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real world stops and risk reward ratio.
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real world stops and risk reward ratio.

  #1 (permalink)
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real world stops and risk reward ratio.

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?

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  #3 (permalink)
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mcteague View Post

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 don't know the answer.

It is important, though that "in the real world it is fine." There may not be a good theoretical (non-real-world ) answer, but having an answer that works is, after all, important.

I would welcome other thoughts, for the same reason that @mcteague posed the question. It seems that it should be possible to get a better grasp on the whole issue. I know there are formulas of one sort or another, but do they satisfactorily do the job?

Or perhaps should one just have a somewhat arbitrary rule that keeps loss in check and just live with it?

Bob.

--------------

Edit: similar thread here: https://futures.io/psychology-money-management/46748-breakeven-stops-entry-1-2-tic-profit.html

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  #4 (permalink)
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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:

Quoting 
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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  #5 (permalink)
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@mcteague Its a good question. I think one way around this is to undo how you think it 'should be done'. Tight stops is a slow puncture to your account. Placing stops where the market tells you is also a slow puncture. Moving to breakeven to soon....slow puncture.

I have a local SQL DB containing data on the instrument that I trade. A few simple queries provide me with information on various metrics that I deem important to my style of trading.

This allows me to place risk well out of reach of these ranges. Immediate market structure is too simple a strategy because there are well funded and coordinated groups that target these clusters in search of liquidity.
You should place your risk where there can be no doubt that your 'read' was incorrect. Context is everything but you have to give the market time to develop new structure and not be baulked out by what it appears to be doing in the short term.

How you approach this conundrum will be defined by your style of trading. Scalping a few ticks at a time is very different from holding trades for hours or days. I'm in favour of a slightly longer term approach where I can leave a trade and not be aggravated by every little twist and turn. I'm only interested in abnormal developments like unexpected volume and structure.

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  #6 (permalink)
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Immediate market structure is too simple a strategy because there are well funded and coordinated groups that target these clusters in search of liquidity.

@Grantx, thanks for sharing this! This is a fascinating topic to me, I'm trying to learn more about identifying institutional behavior and all their different gambits. All I really know at this point is identifying the more obvious stuff like tails and range-extension, but I hope there's a lot more for me to learn here. Roughly-speaking, how far away do you tend to place your stops to avoid this?


Last edited by snax; May 11th, 2019 at 04:33 PM. Reason: clean-up
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  #7 (permalink)
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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've been looking into this topic in depth (and don't have a great answer yet).
Here's is somethings that seem to make sense based on the testing I've done.

1. It depends on your time frame.. Holding a trade for 30 minutes vs holding a trade for 90 minutes will change how much risk
is needed to have to trade work. That is, if you calculated every outcome in the next 30 minutes, and then every outcome in the
next 90 minutes, you would find that average amount of risk to be larger in the case of 90 minutes, simply because the market will generally move more in 90 minutes than in 30 minutes.

2. In addition to your trading timeframe, the time in each bar has an effect. The market moves more (on average) in a 5 minute bar
than a 1 minute bar.

2. It depends somewhat on Time Of Day. For example, assuming you trade NQ, trading at 8:30 Central time would need a different level risk, than a trade executed at 8:55 central time. The opening is more volatile. Before a major report can be quieter.
Trading right after the Fed changes interest rates is another example of times where risk is different/higher than normal.

3. I've noticed a positive correlation between the range of each bar and the amount of risk required to have a trade work (assuming you
picked the right direction, lol) There also seems to be a positive correlation with volume. The higher volume tends to move the market more.

4. As with all things market related, there are examples and counter examples. Using statistics helps to see the general trend. Looking at risk histograms can be helpful.

Best of luck!!

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  #8 (permalink)
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@Grantx, thanks for sharing this! This is a fascinating topic to me, I'm trying to learn more about identifying institutional behavior and all their different gambits. All I really know at this point is identifying the more obvious stuff like tails and range-extension, but I hope there's a lot more for me to learn here. Roughly-speaking, how far away do you tend to place your stops to avoid this?

I realized after posting this that this is a very open question since market-structure is ever-changing and evolving, thus the question of stop-placement is highly-dependent on that particular moment.

I also attempted to research more about identifying institutional or "other/higher-timeframe" activity and didn't get as far as I'd like. I will keep pressing on...

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  #9 (permalink)
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snax View Post
@Grantx, thanks for sharing this! This is a fascinating topic to me, I'm trying to learn more about identifying institutional behavior and all their different gambits. All I really know at this point is identifying the more obvious stuff like tails and range-extension, but I hope there's a lot more for me to learn here. Roughly-speaking, how far away do you tend to place your stops to avoid this?

How you position risk depends on so many things. For example, if you look at the recent increase in volatility on equities, it is clear that you cant just have one approach because conditions have changed and you must adapt accordingly.

Firstly, you should try to find the 'sweet spot' on your chart and by that I mean, where are the measured swings? It takes a lot of time because you have to go through the timeframes to try and find the pulse (sorry its corny but I dont know how else to describe it). The market see saws and oscillates up or down and when you eventually find that rythm you will be able to trade these fluctuations with more confidence.

Also, the market usually has a theme that it is pricing in. For example, right now it is possible this trade war is a contributing factor wrt to the correction in equities. So let pretend the market was ranging, then if you got an extension to the downside you could be a bit more confident in your short trade that the breakout would stick because the action is in line with your expectations.

So how would you place a stop in this scenario? I would scale into the short as the market retraced and my stop would be somewhere above the top of the range. Reason? Because it is clearly selling off and I dont want to miss the short by having tight stops on a market with a selling theme. Also, when it retraces, its likely to find liquidity just inside the breakout but unlikely to make it to the top and breakout the other side (because the theme remember). You want to increase your stop size when taking shorts but if you are playing reversals against the trend, then take your chances but keep your risk tight. You dont want to be adding to losers especially when playing against the theme.

So you see its not a question that can be answered. You should have some kind of idea what the market is doing and then use price action to trade that theme as current conditions dictate.

HTH

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  #10 (permalink)
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Grantx View Post
How you position risk depends on so many things. For example, if you look at the recent increase in volatility on equities, it is clear that you cant just have one approach because conditions have changed and you must adapt accordingly.

Firstly, you should try to find the 'sweet spot' on your chart and by that I mean, where are the measured swings? It takes a lot of time because you have to go through the timeframes to try and find the pulse (sorry its corny but I dont know how else to describe it). The market see saws and oscillates up or down and when you eventually find that rythm you will be able to trade these fluctuations with more confidence.

Also, the market usually has a theme that it is pricing in. For example, right now it is possible this trade war is a contributing factor wrt to the correction in equities. So let pretend the market was ranging, then if you got an extension to the downside you could be a bit more confident in your short trade that the breakout would stick because the action is in line with your expectations.

So how would you place a stop in this scenario? I would scale into the short as the market retraced and my stop would be somewhere above the top of the range. Reason? Because it is clearly selling off and I dont want to miss the short by having tight stops on a market with a selling theme. Also, when it retraces, its likely to find liquidity just inside the breakout but unlikely to make it to the top and breakout the other side (because the theme remember). You want to increase your stop size when taking shorts but if you are playing reversals against the trend, then take your chances but keep your risk tight. You dont want to be adding to losers especially when playing against the theme.

So you see its not a question that can be answered. You should have some kind of idea what the market is doing and then use price action to trade that theme as current conditions dictate.

HTH

@Grantx this is a fantastic response, thank you! You are hitting on a lot of stuff that I'm trying to absorb in my live trading. It is all very mechanical at this point, On any particular morning I'm forgetting a key here or there, but that is to be expected and I think I am slowly progressing. This does help, thanks again.

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