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 MARKET REPORTS |
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Resident trader
How stops can cut a profit run
Will Kraa, December 12, 2007
One day I attended a short introductory free ‘seminar’ by someone trying to encourage people to attend one of his longer seminars that we could attend at a substantial discount if we signed up on the night. (I once asked someone who was doing this sort of thing if he could show me anyone who had actually paid the full amount without the ‘discount’. The response eventually was that he could not, but that ‘everyone is doing it’. He was right but I know that if ordinary retailers did this they would be prosecuted.)
As part of the presentation he demonstrated how stops could make a trading system profitable. He drew a horizontal line showing the buying price for all trades. Then he drew vertical lines representing trades. Each trade was part above the line and part below with some trades moving a long way below the line and others a long way above the line.
Overall the lines above and below more or less cancelled out so the result was not particularly good. He then erased the extended lines below the base line, leaving just small losses, and of course the result now was quite good. The smaller profits made up for the small losses and the larger profits (no longer balanced out by large losses) made the whole thing very profitable. If only it was that easy!
The big problem is that this does not reflect reality. Some trades that go well above the line, making a large profit, would have started out by being a large loss before turning around and becoming very profitable. Wiping out the part of these trades that extend well below the line (and thereby limiting the loss) would also have removed the profit that would have resulted if the trade were allowed to continue.
Let me illustrate with a Forex trade just completed. As you can see from the chart below I entered the trade during a strong upward move in the AUDUSD at 0.8779 and set my stop just below the last retracement in the uptrend at 0.8737. Therefore the risk for the trade was 42 pips. The risk I was prepared to take in this account was $2000 and buying $500,000 meant that for every pip I would gain or lose $50. The total risk for the trade was then 42 x $50 = $2100, near enough to the risk I was prepared to take.
Naturally enough shortly after I entered the trade the price retreated but I did expect that it would continue to go up. This was not a trade I expected to be over in one day so I left the trade open and early Saturday morning found it had been up to over 88 cents, had retreated again but not touched my stop and so I left the trade open for the weekend.
Early Monday morning I had a look and found it was down again but still well above my stop. I had to go out in the morning and when I eventually got back I found my stop had been hit and I was out of the trade. By that time the price had moved up again quite well and I did not want to get back into the trade at the higher price. As you can see on the chart I was right in my assessment that the price would go up but my stop got me out of the trade at a loss of $2100.
The chart clearly shows that if I had not been stopped out of the trade it would have become profitable and I would have been able to lock in a profit of twice the risk. The entry price was 0.8779, the risk was 42 pips so twice that is 84 pips and the price at which the profit was double the risk was 0.8863. This is shown by the line I have marked ‘Profit at twice the risk’. The price exceeded that and the stop would have been moved up to that price. That is where the trade would have been stopped out as the price fell back to the profit stop.
Certainly the stop protected me from larger losses but in this case it also stopped me out from a potentially profitable trade. If the stop had not been there I would have had a profit of $4200 instead of a loss of $2100. It is clear that setting stops does not just protect from excessive losses but also can cut short good profitable trades.
It is especially annoying when a trade is stopped as the price drops just a little below the stop. This is something which is not unusual in Forex trades and has led some to give up using stops. There are problems in doing this. In the first place there is no way of working out the size of the trade based on the initial risk to be taken. Under these circumstances risk management is not possible and trading becomes a questionable pursuit depending more on luck than good management.
In this case, if I had been watching while the stop was exercised, it would have been possible to get back into the trade as prices recovered with a stop just below the most recent low. The next spike down did not go below this low and so the trade would have been profitable.
Since starting this article I have updated the chart to this morning’s action. How would you have liked to have been in a long trade without a stop during this latest down move? On the other hand, let’s say you went short at the line I have marked ‘Profit at twice risk’ as the price fell back below this line. For such a trade it would be reasonable to set the stop at just above the most recent high. But see that nasty spike up just before the plunge? It would have got you out of the trade before a really good profit of nearly 140 pips. Those kinds of spikes are common before a news release (in this case the US interest rate cut). Trade these things with great care or make sure you are not in the market. The possible profits are great but the risks are great too.
There will always be a conflict between stops that are too close, stopping out trades that would have become profitable, and stops that are so far from the entry price that proper risk management leads to trades that are small in size with correspondingly small profits. It is necessary to place stops where the chart would indicate it should be and if this leads to stops that are too far from the entry price then it might be better to pass up the trade.
So it seems to be that stops are something of a necessary evil that can be very annoying at times. Also it is certainly too much of an oversimplification to state that stops will inevitably increase profits. There are times when using stops will close out trades that would have become profitable and if the system you are trading depended for its profitability on those trades then the stops will make it unprofitable.
These things are true but it is not safe to trade without stops. It is better to put up with the frustration of being stopped out of trades that soon reverse again into profitable territory than to trade without stops. Remember too that simply adding stops will not necessarily turn a bad trading system into a good one.
One other question that needs to be addressed is the issue of stops being too far from the entry price. How far is too far? How close is too close? Was my stop in this trade too far away or was it too close? I can feel another article coming on.
More articles from this edition of CompareShares:
Investing: A share portfolio for all seasons
Stocks: Stocks for the long haul: hot European stocks
Resident Trader: How stops can cut a profit run
Trading: The ultimate guide to trading shares for beginners - final part
Stocks: Corporate America embracing renewable energy
Markets: Fed rate cut no heart-starter for US sharemarkets
Stocks: Stock to watch: Uranium Exploration Australia
Companies: Bell Financial shines on debut
Whatever your views, you can discuss this article - or any of Will's articles - on our message board Your 2 Cents.
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