In advance I am sorry, I am new to blogging and it might be an offence to post the same message twice, but I don't know how to quote my other thread.
First off I like to sleep at night, so if you are a new trader don’t misunderstand this as a license to go out on a high risk long with no plan and blow your account out. Many very profitable traders are big on stops and so you should know there must be some wisdom there. Please treat this post more as an intellectual exercise.
There is this really important idea that casinos don’t make their money based on the “edge” of the game but in fact do make there money based when the player runs out of money. Dr. Tharp and Ralph Vince talk about the risk of ruin even in a game 60% in your favour.
Here is a copy found all over the net:
What this says is that a casino would still win even in a 50/50 game like coin toss.
Also in effect it says if you built an automated trading system that can win 60% of the time, if it bets a big part of your account, it will still blow up your account. We know this as getting through a drawdown
That really came home to a trader with a bunch of trailing stops during the “flash crash”, that was the ultimate run at the stops.
All that is nothing new . . . but I have been thinking that a stop loss is a little bit like a mini blowing up of your account. You can build almost any automated trading system you like and if you introduce a stop loss in your back-test you will usually get a lower overall return. That really gets to me, because using backtesting
and computers it becomes clear that the common wisdom of always use a stop is not good for your return. (Of course you can place your stops so far out they almost never trigger, but that is just about like no stop at all.) Stops are like the gambler who must stop vs the house that does not have to stop. Of course the ultimate stop is blowing up your account.
In the bigger picture, if the market were full of traders with stops and many other traders with under-funded accounts, it would cause the market to drop faster than it rises, a phenonium we do see in the markets. Like a casino, a draw-down or string of bets loosing means the player must quit, this would cause funds to transfer from the player to the “house” or in the market the better funded pros with better risk management feed on the small speculators. You can also say new money comes in to the market, but it just bounces around, until someone losses and steps away from the table. Fear and greed come in again. The amateurs would give up on the market just when they should buy. The old floor traders
used to say, when you feel like you want to puke
on your shoes, it’s probably time to buy more.
I recall years ago learning a fascinating idea that a stock with a big “short interest” can rocket up if the shorts get squeezed and they all must cover
. Imagine the emotions of someone with a great short but the stock rises anyway (like Netflicks last year). They must feel just like the guy in Vegas when his ATM
card says no more money for you. At some point you reach a pain threshold, margin call
or just go broke. In a way, it is at this point your money is released back into the trading system. This happens not just to one trader but thousands at once. When the selling pressure
is finally off, the stock must do something and when you are all out
of sellers that something is the stock goes up in value.
I have thought about how you trade this, and it begins to sound like old trader wisdom, “buy on the pull back” and “keep your powder dry”. It even gets a bit like Warren Buffet. I have built a number of automated trading systems based on simple indicators, but the ones based on price using “pull backs” usually outperform. In a way you are buying at fire sale prices, buying low to sell high later. This really should not be a surprise that it works.
But as for stops, they are needed not because they make sense, but because they let humans trade with comfort. If you can’t relax you cannot day trade, but you will pay a fee to the market for that comfort. The pro traders tell me it is worth the cost.