Developing a Trading Strategy Part 2
6. Stop Loss Rules.
Our strategy already has a natural stop loss in the stop order that does not get filled. The objective of the strategy is to capitalise on those days where the high or low for the day is in place early (9.30-11.45am). If we enter a trade on a breakout of either the high or the low and then the market subsequently hits the other stop we know that our trade is invalid. We know from our testing earlier that this only occurred 10% of the time.
We could add additional rules for the stop loss such as:
- Moving the stop to breakeven when we are a certain amount in profit. However, how or why would the market care where our breakeven point is?
- Trailing the initial stop loss as the trade moves into profit.
- Having a fixed maximum stop (say 35 pts). Fixed point values should be avoided, they do not take into account changes in market volatility and do not ‘future proof’ the system.
- Setting the stop at a percentage of the opening range. The theory being that if the market has retraced a certain amount then it is likely to continue and eventually hit our original stop.
- The opening range that we have concluded produces the best system expectancy over our test period, can be relatively wide, averaging 62% of the days range. So, if the days range is 200 points our stop would be 124 points on average. Many traders prefer a much tighter stop for psychological reasons. However, as we discovered with the opening range, there is a payoff between a tighter stop loss and a lower winning percentage.
Let’s examine results based on setting the stop loss at a percentage of the opening range. Assume that the trade is closed at 4.00pm ET if not stopped:
|Stop as a %age of opening range||%age stopped||Average loss on stopped trades||%age not stopped||Average profit on trades not stopped||Expectancy per trade|
Expectancy per trade is calculated as (%W*Av W)-(%L*Av L)
We can clearly see a payoff – as the average loss is reduced by having a tighter stop, the percentage of losing trades increases. With a stop at 20% of the opening range we have an average loss of only 12 points and an average win of 37 – A risk/reward ratio than many traders would like at 1:3. However we are stopped out 74% of the time giving an average expectancy of less than 1 point.
Leaving the stop at the opposite side of the entry range means we are only stopped out 11% of the time for an average loss of 48 points. However, the average profit on the remaining 89% of trades is only 13 points. Many traders would be wary of a risk/reward ratio of 3.5:1 but the much better percentage of trades which are not stopped out at 89% means an average profit per trade of 6.42 points.
In conclusion, it is essential to examine the interaction between percentage winners and losers as well as the average win and average lose. We cannot consider the risk/reward ratio without also checking the percentage of winning trades.
We will continue to hold our stops at the opposite side of the opening range.