Placing stops: The personal “risk-tolerance” myth

Wednesday, September 17, 2008

The bad news: The market doesn’t care what you’re comfortable risking.
The good news: You don’t need to rely on your feelings to place stops.
BY ACTIVE TRADER STAFF

One of the most dangerous clichés in trading is that how much you risk is a matter of personal preference — akin to whether you like your meat medium
rare or medium, or your martinis straight up or on the rocks.

Have you ever listened to an industry speaker or author conclude a discussion
of a trade setup with the advice that you “always need to place a stop to protect
yourself”? When asked where that stop should be placed, the answer is often
something like, “Risk is a matter of personal preference. Every trader must determine what he or she is comfortable risking.”

In case you didn’t hear the “thump,” that was somebody punting. Most likely,
the person a) doesn’t have a clue where the stop should be placed, or worse, b)
knows that virtually any stop will hurt the strategy’s performance and doesn’t want to tell you that.

Besides the basic issue of whether stop-loss orders are always necessary or
advantageous, the hard truth is that effective stop placement is a challenge.
However, it does not have to be based on hunches or how comfortable you feel.

Imagine the following scenario:
You’re trading an instrument with an average daily range of one (1.00) point,
and each 1-point move represents $1,000. The average move (up or down)
from the close of one day to another is .75. The average weekly range (high to
low) is 2.5 and the average move from the close of one week to the next is 1.5.

Say you get a buy signal on Monday and go long on the close at 80; you expect
to make at least a 5-point profit on your trade. You want to protect your position
with a stop-loss order if the market goes against you. Where do you place it?
Should this decision simply be based on a dollar amount you feel “comfortable”
losing, as so many people often advise?

The basic information about this market’s average daily and weekly moves
provides a resounding “no” to this question. Say you have $20,000 in your trading account and you’ve decided you’re comfortable risking $1,000 on a trade. (We will ignore for the moment this represents a 5- percent risk of account equity — a high percentage by most standards.) Because a one-point move represents $1,000, you would have to place your stop at 79 to keep the trade in your comfort zone.

This trade plan might be psychologically comforting, but it’s also a virtually
guaranteed loss. Assuming this instrument keeps trading in line with its average
performance, you could expect price to be 1.5 points higher or lower when it
closes one week from now. If you bought at the absolute low for the week, you
might be lucky enough to see a 2.5-point gain sometime during the week. At any
rate, a 5-point move in one week is probably not in the cards.

On the other hand, the daily close-toclose move is .75, which means your 1-
point stop could be hit in less than two days. The average daily range is 1 point,
so if the next day’s high is lower than your entry price and the market is
falling, you could easily be stopped out in less than 24 hours.

Basically, you’ve put yourself in a position with a high probability of losing
because your stop placement is arbitrary — based on a “gut feeling” of how much money is appropriate to lose, rather than analysis.
In this case, the market itself — by virtue of its most basic price movement,
or volatility, statistics — was telling you a 1-point stop was not a good idea; to
stay in this position long enough to profit, you needed to use a wider stop.

This example obviously simplifies many facets of a trade. In practice, analysis
of a trade setup’s characteristics will help determine an appropriate stop. For
example, by analyzing 50 previous examples of the setup you were using for this
trade, you might have found that 55 percent of the time price fell 1.25 to 1.5 points below the entry price before rallying. To avoid the chance of getting stopped out on such moves, you could place your stop more than 1.5 points below the entry point. This might not feel “comfortable” to you, but it’s what the market is telling you is necessary.

Now let’s revisit the topic of trade risk as a percentage of account equity. In this
example, 5 percent of account equity was initially risked on the trade. One of
the more useful trading clichés is that professional money managers typically
risk only 1 to 2 percent of account equity per trade. Again, this is painting in
broad strokes, but it is true that the less capital you risk per trade, the less likely you are to be destroyed by a handful of large losing trades.

Risk becomes an increasingly more complex topic as you trade more instruments
and strategies. But keep in mind you always need to balance risk in two
fundamental ways: 1) as a dollar amount based on a percentage of total account
equity, and 2) as a percentage of the market price (the difference between
your entry price and your stop). Among other things, doing so will determine
how big your position should be.

For example, say you’re risking 2 percent of your account per trade representing
$2,000 (which means you have $100,000 in your account). You go long a stock at $50 using a tested strategy that indicates your stop should be three points away (at $47). To determine how many shares to buy, divide the amount of money you can risk on the trade by the stop size, in this case 2000/3, or 666 shares (rounded down).

So the next time someone describes a trading strategy and suggests you
should place a stop where you feel “comfortable,” remember one thing:
When it comes to stops, skip the comfort and go directly to the facts.