Wednesday, January 02, 2008

Stops: The Key to Success in Day Trading

I wanted to give this post a positive title. All experienced traders know that the key to being profitable is to set stop losses and use them. Even a system which generates random entries to the market could be profitable if the exit strategy is systematic. If you set and use appropriate stops you can be profitable. Beyond that it is all about increasing profitability and/or reducing variance. I emphasized day-trading here because my model that uses daily data can be profitable without stops. In intraday discretionary trading you can't apply such sophisticated strategies. At least I can't. A black box systematic program maybe could trade without stops intraday.

Anyway, the point is that I know all this stuff but still make the mistake of not honoring my stop-loss even when I'm now trading with imaginary money. Here is my equity curve trading the Australian Stock Price Index Futures with virtual money:



The blue line is the actual equity curve and the red line what would have been if I had stuck with my planned stop. This looks a lot like my real money trading in recent months. A slow consistent climb followed by a fall off the cliff.

So why did I screw up? This chart shows the SPI futures:



They open at 9:50am Sydney time. Ten minutes before the stockmarket. The first five minute bar was red and my NDX and Nikkei models were short so I went short. Very quickly the market reversed and my plan was to exit if the market traded above the opening price, which would show that my idea that the market would trend down from the open was wrong. We can also see here that my stochastic oscillator crossed over and moved up, showing me that I am wrong on this idea that the market is going to go straight down. This should be a slam dunk to get out. So why didn't I?

When the actual stockmarket opened, the first five minute bar was up, but the second one was red:



I "hoped" that the market was actually going down here. This was just noise though as shown by the stochastics - and the first ten minutes of trading in the Australian market is pretty meaningless as each stock is opened in alphabetical order over the first ten minutes (the Dow Jones index is similarly meaningless in early trading in the US). So I should have just ignored this. But hope got me into a completely wrong train of thought that the market would turn down despite all the evidence to the contrary. 20 minutes in I even shorted a second contract at 6352 (the first was at 6341). Eventually, I capitulated above 6370.

I'm disappointed that I'm trading this bad even with virtual money. OTOH I can't wait till Friday when the Japanese market next trades to get practicing again on Nikkei futures.

3 comments:

MWF said...

i find this blog interesting, and after reading it i thought of one that u have not linked to, but would probably enjoy...dave over at the trading digest talks a lot about system development, stops, etc.

check him out at thetradingdigest.com/blog

the finance ninja said...

moom.

I have to admit I've never used a stop loss because I was taught that the market makers just stomp you out a lot. Now I know I have to start learning to use them.

Do you buy the stock/option first then put a order in for a limit loss or the other way around? i've never done one.

you talk about a system. Did you create your own trigger type system? how does one create a system? i just use qcharts to look at technicals. does having a program really improve your trading?

mOOm said...

For swing trading systematic mechanical trading is used by a lot of traders. I've found it hard to use such a system a psychological point of view. There are lots of approaches to system trading. As my trading puzzle shows some can be VERY simple. For intraday day trading some rules and approach makes sense though unless you are able to program things in the end you are going to be making discretionary trades. I put the stops in more or less simultaneously with the initial trade i my current approach and then if the trade goes my way I start moving the stop. Sometimes I get stopped out for a loss, sometimes for a profit and sometimes I exit the trade deliberately (but now I immediately cancel the stop first. Using stops for daytrading is MUCH easier in a platform like IB's than one like Ameritrade's. I use both to trade as each provides different things. There is less danger of stop probing in the futures. Basically it's a non-issue there.