BarroMetrics Views: Stops and their Use
The other day, I came across a blog that found that on a R:R of 1:1, a drop at or below 65% and the equity curve became unstable. He also found by adding stops the win rate would cause the win rate to drop and he also found that his stopped out trades were larger than his profits.
Some of his suggested solutions include reducing leverage and not using stops and trading more often and not using stops. But as he says “Each of these solutions actually will raise a new set of problems”
This leads me to an area that is too often neglected.
It would seem to be that the problem here is the Reward to Risk ratio for the time frame. There is a relationship between:
Timeframe, potential risk, the potential profit, the win rate and loss rate.
The shorter the time frame, the larger win rate needs to be, and the smaller the R:R needs to be for a stable equity curve. The best example of this are the scalpers. They have large size, large win rate and the R:R is close to 1:1. Other timeframe traders e.g. a monthly trend trader, would have smaller size, smaller win and a higher R:R.
Sometimes the solution to the problem like the one posed lies with tweaking the profit target or changing where the stops are placed. Sometimes, larger stops are called for.
This may just be a personal conviction but as a professional trader, I need to trade a size that given my knowledge and experience will merit the risk. I may be able to buy 100 shares at $10 a share and let it go to $0 if need be, but I would hardly be optimizing my return. If I increase my size enough to make the risk worthwhile, it follows that the risk will be large enough to cause me concern if I trade without a stop.
Now we may need to reduce and use larger stops; or we may need to change where we take profits; or we may need to do both. The point is not having a stop in the market to guard against a Black Swan event is one risk I’d be unwilling to take.