October 24, 1999
This is the Fifth Article in a Series of Articles About Exits
Exits - Are Your Money Management Stops Too Large or Too Small?
by Chuck LeBeau and Terence Tan
It seems that Money Management stops are either too close and subject to frequent whipsaws or too far away and expose our capital to large losses. >From the results of our testing, we have concluded that most systems would benefit from the inclusion of relatively large money management stops.
At first thought it would seem that the closer the stops and the smaller the losses, the lower the expected drawdown. However, this seemingly logical assumption does not hold up in testing. In almost all cases the wider stops result in a higher winning percentage and a lower drawdown. Smaller stops appear to be psychologically attractive, but may actually deteriorate system performance because they are susceptible to frequent "whipsaws" caused by random and insignificant price movements. On the other hand, large stops may also be psychologically attractive because they are activated less frequently, and systems with large stops generally tend to have a higher percentage of winning trades. However, the down side is that large stops force the trader to occasionally suffer rather large losses which, although infrequent, can be psychologically difficult to accept as well. Is there a compromise solution to this problem?
We believe there is. An interesting phenomenon we have observed from our research is that it is often possible to tighten the money management stop a short period after the initial trade entry. It has been our preference to allow the trade some latitude to work out in the beginning and this is best accomplished with a relatively large money management stop during the first few days of the trade. However, after a specific number of days the money management stop can often be reduced to a much smaller amount. For instance, if we have a $5,000 stop upon entering a trade on the S&P 500 futures market, and this is an uncomfortably large loss to take, it may be possible to leave the $5,000 stop in place only for the first few days, and then tighten the stop to $2,500 for the remainder of the trade. The chances of being stopped out late in the trade with a $5,000 loss have been reduced, although it is always possible that a large adverse price movement in the first few days could still stop us out with the maximum loss. The exact stop amounts and the time of implementation would have to be determined by computer and statistical analysis of the system's characteristics. In some trend-following systems, we have found that we can benefit substantially by implementing a larger stop in the beginning of a trade, and then reducing the original stop by 50% or more once the trade is underway.
This technique of tightening stops after a few days in the trade has a sound basis: we know that the predictiveness of a trade entry indicator declines as the trade moves out into the future. In most cases an entry indicator has a better chance of predicting the price movement in the next 2 days than in the next 2 weeks. Starting off a trade with a large money management stop allows the trade sufficient room to work in the right direction, since it corresponds to a period of high confidence in the entry indication. As the trade moves out into the future, the confidence of the entry indication declines, so we tighten up the stop to reflect decreasing confidence in the trade.
Other possibilities for dealing with the problem of large stops also exist. Stops such as breakeven stops or profit protection stops that over-ride the money management stop can easily be implemented in later stages of the trade. Once these stops are activated, the possibility of taking the large original stop loss is substantially reduced or eliminated. These and other techniques will be fully discussed in subsequent chapters.
Proper understanding and implementation of the money management stop is vital to a trader's survival. The stop effectively limits the maximum loss that may be sustained in a trade, which in turn contributes to the all-important goal of preservation of capital. Trading without a money management stop is to allow for a high chance of catastrophic loss in your account.
The importance of the Money Management stop is aptly summed up by Jack Schwager with this statement from his book, The New Market Wizards: "If you can't take a small loss, sooner or later you will take the mother of all losses."
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We are in the process of adding a new feature to the Systems pages on our website. We are enhancing the Equity chart on our Systems pages with an animation which shows the historical entries and exits plotted on a year by year continuos contract futures chart. You can now see exactly where the entries and exits took place for each trade listed on the trade by trade report. The animation will cycle through each chart for the year and then return to the main Equity chart and start over.
We have also supplied a set of links at the bottom of each chart which you can use if you want to study any particular year. Clicking on 1994 for instance will launch a smaller browser window with the 1994 chart for that system. So far we have charts for 10 of the 16 systems completed, and the remaining ones (the Bond Systems) should be up and running before the end of the week.
This exciting new display is up and running and you can go there now. Start on the Systems page and then pick any system (except bonds for now) to see the new charts. http://www.traderclub.com/systems.htm
We have also added a small form on the Links page, so that if you want to propose a new link for us to add you can do so very easily. If you would like to recommend a site that is trading related or something of use to our members we will be happy to add it to our links page, http://www.traderclub.com/links.htm
Please feel free to contact us with any suggestions and comments about the website. We want to make it as user friendly and useful to you as we can. mailto:firstname.lastname@example.org
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Chuck will be a featured speaker at this year's Technical Analysis Group (TAG) Conference at the MGM Grand Hotel in Las Vegas. Chuck's topic this year will be: "A New Look at Exit Strategies". Nov 19 - 22 1999
For information and details go here: http://www.traderclub.com/events.htm
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That's all for this time
Good Luck and Good Trading
Chuck Le Beau's System Traders Club