Before the Trade: Smart Stops Cannot Be Eyeballed

Teresa, January 3, 2008 @ 12:09PM ET | Link | RSS | Read via Email | Start a Discussion  

Chandelier Lights on the Graben at Christmas, ViennaBack in 1997 there was a thing called the Omega Research System Trading and Development Club that reviewed and published a handful of trading system every couple of months or so.

Within a short time, most of the systems came to use what they called “common exits”, namely, they all used some sort of ATR stop that eventually morphed into the Van Tharp/Chuck LeBeau Chandelier Exit:

LeBeau offered up some code, and eventually, the idea was incorporated into TradeStation. In the current version, two canned versions of the ATR long/short exit strategies are provided, but additional code must be written to avoid a potentially fatal problem. Whatever.

LeBeau reiterated his views in an article at the Van Tharp Institute website:

William Eckhardt also said the same thing:

The bottom line is that retail traders tend to take big losses while those attempting to trade for a living tend to take small gains, resulting in doom for both. Eckhardt neatly summed up the trader’s predicament:

These all-too-human tendencies have been documented in the annals of behavioral economics/finance and was the subject of an excellent article by John Cassidy called Mind Games: What neuroeconomics tells us about money and the brain.

Stops Cannot be Eyeballed

The lesson here is that stops cannot be eyeballed. A trader that places stops arbitrarily or uses stops calculated incorrectly is destined to always exit too early and miss the home run, or exit too late after a change of trend.

Stops must be placed strategically, yet nearly all commercially available stops have serious flaws. In Engineering Better Bollinger Bands and Thoughts on the Kase Dev-Stop, I demonstrated why stops must accurately reflect volatility and range. That is why we never, ever place stops based on what we can afford to lose. Stops must be placed where they ought to be, and we reduce our trading size as required to manage risk to the account. This is our definitive edge.

Stops alone cannot guarantee success. A balanced trading program has a number of elements:

  1. Identify appropriate trading candidates;
  2. Trade a basket of the qualified candidates;
  3. Implement position sizing to limit exposure and risk;
  4. Follow the buy and sell signals;
  5. Avoid countertrend trading; and most of all,
  6. AVOID INSANE LEVERAGE.

You’ll note that vendors hardly ever cover a couple of the bases, let alone all of them. They often charge thousands for nothing more than a poorly placed stop.

The vast majority these systems and stops are lemons, and that’s why I made the pledge to level the playing field by making InVivo.Stops for TradeStation and eSignal BY DONATION.

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