Scatterplot method for setting intial stop

The first stage of learning is called "unconscious incompetence". A trader in this stage does not yet understand all the hard work that goes along with trading. What's worse is they may have scored a few big hits in these early stages without doing the work, which reinforces the idea that if they could only just get a little smarter in order to "know" what the market is going to do next, bang, they've made it as a trader.

Thus when a guy asks "where do you set your stop," it is an opportunity for the teacher to throw down a rope so the guy can pull himself out of the "unconscious incompetence" phase and progress to the "conscious incompetence" phase. Answering him with "what are the results of your testing" and "it all depends on how much you are willing to risk" does him no good, because he does not yet know how to test and he does not understand the unknowable, probabilistic nature of a trade outcome the moment it is opened. In fact, he most likely has tested stops before in the entirely wrong manner, using some entry that is no better than a random entry. The results of his test are most likely that he loses money pretty consistently no matter where he places his stop.

Stops are recurring question in this thread so I will answer it. There is a lot to it, but here are the basics. Once you decide on an entry method, mark down about 50 such entries in a spreadsheet : date, time, price, and side (long or short). Important: notice there is nothing about exits here at all. (That comes later.) Now you need some sort of metric to measure how good each entry is. For day trading, I like "Pain vs. MFE". Starting from your entry point, you find the best possible exit of the day. That is the "MFE". Then you mark down the maximum the trade moved against you in order to get to that point. That's the "Pain". Now you have two points associated with each entry, Pain and MFE. Plot these on a 2-D scatterplot, with MFE on the horizontal axis. You will see a bunch of really good entries that have a high MFE and low Pain. You can represent your initial stop with a horizontal line on this scatterplot. Wherever you draw that line (initial stop size), you gain access to all of the good trades below the line. It will be obvious to you that there is a certain point where you don't gain anything by moving this line up anymore. This place makes a mighty good initial stop. Now, here is a mindbender: you don't really ever want your trade to hit that initial stop. It is just for safety. But, that is another story for another day. Good luck!

Pete


Hi Sulong, here is once such scatterplot from a YM breakout methodology that is currently in the 1-lot test trade phase. There are a few more things on this plot than I first described. The main feature is a reference set of random entries over the same time period as the entries under study. You want to see a clear difference in the distributions, of course! Also, one purpose of the test trades is to make sure you are backtesting correctly (no cheating!!). They should fall in your backtested distribution. So far, so good!

p.s. I use Excel to do this

PeterF,
If you have a moment, can you explain why your test trades show a better result than your back testing? Can you give us your definition of a forward tested trade?
Thanks,
JO

JumpOff said:

PeterF,
If you have a moment, can you explain why your test trades show a better result than your back testing? Can you give us your definition of a forward tested trade?
Thanks,
JO

Click to expand...

I wouldn't say the test trades show a better result. The way I see it, the distribution of test trades and backtested trades match so far. I was fortunate enough to get a couple of biggies in the test trades, right near the beginning of the test. Whatever. I don't think I can count on 300 point drops every time I short the YM. The overall distribution shows it. More interesting is the appearance of 3 points in a place where there was a gap in the backtested trades. If i get some more points in there I might revise my exit strategy.

Forward test trade: trading real money at minimum size. The goal is to verify the probabilities match those "advertised" by your backtest. There a lot of issues to deal with in discretionary trading, such as "am I cheating when I backtest" and "can I make the same rational decisions under the gun" and "has the market changed". The test trades give you the answer. I know some traders forward test by running the methodology on another set of data, that obviously is not what I am talking about here.

p.s. paper trading doesn't cut it for me in forward testing. I need to be "under the gun" and see if I can make the same decisions. Once again this chart tells you nothing about exits. Before trading I also do monte carlo test to find out how much I can expect to lose if everything is working correctly. Sounds funny, but it is the most important piece of info a trader can have.

A note to those of you who are just joining in the fun: this thread has been split off from the P&V thread in the Technical Analysis forum. Thanks for your contribution PeterF.
JO

I want to point out some more things about using these scatterplots. They are very useful things.

(1) Right away you can see if your entries are meaningful by comparing the "smart" entry distribution to a random entry distribution.

(2) I think of the plot area in three zones: the "cone of death" (the lower left hand corner and above), the "winner zone" (MFE > 2*pain, along the bottom of the chart), and then everything else. The smart entry should have lots of points in the winner zone compared to the cone of death.

(3) After I get an idea of where my initial stop should be (in this case, 30 pts) I study the entries with high MFE but higher pain (in this case 20-30). It usually means I had the right idea but the timing was a little off. Or, they were entries in a volatile market. With this information, I can improve my initial stop setting according to market conditions on a trade-by-trade basis. With this methodology, my initial stop is usually between 15 and 25 points.

(4) Clumps of points in certain areas make good targets for taking an automatic partial profit.

(5) An acid test I use to determine if the entry is tradeable, before I look at exits at all, is to see if the method can go breakeven with a mechanical initial stop and mechanical limit target. In this case, the backtested points showed that a stop of 30 and a target of 50 would give a positive expectancy of about 3 points/trade. That's great! It means that by just turning 1 out of 3 of the losers into a scratch, for example, the method makes money. After designing some intelligent and discretionary exits, I pushed the expectancy up to 13 pts/trade.

By the way, if and expectancy of +3/trade with stop 30 and target 50 doesn't excite you, consider what the expectancy would be for random entries!

(6) A trader whose entry gives a sufficiently skewed plot doesn't have to wonder what his edge is. There it is, on paper.

(7) I watch how the plot develops as I make trades in order to make sure the distribution remains "as advertised". When the entry distribution changes for the worse, it's a sign to put the methodology on hold for a while.

(8) I have tested many different entries and found some are the same as random, some are a little better than random, and some are much better than random (as in the example provided). It pays to only trade those that are much better than random; don't settle for something mediocre.

As a side note, look at all of the entries in the high part of the "cone of death" for random entries. That's why beginners get so frustrated with stops. If the entry used is no better than random, they'll get a large number of trades where they are stopped out for a decent size loss only to see the market come back again. They really dangerous entries are in the lower left hand corner. That's when the entry is completely wrong from the start. The market moves a few ticks in favor, then never comes back. If the beginner learns not to use stops from the entries in the high part of the "cone of death", it is just a matter of time before he gets an entry in the bottom part that takes a big chunk out of his account.

So, there are many ways to use the plot. It's a great tool and any trader can use it. If folks want to put up plots of their own I would be happy to comment.

Lastly, I hope there are no newbs out there who confuse a good looking plot with a solid trading plan. There is still a ton of work to do after finding a favorable entry. It is still very easy to be a net loser with an entry that beats random if other parts of the plan are messed up.

Sincerely,

Pete

Trading gives me too much stress. Worry about this and that. I just wanted to find a company that made it easy and to offer a flat fixed interest rate on my money with No Worries!!! I finally found the company ; a 5 year term at 8% fixed interest is the best I found.

Does anyone know of a higher interest return rate that is simple. You have to study a lot just to find out what is the best investment. I gave up that nightmare. 8% on my money a year is enough for me. If anyone knows of a higher interest rate let me know.

Thanks,
MJ

cheekyone said:

Trading gives me too much stress. Worry about this and that. I just wanted to find a company that made it easy and to offer a flat fixed interest rate on my money with No Worries!!! I finally found the company ; a 5 year term at 8% fixed interest is the best I found.

Does anyone know of a higher interest return rate that is simple. You have to study a lot just to find out what is the best investment. I gave up that nightmare. 8% on my money a year is enough for me. If anyone knows of a higher interest rate let me know.

Thanks,
MJ

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So why exactly did you sign up to a site all about trading?!

-TPO.

Don't get me wrong. I have done some trading with small groups of friends and have made good money, but things have changed a little now. I was trying to read up more about trading and see if what I heard was correct and made sense. I wanted to make sure I wasn’t wrong about certain things. I did find out what I was looking for.

I heard a lot of bad stuff recently and came unglued from the big company trading scandals and mismanagement of large banking firms with funds. I’m not going to go into details. It’s hard to keep your mouth shut when you know what I know. Your right I shouldn’t be here blabbing. I hope all have prosperous financial gains in what ever avenue they embark on.

Cheryl

How about inflation-linked interest rate investment? It could be a better investment than a fixed percent investment for a period now but when inflation rate goes up the real rate achieved may not be that good.

I have thought about it, but the averages of the ups and downs are something I would rather not deal with. It almost tends to be the same. There will be a lot of changes in the next few years and I have heard that this is not the way to go.
The initial interest rate on an inflation-floater may be lower than that of a fixed-rate note of the same maturity. This is because investors expect to receive additional income due to future increases in CPI. However, there can be no assurance that these increases will occur.
In addition, an investment in any of the Direct Access Notes structures involves a number of risks .You should consider carefully these risks. A fixed rate is usually a better and safer way to go. Rates of 6% or higher for short term investments that able you to draw the interest out at the end of the year or sooner are much better investments. These (fixed interest returns) investments are always more simplified and with knowing what’s coming back from your investment is always better. Few companies can do this (Only those that have more information than that of the typical consumer and even in most cases the typical employees at banking companies). These companies are now publicizing the main issues and letting people know in a round about way due to legal ramifications from big banks; that banks are even investing our money in these companies. Hint Hint.