BarroMetrics Views: How Do I Set Stop Levels? (3)
This blog looks at the way I manage a trade. As you may expect, my approach is based on firstly protecting my capital base and only then looking at protecting profits. To do this, I use the Rule of 3 and the Expectancy Return Formula.
The Rule of 3 in strongly trending markets will result in a diminution of returns; on the other hand, in choppy markets, it will decrease the losses. In effect I am surrendering maximization of returns in some periods for a smoother equity curve.
The Rule of 3 provides:
- Exit first 1/3 at a level where the return is twice the initial stop. The initial stop is unchanged.
- Exit the second 1/3 at a logical target. The initial stop is brought to break even.
- Exit the last 1/3 when the trader’s timeframe trend changes or when the trailing stop is hit.
The Expectancy Return is the benchmark by which I test my ideas.
I tell my friends and students that so far as a trading plan is concerned, start your trading career with any plan that has an edge. It need not be the one that will bring you the greatest return – having the best doesn’t really matter until you have some competency in consistency of execution of your risk management and trading rules.
Think of it this way, the type of equipment will make little difference, if any, to a golfing duffer. But to Tiger Woods, the best equipment can be a match-winning difference. So too with a trading newbie, in the beginning all that matters is we have a plan with a positive expectancy so we can learn to execute consistently the trading plan and risk management rules. Once we develop some mastery of consistent execution, we can go about developing our trading plan.
What usually happens is our mastery of execution and plan development go hand-in-hand. This I think is a more difficult route to consistent success but seems to be the way success occurs among those I have helped.
Once our plan has positive Expectancy Return, the stats it provides tell us when a profit is a profit and when an open position plus is merely noise.
For example if our trading system has a 30% win rate, we know that to breakeven our average trade needs to return $2.33. Hence, any open profit that is below $2.33, is ‘noise’. So, unless we see some sign that the trade is not behaving like it should, we wouldn’t consider any open profit below $2.33 as being ‘profit’ we have to protect.
Well those our my idea. I hope this has helped those looking for ideas on risk and trade management.