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real world stops and risk reward ratio.

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mcteague View Post
Trading is like any other form of gambling in that we should only place trades (bets) with a positive expectation. The positive expectation is determined by the chance of winning and the risk reward ratio. (stop to target)

However I find it is often necessary to place stops more widely than I might think technically accurate. This is to avoid market noise and random news based events. When I first started trading the E-mini I got stopped out like 4 times in a row. Even though the chart said that was where risk should be; I just got whacked over and over. So now when I mostly trade stocks I move my stops a little lower to avoid that. And often just go completely stopless, as I only trade high quality stocks.

If the trade is going against me I just exit. So I never really hit the wider stop. However this does not change the fact that the math is now wrong. On paper using the actual stop and target I am now in a trade with an insufficient expectation. I am making a bad trade. But in the real world it is fine.

What is the proper way of addressing this problem so that you avoid possibly fooling yourself and entering weaker trades than you should? Can I make the math right while still compensating for the real world?

I think I see what you mean. This is a work-in-progress for me too but my humble 2 cents would be:

I think essentially there's an error-tolerance and a timing-constraint to deal with. If I can set a tight-stop in a volatile market and get away with it, I need excellent timing and trade-location in order to catch price just before it would run over my stop in order to take advantage of the more favorable move I was hoping to capitalize on. There's a higher probability of getting stopped-out however, so higher risk and my read, timing, and execution must all be pretty close to perfect.

Due to this, you might decide to widen your stops to accommodate the added chop from the volatility and sacrifice optimal trade-location for less risk on your timing and lower chance of getting stopped-out as easily. But how to measure these things? A couple ideas you could look at if you already haven't are:

1. For overall expected ebb & flow of a product under "normal?" conditions: Harmonic Rotation

Link doesn't jump directly to the topic so I can just quote it here:

When viewed within a consistent time frame, a market’s Harmonic Rotation is the size of it’s most common swing. Often this is assessed on a 1 minute periodicity.

By assessing the distribution of market swings across the study period and understanding what is a normal versus what is a larger than normal swing, a trader is better able to understand whether market movements are significant or not. For example, a swing equal to a market’s Harmonic Rotation is not likely to hold very much significance as it is part of its natural back and forth undulations.

The Harmonic Rotation is sometimes utilized by traders in ways such as assisting with entries, setting target and stop losses and assessing the general state of the market.

2. Next...First the easy way out, find some value that is already computed for you and correlates with your product in a way that you can study for some time in order to draw your own conclusions.

For example, if I trade the /ES, I could look at Implied Volatility and Implied Volatility Rank of SPY options and compare to the volatility in the ES and try to see if there is some correlated, meaningful way to estimate proper stop-depth over time .

Harder way, do the math yourself and look into computing variance of volatiltiy in your product and go from there. I see this in a lot of job description skills for quants. I am NOT currently doing this but it interests me if I can understand the math

Good luck!

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