2009-05-31

Defence, Stop Loss and Position Sizing

Keeping the emotions out!


Say you have $20 k in your account. And you have a perfect trade strategy or a trading mentor whom you follow. All is going well and you seem to be on the roll. You have had 2 good trades already trading 1 lot and your account is now $22,000. You feel confident. Increase your trading size to 4 lots, waiting to end the week with another 20 pt win and plans to withdraw some cash out for the before the weekend. And now, all of a sudden, the 4 lot trade is going against you on a 15 pt stop. When the trade is down 10 pt, you add 2 more lots as "defence". Market bounces a little, briefly giving you break even on the combined position but you still wait for your profit objective. You feel the trade is finally working out. And then, boom, the next leg down starts and you get stopped out - provided you controlled the urge to move stop further away or remove altogether for that second chance to break even. You end the day with 4 * 15 and 2 * 10 pt loss ($4000 to be precise) and your account is now looking negative for the week! You are frustrated. If the trade which went against you was your own plan, you kick yourself, scream at your spouse or break few crockery. In extreme cases you punch the screen and cause a further $300 damage. If the trade was your trading mentors call, you go out and call him all sorts of names and bash him wherever you can. Basically you throw your toys out of your pram! Sounds Familiar?


Well many inexperienced traders suffer from this. There are several things at play here which determine the success or failure in trading - and it matters at each trade level as a single trade  can wipe you out if you are not careful and disciplined. 

A) Stop Loss Distance : 

The most frequent mistakes trades make is in calculating their stop loss distance. They want to risk $1000 on a trade. They want to trade 4 lots on each trade. So the stop is $1000/50/4 = 5 pt. Now that is rubbish! Markets are volatile and 5 pt is simply a "noise" in the market. You are more likely to end up seeing yourself stopped out and then the trade making off in your direction. 

A trade, however well planned, is still a play on the probability of success. A trade plan is not a guarantee of success nor being on a roll (having few successful streaks) makes the next trade more or less likely to succeed. Therefore each trade should be planned as individual trade with its own risk parameters.

A trader should always keep two stop loss points. 

One - the HARD STOP which has to be in the order book or with your broker. So if your computer breaks down or you are out on a walk and market moves against you, this is the level at which you will DEFINITELY want to get out.

Second - the soft or MENTAL STOP, a level once breached, you start wondering about the success of your trade. May be the market is not acting the way your trade plan asked for. May be something has changed in the analysis or fundamentals of the market. May be you should not worry about reaching your profit objective as per the original plan and instead worry about getting out break even or with minimal loss. 

The HARD STOP should be at least at point where a normal trading day is not expected to trade if your trade plan is right about market direction. In case of day trading, 0.5 - 1 * Average True Range can be a good start. If you are using 50% retracement type trade, the hard stop can be below the bottom of the move whose pullback you are planning to trade. Your mental or soft stop can be at a level of key support or say 61.8% retracement point. For swing trading the hard stop is much wider below key support level. Trader should pay utmost attention to hard stop level as a right stop level can dramatically change the performance of trader. The very tight stop, and chances of getting stopped out increases. A very wide stop and you cannot take sufficient size (see calculating trade size) and therefore reduces your overall profit potential.

B) Trade Size:

The size you trade depends upon your account size (or the capital you are willing to risk per trade) and the HARD STOP level for a given trade. The first question you need to ask yourself is "how much capital I am willing to lose on a single trade?". Usually deploying 2% - 6% of your account per trade is reasonable since the loss suffered by a single failed trade is not sufficient to cause significant damage to your account. As the account size increases you can trade bigger quantities. Remember to decrease the trade size when you are suffering losses. Ideally if your account falls by 25% you should reduce the trade size by 50%.

With a 4% risk level and 15 pt hard stop on S&P 500 futures, the ideal trade size for $20k comes as 20000 * 4% / 50 / 15 ~= 1 lot. That is what you should trade!

C) Defence:

They say - never add to a losing position. Or averaging has killed many traders. And I 100% agree. However, being experienced traders, you know that markets do not move in one direction and there are pullbacks and counter trend moves. Here the so called "defence" comes into play. Assuming that your HARD STOP was at a sensible place where markets were not "expected" to trade on a normal day and your mental stop was a close support level where markets are usually expected to bounce, you can use area around mental stop level to add to your position to defend. Please be clear that when you are defending you are basically giving up your original trade plan to reach your profit objectives and now you are looking out for a break even or small loss exit. You also have to be quick now as the counter trend pullbacks are usually short lived and the next leg down can do further damage to your increased position. 

The size of defence can be same of half the size of your original trade. Remember you are increasing the risk on the trade by defending and keep that risk into consideration while calculating your original position size in the first place.

Also you need to decide if you need to defend or not. Not every trade needs defending!

It is very important to follow a discipline about stop loss level, position sizing and defence to improve your chances of success in trading. You of course need a winning trade plan to start with but remember that you can still mess up if you do not apply further discipline to trading. That is precisely the reason why many traders still fail following the same/similar trade plan which other fellow successful traders are following.

2009-05-30

HOME WORKS (JUNE 2009)

General Markets

The HW sharing experiment seems to work successfully. I cannot express how confident I feel about my trading plans when other traders come with similar/same numbers. Also it allows me to relook at my work if others have differing view. So lets do it again in June. 

I think if you leave just one comment, you can choose the options to subscribe and follow on comments come automatically to you via blogger?

Or there is also an option to subscribe to all comment on the right hand side on main page which can be used for subscribing in most common blog readers.

Happy trading.

VS

Thirty Minute Rule (Opening Range Play) Analysis

Allan's TMR - Analysis of Profit Objective and Performance
TMR CAN WORK with 5pt stop and 2-5pt profit objective. But returns may not be spectacular. 

Oscar's premium chat room provides worthy company of some of the world's smartest traders who trade with their own capital. Allan, a fellow trader, has once introduced the mythical TMR - Thirty Minute Rule to that room. Not a day goes by when someone does not ask "what is TMR?" so much so that Allan has started asking them to Google it instead. I would suggest you do the same as well, but in very brief, to trade TMR, you watch the first 30 mins of regular trading session (08:30 CST - 9:00 CST) for S&P500 futures. The high and low for first 30 minutes would give you the opening range (TMR Range). Now you wait for breakout from this opening range and place trades in the direction of the breakout. I.e. if price falls below the low of TMR Range, you sell, if price rises above TMR range, you buy. You take profit X points away from the breakout OR you are stop loss if the trade does not go in your direction. Simple! 

Anyways, we recently ended up discussing what sort of stop loss and profit objectives (risk: reward) can applied to maximise the outcome from trading TMR. The issue is to set right level of profit objectives and stop loss level so that the winning trade % (Wining Probability - W) generates sufficient profits to overcome the loss generated from stopped out trades. P&L from 20 days (1 month) of trading can be expressed as

PNL = 20 * W * PO - 20 * (1-W) * ST

Where W = Winning Trades %
PO = Profit Objective
ST = STOP Loss level.

We should also remember that W is dependent upon ST as well as PO or in other words W = f(ST, PO). Typically higher the PO lower the W, i.e. more greedy you are less likely you are to win. Also higher the ST, higher the W, i.e. bigger risk you are taking on a trade, more room you are allowing for the trade to be profitable, however after a certain point, increasing the stop level does not increase the winning trade % sufficiently.

I have done a non scientific data collection and analysis of TMR for last 20 days. Ideally one should do the analysis with 200 days or more. I have used the granularity of 15 min bar and I have collected Max Profit which could have been achieved on a particular day before a 15 min bar broke through the required stop loss level. I have analysed the results based uopn two ST levels. A fixed 5 pt stop and also using TMR Range + 2 pt stop. I have assumed no slippage on the stop entry orders used to enter TMR trades. Some of the observations are:

a) For a given Profit Objective, Wining trade % increases if TMR Range +2 stop level is used at least until 10 pt Profit Objective. 

b) 80% - 90% of TMR trades show some profit before soem of them stopping out. However since one cannot predict the top or bottom of the market, one needs to decide in the trade plan the profit objective to be used.

Results:
--------
i) It appears that a trade plan with 5 pt profit objective and 5 st stop loss would produce about 10 pts profit at the end of month (20 days). This is not great but it is still a profit and a 4 lot trader can expect to earn $2000 per month trading TMR with discipline.

ii) With a slightly lower profit objective of only 2.5 pt and 5 pt stop loss you can expect to earn about 12.5 pt per month (20 day).

commission cost and slippage is not included in these results and it can severely affect profitability. Commission + slippage greater than 0.5 pt could render the profitability to zero.

Conclusion:
------------
i) TMR performance could possibly be improved by using TMR Range + 2 stop loss level. However I could not confirm this analysis on my simple excel based model. I wish to paper trade TMR seriously next 20 days and record performance if we get different result.

ii) In my model, I have assumed that all TMR trades eventually get stopped out. That is not true on a trending day where price closes in the direction of TMR trade without ever touching the stop. This can improve the performance of TMR further. In this aspect, my analysis is slightly more conservative. 

iii) TMR trade entered on pullback after initial breakout from range can also increase the performance significantly. So multiple lot traders can actually plan to scale their entry into TMR trades. However I can only speculate on this line as the results should be actually analysed scientifically.

iv) I have only analysed by going through 20 day 15 min chart - a tedious effort, in TOS and therefore my analysis is subject to Human Error. A better and scientific analysis can be done by using back testing applications where you can submit your trade strategy (in the form of script or set or rules to trade) and then run is past previous data to see what results are achieved. If back testing is possible of TOS charts, I am happy to give it a go. Better results can also be achieved by back testing as you can vary the STOP level and see the impact on P&L. 

v) I wish to paper trade TMR on live data so I would have better data to work with next month.

 

 

 

 

 

 

Max P&L

Date

Open

30 Min High

30 Min Low

30 Min Range

TMR

5 PT

RANGE +2

01-May

869.75

870

864.75

5.25

S

2.25

2.25

04-May

880.75

887.25

879

8.25

L

14.50

14.75

05-May

900.75

904.75

899

5.75

S

5.50

5.50

06-May

912

912.5

907.5

5

S

6.25

6.25

07-May

925.25

927

918.5

8.5

S

20.50

20.50

08-May

916

923.75

915

8.75

S

5.25

5.25

11-May

910.5

912

905.75

6.25

L

4.50

4.50

12-May

911.75

913.5

903.5

10

S

7.50

7.50

13-May

892.75

892.75

886.75

6

L

2.75

2.75

14-May

883

885.25

880.5

4.75

L

11.50

11.50

15-May

889

893.75

886.5

7.25

S

-5.00

9.75

18-May

891

894.25

889.5

4.75

S

-5.00

-6.75

19-May

907

907.75

904

3.75

S

-5.00

-5.75

20-May

915

920.75

914

6.75

L

2.75

2.75

21-May

889.5

893.25

887.75

5.5

S

10.00

10.00

22-May

890

890.75

882

8.75

L

4.75

4.75

26-May

878.75

888.75

878.25

10.5

L

22.25

22.25

27-May

909.75

910.5

905.75

4.75

L

-5.00

2.25

28-May

899.75

902.5

896.75

5.75

S

10.50

10.50

29-May

909.75

912.25

902.25

10

L

15.50

15.50

 

 

 

 

 

 

 

 

Notes

 

 

 

 

 

 

 

1

The granularity is at 15 Min Bar level for the purpose of past data. I.e. the Max which could have been achieved before future 15 Min bar take the stop level

2

It is assumed that the stop entry order is placed at the top and bottom of range. Slippage of .25 pt is not accounted.


WIN% 5 PT

Profit Obj

P&L 20 D 5 PT

0%

30

-100.0

0%

25

-100.0

10%

20

-50.0

15%

15

-40.0

30%

10

-10.0

55%

5

10.0

75%

2.5

12.5

80%

2

12.0

80%

1

-4.0