Aug

11

J SogiThe use of fixed mechanical resting stops seems to be an admission of inability to trade your way out of a paper bag. It is also an admission you are undercapitalized. It is one thing to realize you were wrong. It is another thing to give up on the bottom tick.

Isn't it better to trade your way out of a bad situation rather than give more of your money to the opposition in defeat? It is a harmful mechanical crutch. It is better to watch for a better opportunity to exit with some grace. It is better to know the market, and know yourself.

Larry Williams objects:

What if you cannot exit with grace — market goes limit down 10 days? No way to trade your way out of that…

Stops prevent failures and allow one to regulate the size of the loss.

I'm talking trading here; not investing… value investors buy and hold until value changes or overall market gives a sell, that seems to be best strategy.

Shui Kage adds:

The old Japanese market proverb: "Mikiri senryō".

"To ditch a small loss is worth a thousand ryō" (In today's language: is worth one million dollars).

Most amateurs are unable to take losses at small size and most amateurs are not very good traders.

Phil McDonnell dissents:

PhilIf the market goes limit down (or up) against you then stops will not help either. The stops will not be executed. In that case only proper position sizing in the beginning or an option hedge will protect your position. There is no guarantee a stop will be executed at your price or anywhere near your price in the event of a gap open.

There is no theoretical basis that stops should work either. I have written about this here on numerous occasions. Thus the best advice is to back test, taking stops into account explicitly. When testing stops one should use great care to increae the assumptions regarding slippage. Invariably stops will be hit during fast markets when slippage is the greatest. Compare that to a back test without the stops. If the test using stops gives a superior overall risk reward profile then it is reasonable to use stops. One should never think of stops as the sole money management technique because of the slippage and gap issues discussed above. Rather stops are more of a trading tool to reshape your risk reward profile.

There is another reason to consider stops and that is psychological. Many of us are simply unable to pull the trigger when we get into a losing situation. Suppose you had a trading model that predicted that tomorrow would be up by the close. The obvious way to trade that would be to get in and get out by the close tomorrow. But if your system was wrong (and they all are sometimes) then you may find yourself holding the position simply unable to admit the loss and freezing on the trigger. It is easy to come up with all sorts of rationalizations for this behavior. "The drift will bail me out" might be one. Suddenly your plan has changed from a one day trade to hold it for ten years until the long term drift bails me out. So if you find yourself doing this too often then having a preset stop may be the psychological crutch you need to be successful. Better than that, of course, might be to simply write your plan down and execute it as planned.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008

Janice Dorn adds:

J DornI would add to this that placement of stops is both art and science. It is among the most difficult concepts for a trader to grasp, and there is more confusion surrounding stops than almost any other aspect of trading. How often do we hear: “They see my stops” or “There is clear stop-running going on” or something similar re: stops. That is why when I trade ( not invest), I use multiple contracts, keep taking profits and trailing stops ( on a good trade) and get out as quickly as possible when the trade is not going right for me. Also, I am prepared to lose on a certain percentage of all trades per my trading plan. I used to hate and could not accept getting “stopped out” but now accept it as part of the cost of doing business.

Also, it is very challenging for most traders to “stop out” and then get back in again. Part of the reason for this is inexperience, and the other part is the way that losses are seen by the brain. Losses are weighed about 2.5 times as heavily as gains. This means that if you are down 10% on one position and up 10% on another position, you are break even on paper, but are down 25% in your brain. There is a complex process that goes on inside the brain of the trader that is looking at losses. But that is another topic and I have already digressed from the “stops” thread.

Dr. Dorn is the author of Personal Responsibility: The Power of You, Gorman, 2008

Jeremy Smith tries for the final word:

Everyone uses stops.

Some put them in immediately.

Some keep them stored in gray matter for later deployment.

Some wait for the margin call.

Kim Zussman exclaims:

Kim Z"Say uncle!"

If you trade less than 100% of your investable capital, that is a stop.

If you trade predominantly the capital of others, that is a stop.

If you let the account blow up without borrowing against your home or retirement accounts, or hitting up   friends/family, that is a stop.

If you decide to trade small enough to preserve your marriage, sanity, or life, that is a stop.

Even the Kamikaze had stops.

Nigel Davies suggests extending the discussion:

What about broadening this discussion still further to include the 'reverse-stop', ie a profit target? I don't see much difference between the two from a conceptual point of view, the issue here being psychological (one represents a loss, the other a win).

Can one be ideologically opposed to stops without also being unable to take a profit? I don't see how we can discuss one without the other and they all come under the category of 'planned exits'.


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13 Comments so far

  1. George Parkanyi on August 11, 2008 4:55 pm

    Limit-down 10 days in a row? Sounds like a buying opportunity to me. At least you’re in at a lower price with no slippage. :)

    Stop-loss is fine, but is that all there is? What if brokers offered Start-Loss and Stop-Win orders? (my two staples, though they’re not called that)

    CLIENT: “I’d like to buy 1,000 shares of First Solar at $300 please.”
    BROKER: “OK let me read that back, that’s 1,000 FSLR Start-Loss at $300.”
    CLIENT: “Um, do you have to call it that?”
    BROKER: “Hey man, it is what it is. Do you want to add a Stop Win to that at $310?”
    CLIENT: “Can I change my mind?”
    BROKER: “No, you’re filled at $299.50″
    CLIENT: “Hey that’s pretty good isn’t it?”
    BROKER: “I suppose. Still want to change your mind? I can get you out at …. ooh - $298.40.”
    CLIENT: (dejected) “No, but I’ll take the Stop-Win at $310; no - make it $308.” Click.

    Good-till-pummeled could be another version of the Stop-Loss. At least it would take the indecision out of selling at the bottom.

    Cheers, :)
    George

  2. Henry Magram on August 11, 2008 6:05 pm

    Dr. Williams says in the above comment, "I'm talking trading here, not investing." Every single day, while I buy and sell stocks, I hear politicians, academic economists, and other individuals in the media talking “speculators” and “traders” as opposed to "investors." What fundamental difference exists between traders and investors? None. “Trading” and “investing” are not different categories of action. It may be commonplace to refer to some market participants that buy and sell intraday or intrayear as "traders" and call others "investors" who usually trade in longer time frames. Nonetheless these colloquialisms are misleading and unnecessary. The prevalent economic terminology of our day is a significant problem. The colloquialisms “trader” and “investor” create the impression that it is possible to routinely obtain economic profit using shorter time frames without also seeking to create value, meet the demands of consumers, and raise the standard of living of the general population. Since all speculation aims at the creation of value, the implications of the trader-investor dichotomy are false. Economic profit seeking is always simply speculation.

  3. Greg Herder on August 11, 2008 7:17 pm

    Trying to trade yourself out of a bad position is no solution. Doubling or entering into a pairs trade to try and rectify the damage of a bad position would qualify as the worst trades I have ever made. The stress of being stopped out and having the market retrace and costing me the opportunity of a large profit pales in relation to the pain I have experienced from holding bad positions before capitulating. There is always the inhibiting factor of pride. There is no worse sensation than paying the high of the day or selling the low of the day when being stopped out. By the way, there is a symmetry between being stopped out of a bad position and taking profits on a winning position — when?

    I might add, given the volatility of late, where intraday moves in excess of 2.5% on the ASX200 are nothing unusual, holding a position for any length of time with a stop creates a widfall for most CFD providers.

  4. Anon on August 11, 2008 8:24 pm

    A few simple, mechanical resting stops in August 2007 would have been useful….no? Or was the “paper bag” crinkled?

  5. Bill Mithoefer on August 12, 2008 1:39 am

    I don't really see why setting a mechanical stop is a debated point. If you're viewing trading from the perspective of a professional gambler, why would one avoid setting a "loss limit." In some ways this seems far more important than managing gains. I've often heard that the most successful gamblers set "winning goals" and "loss limits." I would argue that the latter should be more important to a trader who might easily ride a stock up into the sky, while avoiding oblivion.

  6. Craig Bowles on August 12, 2008 8:08 am

    Time limits are useful, even for long-term.

  7. George Parkanyi on August 12, 2008 11:41 am

    Anon,

    In hindsight, your observation makes sense, but at the time, if you got stopped out would you have had the discipline not to go right back in at a lower price? How would you have known for sure we were going much lower and to stay out?

    Cheers,
    George

  8. Mark Bate on August 13, 2008 9:25 am

    Stops are neither good or bad; they are just another club in the bag. It's what you do with them.

  9. Keith Shepard on August 14, 2008 8:42 pm

    People that trade without stops eventually stop trading.

  10. George Parkanyi on August 15, 2008 10:45 pm

    What people, Keith? What are their names? Cheers, George

  11. Luigi Vigilante on August 18, 2008 7:51 am

    hi all, as per stops in cash fx markets, why do so many people still trade the cash fx that (unless they use ecn's) is still a quote-driven market? traders concerned with slippage of stop orders executions should use ecn's for cash fx or, even better, globex via fx futures. in the latter case, all the disputes with the broker will be resolved simply by looking at time & sales.

  12. More Thoughts on Mindful and Mindless Trading « EsForex | Mercado de Divisas | Mercado Forex on March 4, 2009 11:10 am

    […] Thanks for the opportunity to clarify an important issue. For another interesting debate on an important topic, check out the Daily Speculations site’s recent back-and-forth about stop-losses and whether or not they add value. My short take on the question: they do add value, especially when they are conceptually based (i.e., based on considerations that the reasons underlying the trade have changed, not just based on a particular price/loss getting triggered) and when they are placed in the context of expected market volatility and proper position sizing. . […]

  13. More Thoughts on Mindful and Mindless Trading | Diario BV on March 25, 2009 5:10 am

    […] Thanks for the opportunity to clarify an important issue. For another interesting debate on an important topic, check out the Daily Speculations site’s recent back-and-forth about stop-losses and whether or not they add value. My short take on the question: they do add value, especially when they are conceptually based (i.e., based on considerations that the reasons underlying the trade have changed, not just based on a particular price/loss getting triggered) and when they are placed in the context of expected market volatility and proper position sizing. . Share and Enjoy: […]

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