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Article Patience in Profit Taking, Part Two by D.R. Barton, Jr.
Trading Tip Appreciating the Art and Science of Trading by Ken Long
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Patience in Profit Taking, Part Two
“Patience is the companion of wisdom.”
“Can’t see the forest for the trees.”
—Modern version of a centuries old proverb
As I prepared to write this article, my stated intent was to review available research on breakeven stops, mix this with my own experience as a trader and trading coach, and come to a somewhat definitive philosophical, experiential, and research-based conclusion on their use.
I have succeeded. Emphasis, however on the phrase “somewhat definitive.”
And a couple of funny things happened on my way to find certainty in the land of breakeven stops. The first: I was reminded that when we dig into the nuts and bolts of the financial markets, it’s almost impossible to uncover very much certainty. Can you find high probability? Occasionally. A nice trading edge? Sure. Certainty? Not so much.
The second: I found myself losing sight of why I was doing this. My intent was to help fellow traders and investors understand some of the best practices for intra-trade risk management. What really happened was that the engineering part of my brain kicked in. I found myself digging deep into the data of the few research pieces that I found, and then generating my own data. Then, I realized that I was like a pig wallowing in the mud. It’s really fun and it feels good on a hot day, but it really doesn’t get you anywhere!
Which is why I added the second quote for today. I really couldn’t see the forest for the trees. (I had lost sight of the big picture by being absorbed in the minutiae). Interestingly, that phrase has been around for centuries—dating back at least to 1546 when it was included in John Heywood’s collections of English language proverbs. Yet I digress (again!).
Back to Seeing the Forest—It’s All About the Patience
To get to the big picture, it actually is useful to take a look at some of the individual trees to know what type of forest we’re looking at. Are they coniferous? Deciduous? Our trees are the research studies.
I pulled 11 books on trading systems off of my shelves and found only two that addressed breakeven stops in more than a cursory way. Both are oldies but goodies: Chuck LeBeau’s and David Lucas’ excellent book Computer Analysis of the Futures Market and Bruce Babcock’s Guide to Trading Systems.
Both of these studies dealt with using breakeven stops in trend following systems. Babcock is very negative philosophically on the use of breakeven stops, and his limited analysis using two different levels of profit to trigger a tightening to a breakeven stop showed that breakeven stops hurt profitability but reduced drawdowns—a minor negative for the breakeven stop camp.
Chuck’s study used a reversal/always in the market moving average crossover system. He found that breakeven stops helped the results. However, my bias here is that always-in-the-market systems are weak to begin with, so the addition of any exit that keeps you out of the market when it’s acting badly relative to your system is a good thing. Nonetheless, this has to be considered a positive for the breakeven stop.
The last study was published by Bandy in Active Trader magazine and was much broader than the first two. It covered 4000+ Exchange Traded Fund trades over almost 5 years. His conclusion was that moving a stop loss to breakeven dramatically reduces profitability. He applied his exit testing to a system that entered on the last day of the month and exited at the end of the next month. So it was basically testing exit strategies with a timed random entry (meaning no other entry or set-up signals were used to filter entry).
In my early studies for counter trend strategies, I have not been able to find a breakeven stop method that improves performance by a statistically significant amount. When my studies are concluded (or at least further along), I’ll pass the conclusions on.
The bottom line is that breakeven stops are psychologically comforting. Moving to breakeven allows us to mentally “play with the market’s money.” However, under most scenarios, it seems that breakeven stops are not helpful in making trading profitable. (Chuck’s upgrade to a moving average reversal system was the only one that I could find that favored breakeven stops).
And for the day traders that I work with regularly, I think the allure of the free trade or playing with market’s money leads to moving stops up far too quickly. I’ll reiterate that for traders newer to the game, leaving stops in their original protective position and having the patience to wait for the trade to develop will serve you best to learn the craft and to get the occasional bigger winner that really drives longer term equity increases.
Thanks to everyone who commented on last week’s article. If you have comments on this series or have references to other breakeven stop studies that might be useful, please e-mail me at drbarton “at” iitm.com.
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Appreciating the Art and Science of Trading
In any profession that features a strong human performance factor, there will surely be a mix of both art and science that contributes to the final product and performance level. Since the trading profession incorporates such a large amount of human psychology at both the individual and organizational level, it’s worth considering how both art and science are reflected in your own trading practice. It’s also good to know how strong you are in both dimensions so that you can ensure that you leverage your strengths while protecting your weaker areas.
The scientific aspect of trading has a lot to do with quantifiable considerations:
- Statistical analysis of market conditions.
- Statistical analysis of trading results.
- Statistical analysis of various trading systems to rank them by effectiveness and risk adjusted return.
- The predictive power of back testing and forecasting algorithms.
- Analysis of repeatable events to find efficiencies and economies of scale (e.g., in hardware and communications throughput factors).
- At the institutional level, the relationship between supply and demand in determining price.
- The ability to forecast market responses based on the law of large numbers and mass psychology.
- Identifying causation and correlation between variables.
- Identifying cause-and-effect relationships.
- Creating and testing trading hypotheses.
The artistic aspect of trading has to do with qualitative judgments:
- Self-knowledge in terms of skills, attributes, and trades.
- Psychological and cognitive biases that interfere with trading proficiency.
- Interpretation of news events for scenario-based trading.
- Hedging positions against forecasted risk scenarios.
- The area in between the black and white of trading rule sets where the trader’s interpretation and judgment rules.
- Identifying trading strategies, market’s targets that harmonize with your preconceived notions of how the market works and where your edge exists.
- The application of the insights from psychology and sociology into human performance.
- Tolerance of uncertainty, ambiguity, and risk.
- Articulation and operationalization of goals and objectives into quantifiable measures.
- Qualitative descriptions of successful outcomes of your trading practice.
These two lists just scratched the surface of the art and science of trading. You should be able to see how both of these domains are powerful influences on the final outcome of our trading practice. Finding the proper blend of these two domains will be crucial to your success as a trader.
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Bothersome Stops: A Response
An old friend and experienced trader emailed us with his take on stops in regards to last week's mailbag question...
Include me in the negative opinion camp about using hard trading stops.
I believe that market makers and others will run stops when they can since it is instant liquidity for them. I think that their basic goal is increased trading volume with little significant price movement. In fact, when I recognize certain overall market conditions, I will use day entry limit orders setup to look like stops to take advantage of other traders running stops. This works well but triggers infrequently. This indicates that running stops doesn't happen as often as some beginners may think it does.
I have run live trading tests on my discretionary trading using entered stops and mental stops; mental stops are far superior for me except when day trading technical patterns. I use stops on those kinds of day trades because I believe that in the very short run the market is essentially random. In those conditions, noise can often take me out incorrectly.
My mental stop method gives me more trading options at the price stop point. If a trader was wrong about the entry, it would be foolish to assume that the trader was 100% correct about the exit point. People understand that entries are a probabilistic thing and then quickly forget that so are exits. Beginners tend to exit way too early in my experience. Some of my best trades start off looking like the worst.
For beginners using hard stops now, my advice is that they are most likely trading positions much too large relative to their cash. Both of your proposed solutions (wider stops and lower position sizes) essentially say the same thing a different way. One of my principles is that every trade has a mix of luck and skill and in the long run the luck will cancel out. Therefore, I use almost no hard stops at all but almost always have lots of cash remaining.
One other issue for beginners is trying for perfection. Beginners seem to think that there is some secret system in the market that will bring them riches. Belief in magic systems helps to cause this hard stop issue. Traders are not perfect, so why would anyone assume that the market (made of up many traders) is perfect? One day one may wake up and say, "I was wrong about my stop price because I am not perfect, but hey, what a fantastic trade!" Or put another way, two wrongs can indeed make a right in the stock market! There is no magic!—Level7
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