Expected value and trading stops – Managing market exposure to maximum advantage

One area of trading and investing strategy that seems to spark a great deal of debate is the use of a stop-loss points or stop orders.  Briefly, the question is:  Should traders have a pre-defined point at which they will abandon trades, and should this be a regular, integrated part of all trading strategies?

There is a related question that also seems to come up quite a bit:  How should a trader know when to add to a position?  Is it best to add to a position when it has started to show a profit?  Is it better to “average in” at a lower price?

I mention these two questions because from my perspective, there tends to be a great deal of confusion swirling around about these issues.   I have heard traders say things like, “All of my indicators said to stay long, but I had to honor my stop loss point”.  Or, “Without a stop-loss order in place, a trader is taking way too much risk”.

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Given, there are many ways to trade that can work.  However,  I want to offer a different perspective.

The most important factor when deciding when to buy or sell is your estimate of the market’s expected value (see endnote) from the current moment in time, not from where you entered the trade.

Lets say a trader enters the market on a swing trade and after the first day is down money.   Should the trader be thinking, “I am down on the trade, i need to honor my stop-loss” or should he be thinking “At this moment in time and based upon all additional information, what is my estimate of expected value?  Is it more positive, the same, or negative? How should I manage this change in expected value relative to my equity?”

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I would argue that the second sequence of questions is far more valuable than the original, inflexible rule.   You want your trading position to be based upon the present reality (both your market/analytical view and equity) and not a historical event (where you entered the market).

I believe one reason many traders view a rigid, pre-planned stop-loss as critical to risk control is because they only consider resizing positions between individual trading events.  For example, after a loss (or a few losses) the trader re-sizes their trades based upon their current equity level.  It is this re-sizing that reduces the risk of ruin, not (in and of itself) the use of stops.    There is no reason why (if necessary) a trader can’t  re-size positions over the course of one trade.

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Lets take the second question:  How should the trader know when to add to a position?  I would argue that this decision should not be made as a function of if the trader is “up” or “down” money on a trade.  Rather, it should be based upon an increase (or decrease) in the trade’s expected value.

For example, lets say a trader gets a breakout signal to buy 10 points above the opening price.  The trader enters and the market ends up moving 10 points above the entry level.  The right question to ask in this scenario is something like:  What is the expected value given the additional information (price is now 20 points above the open)?   A simplified logic might be:

  • If the expected value is significantly higher than at the entry level, add to the position
  • If it is significantly less, reduce the position
  • If it is the same,  keep the position size the same

All else equal, this same logic would hold true even if the trader was down money on the trade.   This is just a conceptual example – The specifics of how this would be managed can be mapped out more clearly given a specific context and desired risk level.

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The bottom line is  this:   If you don’t have the equity or staying power to manage your trading edge “as it is” you are not going to make things better by arbitrarily putting in “risk controls” like stop losses.  In fact, doing this can often kill a good trading strategy.

So the question becomes:  When do you get out of losing trades?   I suggest exiting a losing trade for the same reason you would exit a winning trade or any other trade:

  • Your analytical method indicates the “edge” you were trading for has (win or lose) run its course
  • Your capital position indicates you can no longer trade the strategy
  • New information has called the strategy into question

This decision process is not just an approach for systems traders.  In fact, I think this type of logic is one advantage that good discretionary traders have traditionally had over the majority of systems traders.  A discretionary trader might manage existing positions by asking, “If I was not in the market, would I want to get in?” and then only stay in the position for as long as this was true.

Are pre-defined stop loss levels ever useful?  I think they are.  The critical distinction is that a good stop loss level is based upon the logic or “edge” of the strategy, not simply an “uncle point” related to account equity.

Good Trading.

If this article interested you, you might also like this one:  Thinking About and Managing Trading risk

* Expected value in this context means what a trading decision is “expected” to be worth over a large number of trades.  It is computed as the probability of a win * the average win minus the the probability of a Loss * average Loss.

Leave A Reply (1 comment so far)

  • http://pulse.yahoo.com/_43LXOE73X2XIOVGCSZOMMD4IIU satan2liberals

    Best advice with sound logical reasoning on the use of stops I’ve ever read.
    Perhaps because some of it mirrors my own epiphanies in my personal trading journal.

    Not sure I understood all the implications but thanks for effort.

    Usually I’m known as a harsh critic but that’s because I have a penchant for calling them as I see’em, Kudos to you Sir ,consider me a fan

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