Smart Stops Cannot Be Eyeballed
Back 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:
- The Chandelier Exit
“We like the Chandelier Exit as one of our primary exits for trend following systems. (The name is derived from the fact that the exit is hung downward from the ceiling of a trade.) This exit is extremely effective at letting profits run in the direction of a trend while still offering some protection against any reversal in trend. In fact our research and that of our friend Dr. Van Tharp has shown that this exit is so effective that we can literally enter markets at random and if we use this exit the results over time are likely to be profitable. (If you don’t believe us just test it yourself over a handful of markets.) In general the best values for the ATR in most markets ranges between 2.5 and 4.0.”
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:
- Don’t Neglect Your Exits
“We first observed the impact of exits years ago when attempting our research of popular indicators we were testing as entries. We found that even a minor variation of the exit strategy would drastically affect the number of trades, the size of the winners and losers, the percentage of winners, the size of the drawdown and the total profitability. Although we set out to test entries, we quickly discovered that the performance data was entirely dependent on the exits we used and the entries had little if anything to do with the results.”
William Eckhardt also said the same thing:
- “Many systematic traders spend the majority of their time searching for good places to initiate. It just seems to be part of human nature to focus on the most hopeful point of the trading cycle. Our research indicated that liquidations are vastly more important than initiations. If you initiate purely randomly, you do surprisingly well with a good liquidation criterion.”
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:
- “If you make a bad trade and you have money management you are really not in much trouble. However, if you miss a good trade there is nowhere to turn. If you miss good trades with any regularity you’re finished.”
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:
- Identify appropriate trading candidates;
- Trade a basket of the qualified candidates;
- Implement position sizing to limit exposure and risk;
- Follow the buy and sell signals;
- Avoid countertrend trading; and most of all,
- 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 Universal Stops for TradeStation 8.x and eSignal 10.x to individual traders for only $50.
