Are You REALLY Accepting the Risk of Your Trades?

In listening to the “Trading in the Zone” audiobook, I came to a section about truly thinking in probabilities and what it means to accept the risk of your trades. This got me thinking about a few things.

The basic facts are that we cannot know what will happen before we take any individual trade. There are too many unknowns and unknowables to have any certainty. We can have an edge that plays out over time, but in each individual trade literally anything can happen as any other traders enter or exit trades while we are in the market. It’s one thing to know that not every trade is a winner. It’s another thing to fully accept that before you put on a trade.

It occurred to me that the way I think about stop losses is wrong. Before I trade, I pick a stop point, usually by technicals, and how much money I’m “willing” to lose at most. This is not truly accepting that risk!! If the trade goes bad, I feel awful that I lost, that I was wrong, that my net wins/losses keep sinking. I feel like the market faded my decision and took away my money. Of course I don’t think the market is consciously trying to get me. I attribute it more to my own “bad” judgement. This also means that if a trade goes in my favor, I’m afraid of the market reversing and taking that little bit of profit and some capital away. I cut the winner. I also will bail out at break even if a trade fades a little, then goes back to my entry point. I feel lucky to “save” the money that was at risk. I cut myself off from the possibility that the trade might work out. I basically guarantee that I will either lose 1R, scratch or win much less than my usual 1R. Add in commissions and it’s a recipie for being a net loser.

Now sometimes, like in my last GSVC trade, I’ll manage the winner well. I did so because I had so much cushion from my entry point that I was no longer afraid of taking a loss. I hadn’t accepted the risk, I was just ignoring it because I had so much breathing room. If the trade had languished near my buy point, I’d probably have been looking for excuses to bail out near 16, if not for a small loss if it “looked” ominous.

It hit me that to really accept the risk of a trade, I need to think of the stop loss as the ante I need to pay to find out if the trade will work or not. Instead of defining it as a “worst case scenario that probably (in my head) won’t happen”, I need to think of it like the cost to buy a lotto ticket, or the chips required to pay the blinds in poker. Your stop loss and position size should represent the amount of money you are going to pay to see if this particular trade happens in the way that your edge predicts. As soon as you put on the trade, that money is spent. It’s gone. It’s not yours anymore. You don’t need to fear losing it any more than you fear losing the dollar you pay at a carnival to throw darts at balloons trying to win a prize. If you do fear that, you are trading too large. If you had to pay $1000 to throw that dart, you’d think twice. You’d measure the cost against what you might win. As a loser trader, you just put on any old trade and then hope it works out. That’s like paying the $1000 and then hoping you hit a balloon so you get the $1000 back to pay your rent, plus whatever extra winnings you get. You are going to make poor decisions, overpay for the chance to find out if you are right, and lose in the end.

I’m going to work on my personal thoughts about stop losses. I’m going to try to think of them not as a “worst case” possibility, but a certain cost. If I’m not willing to outright pay that certain cost for my potential trade, then I have no business taking that trade. A trader’s job is to judge opportunities, and unless you accurately judge the costs of testing your judgement, you’re sunk.

Ante up or fold!

Just 2 NQ Points A Day

Just 2 NQ points a day. That’s all I ask. Instead of trying to get every last tick out of a given move, I am content to consistently pull out a little bit, over and over. This is the intent of the strategy.

The strategy is based on these market attributes:
1. The index futures (NQ Nasdaq emini in my case) tend to back and fill a lot. One way trends are (relatively) rare. Important price levels are revisited over and over again.
2. Market prices tend to move. Price doesn’t hold still for long.

Two points and then quit for the day should be achievable almost all the time. I just want to make chip shots. Just be consistent and do it over and over.

On a 5 min NQ chart, around half of all the bars are wider than 2 points:

The average daily range for NQ lately is near 40:

A two point target is in the noise. But that’s the point: Instead of trying to drink every last drop of a passing river, I want to dip my cup in and just catch a little of what is flowing by. I don’t need to catch an entire wave. Just a little portion of it.

All this time as a loser, I have been trading in hopes of catching a big move. I might have a 5 point target and a 2 point stop. I was constantly setting myself up for failure. I would enter at the market and hope for a big move, ready to take the small loss if need be. That risk:reward might look attractive, but my stop was being hit nearly every time.

So I literally faded my strategy. I looked at the current market, and placed limit orders to fade moves roughly 3 points away from the current price. That put my entry at pretty much exactly where my stop loss would have been if I traded my old way. Once one of them hit and was filled, I set a disaster stop of 5 points (basically an arbitrary number at this point), and a profit limit order just two points away from my entry. Then I sat and waited. My profit target would be hit more than 80% of the time. If the market kept going against me, I waited for it to come back. I honored the disaster stop, but in the first 18 paper trades it was never hit. Most of the time, I could get out for break-even or just a small loss close to 2 points. That exit for a small occasional loss is exactly where my trailing stop for a profit usually was under my old strategy.

To avoid fading a strongly trending market and getting my disaster stop hit, I didn’t use this method near the open or market close. I avoided fading near the highs/lows of the day. I waited for the afternoon doldrums and tried when the market was listless, choppy and noisy, putting conditions in my favor.

Another positive element in this strategy is the very short time that I am exposed to the market. In some of the engineering applications I encounter in my work, a trade-off is made between accepting risk vs. having reduced performance. A probabilistic design method is employed. Instead of designing for the worst case failure mode at the worst possible time in all conditions, we look at the probabilities that these conditions may overlap. If the worst case failure only happens at very extreme conditions, and a vehicle only spends a tiny fraction of a percent of its service life at that condition, designing for this condition puts a large burden of weight and performance reduction for the entire class of vehicle across the whole service life. We can slim down the vehicle by only designing to a probabilistically acceptable failure condition. We still have to avoid a disaster, so we make sure any failure is not catastrophic by keeping enough margin in the system. We just allow a failure to cause an aborted mission or acceptable amounts of damage. Back to my trading: most of these trades last only a few minutes or so. While big adverse moves happen in the market, the odds that one of these moves come during the few short minutes that I am exposed to the market are very small. If I’m always in the market and holding positions, then the odds are high. But the shorter my exposure time, the smaller the probability of a big event becomes. Since the probability is not zero, I still have the disaster stop, just like in the vehicle design. LTCM didn’t have a disaster stop. They KNEW that it was statistically “impossible” that they would see the conditions that would blow them up. I am not naive like that. A non-zero probability is still possible. You have to prepare against it even though you will probably rarely see it.

The biggest weakness I see is if I end up fading a persistent trend. I’ve paper traded this strategy a bit, and on a strong trend day it’s easy to rack up two 10 point losses in a hurry. That wipes out a lot of winning trades. This strategy would be best used during choppy sideways markets. How to rigorously define that is not clear to me. I guess that’s where I often get hung up. I can’t know exactly if a move will turn out to be an adverse trend every time. I have to define a way that works much of the time an accept the few times it when it doesn’t. I want to take discretionary elements out for now. The book “Trading in the Zone” is helping me to think more probabilistically rather than in “right or wrong” terms.

So the idea is literally fading my old self to have a winning strategy. I’ll be doing some back testing with it soon. If you have any comments about this
approach, I’d love to hear them.