Monday, August 4, 2008

Non-stop Discussion of... Stops

No matter how much I write about stops, this topic doesn't seem to go away. Like Phoenix from ashes, time and again it arises. Recent discussion with a long-term trader returned me to this endless source of questions, doubts, hopes and frustrations.

Warning for overly sensitive types. The text below may seem harsh. Consider it tough love. My counterpart in this discussion took it this way and, I am sure, stands to benefit from it.

The story is probably all too familiar. A good trader in all other regards, knowledgeable about both fundamental and technical sides of trading, capable of picking right sectors and stocks, determining the direction and timing his entries. Beautiful performance on winning trades. Overall performance, ummm... leaves to desire. Threading water at best, losing money is more like it. Why? You probably guessed it. Some of misses are so disastrously big that they manage to negate all the wins and add some red on top.

I think I'll never understand why traders so stubbornly refuse to take stops. No, I was not born with this skill ingrained or inherited. I had my share of blown stops in early years, and they cost me dearly. But but but... how many times the same lesson needs to be taught before we finally heed it?

Here is why I don't understand it. Are you, a trader who doesn't want to take stops, compete for the title of Da Best Trader of All Times and Nations? Because if you manage never ever to lose, you sure are going to be one. No trader in history avoided losses. Not one, period. Whoever your trading idol is, be it Jesse Livermore or the guy who taught you how to click Buy button (hint: GENTLY), did he win all of his trades? No matter how skillful you are, you will lose on some of them simply because of market's nature. Uncertainty Thy Name O Market. It works in odds, not in certainties - meaning, even the best of setups and flawless trades executed according to those setups will fail sometimes. Now, if you acknowledge this (and if you don't, you have no business to be trading), why not limit your losses? This is exactly what stop loss does - according to its very name it STOPS YOUR LOSSES.

Let me say this... the question above is rhetoric one. I know why you refuse to do it. I already wrote about it in the past at
here
(and discussed how to place them in two articles before that). One aspect of this, however, I want to return to. This aspect is RANDOM REINFORCEMENT. It means that not every time a market is going to reward you for doing the right thing or punish you for doing wrong one. Sometimes a stock you just took a stop on will rebound right away. Sometimes a stock you held against all rules will reward you for breaking the rules. Each such case will lead you into temptation to abandon your discipline. "Just this time, please, and I promise to be good again" Nope. Won't happen. You will be bad again, because being bad was rewarded. This great temptation by the market is like siren song - never what it seems to be yet who of us can resist.

Cure is simple. Run the stats. Calculate the total of all losses that got out of hand. Calculate the total of all the losses taken according to the rules - when the stop was hit that is. See what those stocks did after you got out - rebounded? Died on the vine? calculate where your portfolio total would have been should you take all the stops in disciplined manner. Calculate the same fior the case where you would have refused to take any stops. You got your answer.

Me - I take any stop whenever it's hit and consider it my salvation. Foe stop to me is not.
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