EDIT: September, 2, 2012 – CG did an analysis on random stops and targets in 2011. Here is the link: http://sg22.ly/QVr9Ob
This is the third post for ‘Monkey Trades’ using the 5 minute bar breakout strategy.
The first 2 are below.
If you haven’t read through them; I suggest it. I was asked about stops as part of this strategy in the VTF, so I will do my best to outline what I do and what I think you should do.
First let’s lay down some ground work for stops, then define what stops are.
Stops try to prevent catastrophic losses.
Having stops is part of having a trading plan. Stops prevent bad trades from running away with your account.
Stops help remove emotions.
Stops help you remove the ‘hope and pray’ trade. If you are stopped, you are stopped. End of trade.
Stops add complexity.
If they are too optimized, when the market changes you will be stopped out for losses. If they they are too wide, you will take larger losses that you have to.
Stops are an art more than a science.
Stops when used correctly help you get a feel for how the market is trading. For example, is it a day were we are taking out stops and reversing? If you are getting stopped out a lot, look at why you are getting stopped out. Are you wrong? Are you fighting the trend? Are your stops too tight for volatility.
You should notice I didn’t mention trailing stops or stops as profit targets. I use stops to prevent losses or protect profits. All a stop should do is make it so you can live to fight another day.
Now that I shared what I think a stop should be, let me show how I figure out my basic stop.
The simplest stop is a % of your account per trade as risk. Typically most trading books will say use a stop no greater than 1%. What is 1%? If you have a 10k account, then you can trade 1-2 contracts with a stop no larger than $100 per contract; if you follow this rule.
Seems pretty arbitrary doesn’t it? What are we missing?
We are missing the behavior and characteristics of the instrument we are trading, aren’t we? A $100 stop could only be 2 ticks. You’ll get stopped every time. It could be 4 ticks, 10 ticks, or 50 ticks depending on the instrument.
Lets use a really simple rule of thumb and expand on it from there. I will use /YM as an example.
Every platform should have ATR (Average True Range) as an indicator.
Developed by J. Welles Wilder, the Average True Range (ATR) is an indicator that measures volatility. As with most of his indicators, Wilder designed ATR with commodities and daily prices in mind. Commodities are frequently more volatile than stocks. They were are often subject to gaps and limit moves, which occur when a commodity opens up or down its maximum allowed move for the session. A volatility formula based only on the high-low range would fail to capture volatility from gap or limit moves. Wilder created Average True Range to capture this “missing” volatility. It is important to remember that ATR does not provide an indication of price direction, just volatility.
Wilder features ATR in his 1978 book, New Concepts in Technical Trading Systems . This book also includes the Parabolic SAR, RSI and the Directional Movement Concept (ADX). Despite being developed before the computer age, Wilder’s indicators have stood the test of time and remain extremely popular.
Using ATR, my max stop should be no less than 100 points; that’s equal to $500 on the /YM per contract. That’s pretty reasonable risk; but not for a $10k account. That gives us a maximum of what our stop could be. Since we aren’t trading on a daily chart time frame, let’s see what the ATR is on the 5 minute on average.
Just look over the past 5 or 10 days at what the max and min of the ATR is on the 5 minute charts. I am using Globex hours. I looks to me that the the minimum ATR is about 3 points for the overnights and the max during trading hours is about 15 points.
Since the YM trades in 1 point ticks, 3 tick stops will get me stopped out a lot. We don’t want to use a stop that small.
We looked at a daily chart and got 100 ticks as a stop, then we looked at a 5 minute chart and found that 15 ticks seems to be max volatility.
If you have a $10k account, then you have a stop somewhere between $60 and $500 potentially per contact per trade. If I was solely using a 5 min chart as my trading methodology for this system, I would start at the low end of 15 ticks. If I was getting stopped out too much and unable to make profits on setups, then I would gradually expand the stop to adjust for the volatility.
Something important you should consider, if your instruments max ATR is too big a monetary and emotional loss for you or your account, maybe you should consider a lower leverage instrument or not trade until you are better capitalized. Trading emotionally and with too little capital is the best way to lose.
For me, I use $250 per contact per trade. That gives me 50 points as a catastrophic loss. Remember what I said a stop was. It prevents your account from exploding in a single trade. I never said it was a panacea for bad entries or bad trades. You can use 15, 100, or any number in between – just don’t use less than 15 right now or risk being stopped out fast. 20-25 seems good enough to avoid choppy trades any larger and you are risking more than you might have to.
I learned a long time ago that if I am not feeling a market, there has been a large move overnight, or there is news coming up, then I don’t trade. The market will be here tomorrow. And the next day.
The charts I’m going to show you are for September 1st, 2012. I talk a lot about market context in more advanced topics, today is a good example of why you need some context. Look at the chart below.
The 5 minute range is noted by the pink lines. The blue box is the 9:30AM-4PM EST session. I know it trades until 4:15 for cash settlement, don’t bust my balls. I’m trying to keep it simple.
You can see overnight we had a nice rally, then sideways consolidation. If I hadn’t read any news, and just saw this chart I would be looking for a fade short. Remember the blue box is empty at this point in the morning, its 9:30 am. Short seems like a good risk reward on a gap fill, with a stop over the over night highs.
I just introduced two new trading techniques, the overnight range and the gap fill. I won’t go over it here, but it’s something to add to your toolbox outside this strategy.
For this world, let’s say as soon as I saw the 5 min candle close, it broke below and I shorted. This is is almost immediately not a winner. Why? That just how it goes.
Where is my stop, let’s say I used the 15 point ATR max on the 5 minute. Within the next 2 minutes I am stopped out and I lose $75 per contact. If I used a bigger stop, say 25 points, I just lost $125 per contact. It’s the end of the world for some people.
What would have happened had I not stopped out. /YM ran up over 100 points from that short entry. The $75 to $125 loss just got 5 times bigger. Stops are good. Some of you are looking at that chart and saying – ” It came back down in the afternoon, adding to that losing trade was a winner.” Are you willing to bet half your account or more that it happens like that next time? Stops are good.
Now what do you do? Do you buy the break out over? Do you throw your hands up in frustration and walk away? Do you add more contracts short until you make the market go down?
The best answer is the hardest. You stop and evaluate the next trade and forget the loss.
Summary and Thoughts
We covered the 5 minute breakout strategy with no indicators in the context of using a stop. We used ATR to estimate a stop loss based on volatility.
Let’s say the market rolled back over after stopping you out. Would you have been able to jump right back in short?
This is where market context starts to help you refine your trading. You can trade blind, but you have to accept that your odds are going to be 50/50 at any time. Use a strategy that you can verify in the market to put your thumb on the scales. The 5 minute breakout can be a start of that tipping point.
What really happened today?
Lets look at an actual chart I used.
I left the 5 minute range on the chart for you, look back to last week. Notice that chop range? From the 15 minute, above, you can see that we had based overnight and were pushing up against previous resistance. I knew that Chinese markets are on holiday all week and that economic data hasn’t been stellar. Last week we tested lows a lot, and were unable to break down. I really felt no edge and was thinking that this would be a primarily sideways day after a big move overnight.
We were also trying to break the previous days highs. Friday’s highs, if you aren’t following along.
Every morning I look at bloomberg.com for the economic calendar, today was no different. There were 3 fed guys speaking and 2 economic releases just after the open. PMI had already come out and the reading was within consensus. I had no edge. No trade. Sometimes you get lucky, because I would have shorted had I been blindly following the 5 min breakout strategy, and been stopped out fast. I would have hopefully bought the upside and probably ended flat.
In reality I made only a few trades. I jumped on the sell at 2PM and 3PM, because we didn’t get continuation after lunch. I was also watching AAPL because of my ITM 640 CALLS and I just didn’t like the weakness it exhibited.
I should have played the breakout of the previous highs. Prior high, low, open, and close are part of my real discretionary strategy. I also look for resistance/support every 0.25% we move up or down, nothing but a little mean reversion at play.
I will keep posting these blog entries and we will track the progress of playing a 5 minute breakout. Now that we have stops we can use, it can be less arbitrary.
See everyone in the VTF,