More profit through clever risk management
To find the best stop
Only the fewest traders earn long-term money on the stock market. One of the reasons for this is the indiscriminate or incorrect setting of stops. But how much leeway should you give to a trade and when is it better to get out? There are many myths, some of which are misinterpreted and blindly believed. Traders who have long-term profitability, however, are working on a statistical basis, which we would like to present to you in the following.
Before we look at the statistical approach, we want to look at the six most important mistakes made in risk management.
Error 1: Avoid stops
Using stops can ruin the account quickly – especially if you enter a position out of a feeling. A common beginner's mistake is to convince yourself: "The course will come back, I just sit it out." If the account is very large, this can work, of course, but you should avoid it. Even if it works 100 times, it can ruin your account at the 101 time. A stop belongs to each system and serves, if it is well chosen and serves to secure capital. That should be your ultimate goal.
Error 2: Trailing stops
A trailing stop is a stop that is drawn after the course after it has started in the desired direction. For example, you might want to keep track of the interruption in the x percent rate every x percent, and thus minimize your initial risk. Or you may prefer to call two easy examples – your stop always goes back to the last low (in a long position) or high (in a short position). In the meantime, many brokers also have an automatic function.
That sounds reasonable at first. After all, who was not strong in profit and then had to give up all the profits again, because the market was spinning at one time? However, a trailing stop in Daytrading systems can also worsen the result. Because the individual trade is not decisive, but the overall result. What do you use if you win more than 100 euros in one day, but earn a total of 200 euros less on the other days?
For your psyche, a trailing stop is a good thing. Many traders are afraid to return profits. That's human. But the market has natural fluctuations, which often throw us out of the market thanks to a trailing stop. Test it for your own system: Enter the profit or loss of your regular system and also the profit or loss that you would have made with the trailing stop. At the end, you add both Excel columns and compare the result. Is that
If the result of using a trailing stop is worse, the market simply needs more space.
Error 3: Set Stops on striking highs and lows
Many retailers place their stops on striking highs or lows or strong resistors or supports. This is of course very simple and quick to understand. But there are often many orders from other market participants and one or the other might be inclined to move the course quickly in that direction. Therefore, avoid setting the stop rates in this way. Figure 1 shows an example where you could have put the stop on the basis of striking lows in the past. It is more sensible, however, to put stop courses slightly above the resistance or below the support marks.
Error 4: Too small stops
The market has a certain basic fluctuation, according to which your stops should be directed. Even if you are often right in the direction of your trades, there are many ways in which the market can move there. And he often does this by running something against them first. So, if you put your stop in the natural fluctuation of the market, too much coincidence is included in your trade and the system is very susceptible to small changes. Test the self and you will see that this system is not robust. The probability is extremely high that it only works in certain market phases and has large Drawdowns.
Error 5: Stops according to pre-defined risk
Some traders assume that they want to risk a fixed amount per trade, for example, 50 euros. This sounds good at first because the trader has thought and works with a Stoppkurs that limits his risk. But for what reason should a stop at exactly 50-euro loss make sense? This approach is completely random because the trader makes a decision based on his custody account size and not on market criteria. However, the market is not interested in whether you feel comfortable with a stop of 50 euros. You need to scale the stop and take care of what the market does, and align your actions with it.
Error 6: The myth of chance/risk ratio (CRV)
There are traders who tell you that you only need a high CRV to earn money successfully on the stock market. Just because you have a good CRV does not mean that you are making money with it. Don't be fooled. The hit ratio plays an important role, as well as a positive expectation value. For example, what uses a CRV of 10:1 (if you win, you earn ten times your risk) if you only have a 10 percent hit rate? In this example, only a zero-sum game would come out at the end.
The statistical test
In the following we would like to show you one of the many possibilities to make a stop meaningful. We statistically evaluate where the best stop is. To do this, you continuously calculate the best using a computer program – at which stop the expected value per trade is large. You can do this via a simulation or you test your system with different stop sizes, for example with 30 ticks, 35 ticks and so on. The results are continuously included in a chart and look for the best results based on historical data. If the values are similar to the best value, they have a plateau formation – there are many values at the same level.
Look for a better understanding of image 2. On the x axis, the various stop rates in ticks of a fictitious trading system are listed on the chart. The y-axis shows the expected value per trade in US dollars. Now take a look at the first value. If you stop 20 ticks, you get an expected value of approximately 78 US dollars per trade. Our system was tested with a stop in the interval of 20 to 100 ticks and each individual value entered. As can be seen here, neither too small nor too large a stop is optimal. They would steadily worsen the overall result. The optimal stop is in our example at 32 ticks. You can easily see that all surrounding values achieve similar high profits. This is the previously mentioned plateau formation.
You now select a stop from this plateau. You should prefer a value that is in the middle. As you see, it goes left steeper down than right. Therefore, in this case you should select a stop that is further to the right on this plateau, as this is much more stable. If the expected value curve shifts even by a tick to the right by market changes, its expectation will fall to 100 US dollars. You should carry out these calculations continuously for your trading system in order to always calculate current data.
Take account of volatility
They should also take into account volatility in their calculation. You can do this by including in the backtests and so in your stop evaluation different market phases. In any case, there should be market phases which are very low in fluctuation and which are very high.
Another option is to set a volatility-related stop. You can calculate the same as a fixed stop by using the multiple of a particular volatility indicator (for example, the average true range, short: ATR) as a stop. You can also take a specific measurement range (for example, the opening range of the market) and multiply this range with a fixed value. For example, you could define your stop as the 2.5-fold of the opening range and you have already included the volatility sensibly.
It is also absolutely necessary that you repeat the test for the optimal stop calculation on a regular basis. Observe whether the values have changed. Normally, not much changes, but already a small change and thus a false stop can provide a worse result of your trading system.
Conclusion
Many stop myths are counterproductive and in the long run they worsen the performance. No stop is, however, a solution, because that can be very expensive. Rather, it makes sense to determine the optimal stop with a statistical evaluation of each trading instrument.
Author
Drian Kömel
Drian Kömel has studied business mathematics and has been dealing with the stock market since his youth. It focuses on the statistical system development and the trade of cot data and time curves. He is also the author of "How to achieve above-average returns".
Article provided by Trader's