Wednesday, November 19, 2008

Stops and Risk

Stops and Risk seem to go hand in hand, but I feel stops (especially tight stops) give one a false sense of security and an inaccurate assessment of risk. I set stops/targets in conjunction with the probability of the stop/target actually getting hit. The average daily range in the ES over the last two weeks is around 50 points! The ATR on a 15-min time-frame is around 7 points. In a volatile market like the one we're in these days, the probability of a 1-2 point stop getting hit is extremely high. By the same token, the probability of a 2 point profit target getting hit is also high. On most of my setups, I'm using 5-7 point stops with 2-5 point profit targets. When I enter a trade, I judge the probability of the stop/target getting hit. If the probability of the 3-5 point profit target getting hit is higher than the 7 point stop-loss getting hit, I take the trade. I never enter the market with full size. Instead, I add to the position, even if it goes against me as long as the setup is still valid. But I only add to the trade uptil my stop-loss level at which point I accept the max loss on the trade. This requires a high hit-rate since one losing trade could wipe out 2-3 winning trades, and I'm sure people who strictly follow a risk/reward rule (1:2, 1:3 etc) will disagree with this methodology.

I'd love to get some feedback on this.

2 comments:

  1. I personally like going with 1:1.5 to 1:2 R/W. The setups that I trade normally don't need that wide of a stop, that's also provided the market is not chopping around too much, which in that case I do better to stand aside. I think it all depends on the setup your trading. The candles I'm testing now do need much wider stops, and I also have to be much slower about raising my stop to give the trade more wiggle room. I've watched John Carter trade with more downside risk than up, and it works great for him. One thing that was very helpful for me in deciding where to place my stops was to look back at past trades and see how far the profitable trades went against me before hitting their profit targets. It usually depended on market conditions as to how far away to set them. In this volatility your totally right about the risk of getting shaken out prematurely, it's happened to me.

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  2. I have a spreadsheet that tracks my trades, and how far price went from my initial entry before the trade became profitable. Problem is, I have to manually enter the trades along with the data on how far price got from my entry, into the spreadsheet which is very time consuming and I don't have time to keep it updated. But that's a key data point that I would love to be able to track. When I was tracking it before, the ideal stop-loss for me was around 3 points.

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