50300
1.511.710.16.39.45.24.93.64.44.4
2.112.09.46.111.44.84.93.64.44.4
1.611.48.85.611.64.95.03.24.34.2
.910.67.48.912.14.15.02.93.95.4
1.48.56.8*6.711.13.14.22.23.34.9
1.98.25.06.78.34.83.02.94.44.1
1.57.53.78.410.05.94.71.85.22.7
1.26.73.58.89.75.97.82.94.92.4
1.26.03.07.78.75.37.72.84.92.4
1.26.03.07.78.75.37.02.84.92.4
1.511.810.16.39.85.25.03.64.54.4
1.26.03.07.78.75.37.02.84.92.4
Pattern of Results. The size of the stop-loss must be based on thespeed of the trend. A small stop with a slow system will usually be hit andrarely allows the trade to reach a profit. A large stop with a fast system willnever be reached before the trend signal reverses the position. It shouldnot be surprising that only a narrow band of stops applies to one trendspeed.Intraday Stops with aDaily SystemIt is tempting to react quickly to an adverse price move to keep lossessmall. Although the trend may be determined using daily closingprices, a stop could be activated when prices move badly during the
97
The Mixed Role Stops for Controlling Risks
Table 6-3. Stop-Losses: Results of Longer Term Tests(Continued)Values are annualized rate of return, adjusted to a 2 5 % maximumdrawdown.c. Deutsche Mark: 2570 Days (11/24/82 to 11/23/92)Days .02
.05
.10
.15
.25
.50
1.00
2.00
4.00
7.00 10.00 NONE
5 -1.9 -1.9 -1.9 -1.9 -1.910 -1.4 -1.1 -1.0 -1.0 -1.125 1.7 2.6 3.6 2.9 3.850 5.2 6.9 6.8 6.4 3.775 3.4 4.8 6.15.6 8.5100 5.3 7.2 8.5 8.3 4.5150.5.3.0 -.4 1.6200.7 2.0 1.7 1.1 10.1250 8.0 9.18.18.16.5300.7.4.2 -.1.5
-1.8
-1.8
-1.8
-1.8
-1.8
-1.8
-.73.8
-.65.5
-.65.7
-.65.3
-.65.2
-.64.9
-1.8-.65.4
12.813.410.8
11.010.011.5
11.5
10.8
10.8
10.8
10.8
8.1
6.87.77.25.1
8.77.47.79.68.85.6
7.67.89.17.55.33.66.97.65.4 11.04.3 12.3
7.67.53.67.09.1
7.67.53.67.0
11.7
5.55.1
10.7
10.410.4
d. Eurodollars: 2556 Days (1/03/83 to 12/14/92)Stop-Loss in Whole PercentDay
.02
.05
.10
.15
.50
1.00
2.00
4.00
7.00 10.00 NONE
510255075100150200250300
1.21.83.84.06.57.14.17.31.1.2
1.32.13.08.5
1.43.16.7
1.01.0 1.02.7 2.7 2.66.18.2 7.48.1 7.87.79.2 10.8 10.06.36.4 7.22.6 6.4 5.0.4 2.9 5.9.1 4.1 3.8.3 6.7-.8
1.12.77.47.79.97.87.66.56.95.6
1.12.77.47.79.97.87.66.55.65.4
1.12.77.47.79.97.87.66.55.65.4
1.12.77.47.79.97.87.66.55.65.4
10.2
4.81.85.4-.8-.1
10.5
8.18.92.9.8-.8-.6
.25
1.12.77.47.79.97.87.66.55.65.4
1.12.77.47.79.97.87.66.55.65.4
Results of Longer Term Tests: The table shows the risk-adjusted test results of a trendingsystem. All annualized rates of return are based on a maximum drawdown adjusted to 25%of the initial investment, allowing results to be compared fairly. The far right column,marked "NONE," had no stop-loss and therefore the largest risk. Results of using the smallest stops (.02%) are in the far left column. Although stops improve performance in specificcases, there does not seem to be a consistent pattern. Smaller stops are especially erratic asthe trends increase in length, often showing alternating better and worse performance.
trading session. Unfortunately, the market noise will cause many morestops to be reached. At the end of the day, you will have capturedlosses that would have disappeared had you waited for the closingprice. The accumulation of intraday losses and the increased number oftrades will be far worse than basing the stop-loss on the same daily dataas the system trend calculations.
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Using Old and New Trading Tools for Reasonable Objectives
Table 6-4. Stop-Losses: 4-Year Test ResultsComparison of cash returns vs. risk-adjusting returns.Deutsche Mark: 1030 Days ( 1 1 / 2 2 / 8 8 to 11/23/92)Annualized Rate of Return (On Cash, in Percent)Stop-Loss in Whole PercentDays .02
.05
.10
.15
.25
.50
1.00
2.00
4.00
7.00
10.00 NONE
510255075100150200250300
-7.1-5.05.510.22.24.2.99.18.31.8
-7.3-5.35.49.91.63.6.78.9'8.11.5
-8.3 -9.9-6.2 - 7 . 65.45.410.19.65.01.63.57.4.7 - 1 . 18.78.27.78.01.2.9
-8.5-7.04.28.37.05.47.66.46.74.5
-7.1-4.46.58.35.18.79.37.96.16.4
-7.1-4.37.48.75.08.611.29.77.98.1
-7.1-4.37.48.03.69.38.87.05.25.4
-7.1-4.37.48.03.49.1•7.55.25.66.6
-7.1-4.37.48.03.49.17.24.64.95.9
-7.5-6.82.85.62.81.31.25.35.92.0
-7.1-4.37.48.03.49.17.24.64.75.5
Annualized Rate of Return (Adjusted to a 25% Drawdown)Days .02
.05
.10
.15
.25
.50
1.00
2.00
4.00
7.00
10.00 NONE
-3.7-3.92.712.74.42.83.714.014.75.7
-3.6-2.84.823.33.68.72.422.018.84.5
-3.6-2.94.622.52.27.01.719.317.63.4
-3.8-3.24.625.22.26.81.719.216.72.8
-4.2-3.64.621.77.818.1-1.717.116.01.9
-4.0-3.53.317.314.59.512.113.412.88.3
-3.6-2.57.116.07.518.112.013.29.99.8
-3.6-2.410.916.86.611.314.615.112.912.8
-3.6-2.410.915.54.419.110.89.17.47.0
-3.6-2.410.915.54.218.68.35.98.210.3
-3.6-2.410.915.54.218.68.05.37.29.2
510255075100150200250300
-3.6-2.410.915.54.218.68.05.36.98.7
Benefits of Being Outoff the MarketBeing out of the market may reduce equity fluctuation, even though asmaller profit is taken at the end of the trade. If the use of a stop-loss neither helps or hurts profitability, then the time spent out of the marketwill avoid some erratic price movement and improve the reward /riskratio of trading performance. Holding a position that alternates from aprofit to a loss without ultimately ending up profitable does not benefityour trading.
The Mixed Role Stops for Controlling Risks
99
Table 6-4. Stop-Losses: 4-Year Test Results [Continued)Eurodollars: 1042 Days ( 1 1 / 2 2 / 8 8 to 1 2 / 1 4 / 9 2 )Annualized Rate of Return (On Cash, in Percent)Stop-loss in Whole PercentDays .02
.05
.10
.15
.25
.50
1.00
2.00
4.00
7.00 10.00 NONE
510255075100150200250300
.3.9.4.5.8.8.1.1.2.3
.31.0.91.01.11.0-.1.1.2.2
.31.11.21.31.11.0-.1.1.2-.3
.31.01.31.61.31.1.6.7.9.4
.31.01.31.61.31.0.91.11.2.6
.31.01.31.61.31.0.91.11.2.6
.31.01.31.61.31.0.91.11.2.6
.31.01.31.61.31.0.91.11.2.6
.31.01.31.61.31.0.91.11.2.6
.31.01.31.61.31.0.91.11.2.6
.3.9.3.3.7.9.0.1.2.2
.31.01.31.61.31.0.91.11.2.6
Annualized Rate of Return (Adjusted to a 25% Drawdown)Stop-loss in Whole PercentDays .02
.05
.10
.15
.25
.50
1.00
2.00
4.00
7.00
10.00 NONE
510255075100150200250300
2.42.422.4 25.74.6 11.312.6 23.820.7 27.418.3 25.91.4 - 1 . 31.71.25.94.96.55.6
2.419.528.633.027.125.6-1.31.04.4-3.4
2.425.932.938.832.628.57.39.116.84.1
2.425.932.938.832.025.611.413.814.85.2
2.425.932.938.832.025.610.914.115.15.4
2.425.932.938.832.025.610.914.115.15.4
2.425.932.93 8.832.025.610.914.115.15.4
2.425.932.938.832.025.610.914.115.15.4
2.425.932.938.832.025.610.914.115.15.4
2.921.92.97.618.522.1.73.54.44.3
2.425.932.938.832.025.610.914.115.15.4
Comparison of 4-Year Results: The pattern in the "NONE" column (indicating no stops)shows that the risk-adjusted results are, in general, more consistent than unadjusted returns.Risk-adjusted returns show some large improvements due to the use of stops, but the totalpicture is very inconsistent. The variation is especially apparent by comparing the smallest.02% stops in the far left column with no stops in the far right column. Large stops affect thelonger-term trends first (seen along the bottom of the table) and slowly work their way to thefaster trends as the size of the stop gets smaller. Deutsche mark returns are uniformly betterwith 2% stops but inconsistent when stops become small. Eurodollar returns are best with nostops, which confirms their strong trnding character.
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Using Old and New Trading Tools for Reasonable Objectives
Figure 6-2. Contour map presentation of Eurodollar performance. Resultsusing small stops, along the left part of the chart, are much more Inconsistentthan larger stops, or no stops, seen at the right.
Figure 6-3(a) shows the contour map test results of the 10-yearDeutsche mark adjusted rate of return. The best performance is thesmall peak in the center bottom of the map. This corresponds to a slowtrend and relatively large stop-loss of .50 percent. The darkening area aswe move toward the top and left of the chart shows faster trends andsmaller stops.
The Mixed Role Stops for Controlling Risks
lOl
Figure 6-3. Contour map of 10-year Deutsche mark stop-loss tests, (a)Adjusted rate of return. Large stops and slower trends produce the bestresults, Indicated by the peak at the center bottom of the map. A systemmust be finely tuned to capture this.
Figure 6-3(b) is the contour map of the return/risk ratio (annualizedreturn divided by 1 standard deviation of equity changes) over the same10-year period. The white area, showing the best performance, is largerthan in the previous map and includes areas in the bottom left. Thismeans that the use of a small stop with a slow trend does improveDeutsche mark performance by exiting trades that become volatile andunprofitable. The far left edge remains inconsistent, and the right side isvery uniform.
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Using Old and New Trading Tools for Reasonable Objectives
Figure 6-3. [Continued) Contour map of 10-year Deutsche mark stoploss tests, (b) Return/risk ratio. Smaller stops may not Improve profits butcan Improve the return/risk ratio of longer-term trends In this contourmap. A better return/risk ratio can be converted to a higher rate of returnusing leverage.
Viewing the results as a return/risk ratio shows a much clearer picture. For the Deutsche mark, considered a "trending" market, stopsshould improve performance by reducing risk more than it reducesprofits for longer-term trends and for most stops except those that arevery small. The noisier index markets and most stocks do not show thisresult.
The Mixed Role Stops for Controlling Risks
103
A Stop-Loss May Conflictwith the StrategyThe nature of a stop-loss order is often contrary to the system withwhich it is used; it may "fight" with a trend-following program. Thepurpose of a trend is to smooth out and ignore market noise; the trendline is substituted for prices to represent a better approximation of pricedirection. A stop-loss that is too close will be reached by an erratic pricemove, offsetting the value of the trend.Trend SystemsWhen a stop is reached, the trend has not yet reversed. The system issaying that the trend is still intact. If that is true the trend will continueand the loss will turn into a profit, but you would not have a positionbecause you were stopped out. If the stop works most of the time, thenthe trend changes whenever the stop is triggered. That is the same assaying the trend is too slow. A faster trend would catch the change ofdirection sooner. In either case, the solution does not seem to lie withthe use of a stop-loss.Countertrend SystemsTrading against the trend requires frequent small profits. To get moreprofits, it is necessary to hold larger losses, waiting for prices to moveyour way whether because of noise or good forecasting. A stop-loss willcause more frequent losses and prevent profits from developing. Thetwo will not work together.Apparent ImprovementTests show that stop-losses improve results, either outright profits orreward /risk ratios. Usually, that is not the case. Tests of short intervalsmay not be representative of the long-term picture. The use of intradaystops can easily misrepresent the fill that is received from a stop. Thelack of liquidity, or a price shock during the trading session cannot beseen by most computerized testing packages.One event can appear to make the use of a stop-loss worthwhile.Reducing the loss from a major price shock to a reasonable level may bea good exchange for small give-ups. A trader must realistically assesswhether a resting stop or visual stop would have offered the protectionneeded. It is difficult to design a system that continually gives up profits in expectation of possibly reducing risk in a single case.
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Using Old and New Trading Tools for Reasonable Objectives
Reentering a Stopped-OutPositionOnce a trade has been stopped out, but the underlying trend or countertrend position does not reverse or exit naturally, the trader faces anotherproblem. Do you reenter the market and chance another loss in the sametrade? Then the compounded risk would be much larger for each trade. Ifthe decision is to reenter, what criteria should be used? Because the trendfollowing signal remains the same, there is no new signal to buy or sell;therefore, the trader must have additional rules for reentering the market.That makes the system much more complicated.
Managing Risk with andwithout StopsIf small stop-losses are not predictable, then the best choice for controllingrisk is to deleverage, reducing the risk to acceptable levels. Deleveragingis always the safe alternative. It can be achieved with the following simpleprocedure:1. Find the long-term risk level of the trading program, using a combination of maximum drawdown and standard deviation of equitychanges (see Chapter 4).2. Adjust the system risk to your acceptable level. You probably wantless than a 1 percent chance of losing more than 10 percent of theinvested capital during any year; therefore, set 3 standard deviationsof the annualized risk equal to 10 percent of your investment.3. Determine the investment size or the amount of capital to be traded,based on the adjusted risk in step 2.4. To give protection from major price shocks, use a larger stop-lossthat will not be easily reached due to noise.For example, you have a trading program that returns 40 percent peryear with a 95 percent chance that losses will be under 15 percent duringthe 10-year test period (1 standard deviation of the equity changes is equalto 7.5 percent). However, you want to keep the risk under 10 percent, whichis two-thirds of the current level. If the required capitalization is US$1 million, then increase the investment by one-third to US$1.33 million.Because control of risk is more important than higher profits, weaccept a 20 percent expected return to keep the risk at 7.5 percent. Byusing a large stop-loss, the returns on the test optimization are moreconsistent, and we have greater confidence that the stop-loss will notinterfere with the expected returns.
The Mixed Role Stops for Controlling Risks
105
The Dilemma ofProfessional TradersInstitutions allocate their professional traders a specific amount of trading capital on which their performance will be judged. To maximizeprofits and minimize risk, they tend to use high leverage and smallstop-losses. The result is often modest profits and larger risk.As discussed earlier, the amount of noise in foreign exchange marketscauses small stops to be triggered frequently, preventing traders fromreaching their profit objectives. But small stops are seen to be necessarybecause of the high leverage and potential risk. Most foreign exchangetraders would be under pressure to explain losses in excess of 10 percentof capital.Therefore, the best performance profile is not achieved by using smallstops. It is best when the program is deleveraged and only larger stops,or no stops are used. But deleveraging means using a smaller amount ofcapital. As was pointed out in Chapter 4, if you achieve better profitstrading a smaller amount (which can be seen from the size of the positionstaken in the market), the head of the Foreign Exchange Trading Divisionmight say, "If you can produce 20 percent return using only half themoney, then use all of it so that you can get a 40 percent profit!"Unfortunately, the reserve capital is needed for a period of unusuallyhigh risk. It does not occur often, but you must be prepared for it anyway.What do you do? If you don't trade more of the capital, it might be takenaway. If you do trade more and the market is hit with a price shock, youcan lose an unacceptably large part of the capital. The answer is don'ttrade more. You must be able to explain that deleveraging to achieve riskcontrol is safer for the investment portfolio and for the company.Artificial risk controls are counterproductive over the long term andoften over the short term. It is a corporate problem that must be resolved.The trader must only produce returns with the best return /risk ratio.
SummaryIt is difficult to trade without a clear idea of risk, and a stop-loss, orfixed-value limit, is the most agreeable to traders. A stop-loss based onthe number of points you are willing to lose is not a good choice. Butperformance using a stop-loss is inconsistent and, during a fast marketor a price shock, when risk protection is most important, a resting stoploss could result in the worst fill. Stops based on logical price levels,such as support and resistance, or volatility, are much more likely toimprove performance. Tests confirm that larger stops give better performance than small stops.
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Using Old and New Trading Tools for Reasonable Objectives
If a relatively small stop-loss consistently improves a trend-followingsystem, the trader should see if a faster trend might work even better. Ifa larger stop-loss improves performance, it may have been the result ofa single event—it would be difficult to build a system around one situation.Reducing risk by increasing the investment size, or lowering leverage, is the safest method of all. With smaller exposure, risk is alwaysproportionally less. If you increase the leverage of your system becauseof the perceived safety of a stop-loss, one price shock is enough to causeserious damage. A stop-loss does not guarantee risk protection. If youneed to deleverage to avoid occasional large risk, then a stop-loss mayno longer benefit performance.
7
UnderstandingPrice ShocksA price shock is the ultimate risk. It is an entirely unpredictable, largejump in price that is too fast to trade. Price shocks cause the ruin of moretraders than any other problem. A price shock can be seen as a largeopening gap, or a very volatile trading range, often three or four timesthe average size, sometimes bigger by a factor of 10. Because they occurinfrequently but are so dramatic, price shocks are treated very differently by many analysts when they develop a trading system. Some analysts will make up special rules to be applied for specific past events;others will include shocks as a part of the normal price phenomena, tobe resolved by strategy testing.
Trading Risk Is HigherThan ExpectationsThis chapter will show that price shocks, which are frequently smalland only occasionally extreme, are the reason the risk of trading isalways greater than expected. When you look back at historic pricemoves, especially with a computer charting or a test program, such asSystem Writer, TeleTrac, or MetaStock, it is easy to identify a price shock.The clear ones are seen as highly volatile days or large gaps.How do you handle them? When you are testing or developing astrategy, you look for a trend or pattern that would have had the rightposition to take advantage of any major move. But is that really possible? Could you have known which direction the price would havemoved? And what about all the small shocks? Many small price shocksare not obvious. Although they do not attract attention if their size does107
108
Using Old and New Trading Tools for Reasonable Objectives
Figure 7 - 1 . Chart analysis with typical price shocks. The Deutschemark chart shows eight clear price shocks. Those marked 1-5 are expected to have generated profits for a trend system; those marked A-C are mostlikely to have produced losses. The Gorbachev abduction first appears tobe the obvious price shock, but closer study shows that there are surprisingly many gaps and volatile days. Unfortunately, some analysts choosetheir strategy by its ability to profit from these past moves.
not cause any serious problems, they are just as unpredictable as largeshocks.Figure 7-1 is a chart of the September 1991 Deutsche mark, traded onthe IMM. It shows the Gorbachev abduction on August 19, which produced a large profit for many traders. Those profits disappeared twodays later when the market abruptly reversed. A closer look at the chartshows that other shocks were nearly as large. The point marked A indicates an unexpected change of direction ending two days later and 300points lower. The Moscow coup spanned only 250 points.
109
Understanding Price Shocks
Other shocks can be seen by the gaps or the high volatility in a direction opposite to the previous day. The points marked 1 through 5 areprice shocks that were likely to be profitable for a trend-follower; thosemarked A through C would probably have caused losses. We can seethat there are many sudden changes and gaps in price movement, eachrepresenting an unexpected event and all adding risk.If you assume that you could have profited from a large price shock,you have mistakenly reduced your assessment of market risk. You caneliminate a price shock from a chart analysis or computer test, but youcannot remove it from real trading. A price shock is not predictable. Thatmeans you cannot assume that you would have profited from the pricemove, nor do you have to say that all price shocks would have causedlosses. You can assume that half the shocks will be in your favor, and theother half will be against you.
Types of Price ShocksPrice shocks have no rules or patterns that can be applied in advance.Because they are always unexpected, they can occur any time and during any market environment. However, there is a distinction between aprice shock that is the result of a structural change and one that is temporary or ambiguous in its effects (see Figure 7-2).
(a)
(b)
(c)
Figure 7-2. Three patterns associated with price shocks, (a) A sudden drop to A has a sound basis but was exaggerated. Prices partiallycorrect to B. (b) A structural shock will continue in the same direction(B) after the initial move (A), (c) A "false" shock (A), without basis,reversed as news corrected the situation. After 3 days, the effect haddisappeared.
110
Using Old and New Trading Tools for Reasonable Objectives
A price jump based on an assassination or abduction, such as theGorbachev coup on Sunday, August 18, 1991, is entirely speculative.How do you assess the importance of the death of a leader in terms ofSwiss francs? Whether temporary, as in the case of Gorbachev, or permanent, as with the Kennedy assassination, the economy of a countryoften shows little long-term effect.In general, wars, rumors, assassinations, and political coups havetempor