Research on Stop Loss

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17th April, 2002

Automatic Stops or Mental Stops? | Mental Stops all the time? | Where to place Stops | Follow through action required | Succour in 2%

The Colour of Money - Ongoing issues in Risk Management

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Dear Readers,

We are dispensing with the usual market readings today morning, because we feel a great NEED to discuss Stop Losses with you. Market readings might follow in driplets later during the day, OR we may just come out with the Evening Edition. Hopefully you will not mind this small modification in the routine and will like what we have on offer today morning.

TALKING ABOUT STOP LOSS
The most rudimentary set of Trading Rules lay justifiable stress on the importance of cutting Loss on trades that go wrong. And trades tend to go wrong more often than we would like. There is very little guidance available, however, on the How-When-Where regarding Stop Losses.

We would like to share some of our experiences today with you, Dear Readers, for whatever they might be worth. Your comments and feedback are welcome.

We touch upon the following:
1) Automatic Stops or Mental Stops?
2) Mental Stops all the time?
3) Where to place Stops
4) Follow through action required
5) Succour in 2%

Automatic Stops or Mental Stops?
The common advice is to pre-decide on a Stop Loss before entering into a trade and to place a Stop Loss Order alongwith the trade. While we agree with the basic tenet of pre-deciding on a Stop Loss before entering a trade, because that would compel us to THINK about the If-Then-Else in a trade, our experience has been that Mental Stops are better than Automatic Stops.

Mental Stops are levels or regions where you INTEND to cut the loss on a trade. They differ from Automatic Stops in that they allow you to watch the price action around the Stop level or region and to remain in the trade if the market moves back into the direction of your trade. In the case of Auto Stops there's nothing to be done if you've been stopped out and the market has moved back in the direction of the original trade thereafter.

The downside of Mental Stops is that you have to continue to carry the responsibility and the tension of watching the market and your position. It requires that you be honest with yourself and CUT the loss if you see the price action around the Stop level-region necessitates cutting the position. In the case of Auto Stops, there is a sense of passing the responsibility of our positions onto the market and saying "The market did it to me" when we get stopped out.

Another reason why Mental Stops are better than Auto Stops stems from the very rationale of Stop Losses. We use Stops to cut our loss when we are sure that we do not want to carry the particular position any longer. If we have chosen our Stops correctly, it is quite likely that the market will give us time to adjudge whether our position is worth retaining or not and Mental Stops can be used effectively.

A big drawback of Mental Stops is the difficulty of watching positions while we are sleeping. We are trying to figure how to get around this difficulty and would be glad to hear about your experiences in this regard.

Mental Stops call for greater maturity and finesse on the part of the Trader than Auto Stops, but are probably better than Auto Stops.

Mental Stops all the time?
The above does NOT mean that Mental Stops are superior to Auto Stops ALL the time. There are some instances when Auto Stops are much better. These are, basically, those occasions where you KNOW beforehand, the exact level whereafter you would want to jettison your position.

An example of this kind of certainty is when you are trading a FLAG formation. Say you have identified a possible Bull Flag and have bought at the bottome of Flag. If things turn out as hoped for, the market should go up immediately thereafter and should NOT fall below your entry. IF the market does fall back to and below your Long Entry point, it is a clear indication that the Flag has not materialised and as such the trade should be closed.

This is because Flags formations usually provide clear and well definable Risk-Reward trade offs.

Thus, when trading Flags you can and should place an Auto Stop just a little below your Long Entry (assuming you have entered near the bottom of the Flag). Having a Mental Stop in this case would be wrong because if the Flag is proved wrong, the market will, in all probability slice through the Mental Stop region, giving you no time to act/ react.

Where to place Stops
We Stop out of a trade when we no longer want to hold onto that particular position. The question that arises is, WHY do we want to get out of that trade?

There can be 2 reasons for stopping out of a trade. EITHER the market tells us that our intrinsic View or Directional Assesment itself was wrong. OR we stop out of a trade (even if we still believe in our basic Bullish or Bearish reading) because we think we can establish another position at a better level than the previous one.

The effort should be to choose a meaningful SL which is neither too close to the Entry to get activated soon after entry (only to have the market go back in the original direction thereafter), nor so far away from the Entry that we have no time or space left for Follow Up action.

The difficult part about the paragraph above is that it requires us to have a Trading Plan or Strategy and to choose our Entry much more carefully than we tend to do, in accordance with that Plan.

Follow through action required
We come back to the REASONS for wanting to Stop Out. In the first case, when our directional reading has been proved wrong, we should look to enter into a trade in the opposite direction - a case of Stop-and-Reverse (SAR). It needs to be pointed out here that it is NOT necessary to SAR at the same instance and level all the time. If you are an intra-week (or longer) Trader, you can enter into a Reverse trade after stopping out of the original trade, allowing yourself time to reformulate your strategy.

In the second case, where we continue to believe in our directional reading but want to re-establish the trade at a better level, the follow up action required is to, in fact, Sell or Buy again (as the case may be) at a better level.

We, personally, are not too good at following through on a Stop Loss. But, we did not do too badly in the last few days. You might recall we had sold $250K against JPY at 131.70 on 11-Apr-02. Thereafter the market went up to 132.40 on 15-Apr and came down to 131.36 on the same day before moving up back up to 132.20+ on the same day. We stopped out of our $250 K Short (entry 131.70) on the way up from 131.36 at 131.80 on 15-Apr but re- established the Short at 132.10 (albeit a smaller amount of $200K). Of course, the Market was magnanimous enough to give this one to us and we are grateful to it.

Succour in 2%
All of the above is good and fine. But what do we do when things go wrong suddenly and drastically? We have often seen ourselves hit the panic button and take a loss near the highs or lows of the market after an unexpectedly large move has hit us, when a little more patience would have enabled us to cut the position at better levels and lower loss.

How do we avoid the panic? Here, our study of the Probability Distribution of Amplitudes in various time frames (1, 3 and 5 days) comes in handy. We have seen that there is 50-75-80% chance of the market registering a High-to-Low movement of 1.5-2.0% over these time frames.

The flip side of this observation works for us and enables us to avoid panicking if things go drastically wrong. For, if the market has already moved 2% AGAINST us (soon after our Entry), there is only 20-50% chance that the situation will continue to get even worse in the IMMEDIATE context. Waiting for a few hours or for a day might give us an opportunity to exit the trade at saner levels.

We were able to use this observation over the last week, again in $- Yen (and to a lesser extent in Euro-Yen). You might remember we had sold $100K at 130.41 on 10-Apr. Thereafter, on 11-Apr and 12- Apr we saw $-Yen shoot up in early Tokyo trading, reaching up to 132.40 on 15-Apr, leaving us quivering with Shorts ($100K at 130.41 and $250K at 131.70).

Armed with our view that there was strong Resistance in the 132.50-75 and 133.00-20 regions and with the observation that there is only a 20-50% chance of the situation getting MUCH worse, we were able to hold onto our Shorts and eventually square them at respectable levels yesterday, on 16th April, losing only $6

It can be said that we would have done much better if we had ADDED to our Shorts near the highs (132.20-40 in $-Yen and 116.50 in Euro-Yen), but frankly were scared of doing so. Hopefully more research and better planning will enable us to do better next time.

Conclusion
To conclude, all of the above presupposes a Plan of Action, which is one of the requirements of Money Management. We thought Money Management was all about betting small. While that is an important part in itself, it is not all by itself. We find that we are only beginning to take baby steps towards Money Management, which goes beyond mere market readings and getting in-and-out of the market. Hopefully we will be able to progress further on this road.

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