A stop Technique which i have recently implemented
I have been battling with stops every since I started trading. Stops can be so arbitrary. If you look at any chart, most likely you will find that there are many reasons for choosing or not choosing a particular stop level.
Then there is the eternal question to be answered: Mechanical vs mental stops. It seems like both work against you: Place a mechanical stop too tight, and you get stopped out. Place it too loose, and the more chance you have your stop will fall victim of mean reversion and you get stopped out at the worst possible price. Place a mental stop, and you watch the price blow through your stop before you have the time to act accordingly.
And finally, put stops at text book areas on the chart, and you will most certainly get stopped out, and after a few days you realize you were stopped out at the extreme.
Do other traders get these feelings or is it only me?
Statistically the effects of stop losses can be mitigated by also placing profit targets with the same technique, however, the larger the reward to risk, the less effective this technique becomes. Leaning towards Position and Swing Trading, this technique definitely has a big downside that it often results in premature exits on profitable trades.
Long story short, I have reconciled my stop technique to contain a mix of several techniques, and this seems to be working quite well for me now.
First of all, I use my stop for position sizing. This is basically the fixed risk method where the difference between your trade price and your stop determines the size of your position. This is fine as far as confidence is concerned, but as shown in a previous post, just this on its own may lead to wild fluctuations in position sizes which can affect the consistency of your equity curve.
Now, if that stop is calculated solely on the basis of volatility, say a multiple of the ATR (Average True Range), then the position sizing model becomes a volatility sizing model, which seems to perform well when compared to other models.
However, in most cases this volatility model puts a stop in nonsensical places on the chart, so a discretionary element is required. It won’t make sense to use a volatility stop if that stop is a few cents above a long term support line, for example.
My simple solution is to address as many of these issues as possible into one, compromising, stop technique. I place a stop on a place in the chart where it would make sense and consider that to be my mental stop. If that stop is breached, I will be following the price intently to see whether it was a fake out or whether there will be a continuation. I also place a hard stop 1 ATR below this level. The position size is determined on the distance between this hard stop and the entry price, hence it has both a volatility element as well as a proper risk element which is determined according to your stop. This method allows larger position sizing when closer to a turning point, which is consistent with the theory that you should place your biggest bets where you have the best risk/reward scenarios. Conversely it will raise a warning sign that you may be too late for a sensible entry if the position size results in too small a figure.
I find that I usually rarely hit the hard stop, so that becomes a true worst case scenario, which I am happy with as I consider hard stops as a necessary evil. However this level has a great impact on the position size which in risk terms is a crucial part of the equation.
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