gents, you’re both right - just depends on what you’re doing.



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