Money Management

An Alternative to Stop-Loss

I hadn’t made any significant changes to my strategy for over ten years, but last year was different – I stopped using a stop-loss. Shock! Horror! Trading suicide? Or is there another way to control risk?

Let me explain. I trade potential trend continuation after retracement on UK equities mainly drawn from FTSE100. When the market is rising the equities that trigger will generally be in a good up trend, strong and outperforming the FTSE100 index. Conversely, when the market is falling they will generally be in a good down trend, weak and under performing the index.

I’ve always had problems with my stop-losses on two counts.  Firstly, that all too familiar and frustrating experience of price taking out my stop and then shooting off in the right direction leaving me behind. Increasing my paranoia that the market is out to get me personally.

Secondly, when a stop-loss takes me out of the trade I am left looking for another entry whilst the conditions of my strategy are still valid, taking on another dose of risk in the process. A number of such “false starts” can be a costly business.

There had to be a better way of controlling my risk and a hedging strategy is proving to be the answer. At the point where I would have taken my stop-loss I now hedge my equity trade with a pro-rata contra position on the index (FTSE100).

Rather surprisingly, perhaps, the net result of the hedge itself proves profitable in its own right, more often than not, which reflects the relative strength or weakness of the equities that that I mentioned earlier. Naturally, that’s not always the case and there can be instances of the hedge leaving you in a worse position than had you taken the stop-loss in the first place. On balance, though, I have found the strategy advantageous (so far, I hasten to add). There are other disadvantages which I will touch on after a couple of examples.

Here they are:

Placeholder

1. Long entry at 1401.

2. I would have been stopped out at 1330 for a loss of -71 points. Instead I hedged with a pro-rata FTSE short at 5671.

3. At this point ANTO was 1315, down a further 15 points (1.1%) but FTSE was 5528, down a further 143 points (2.5%). Thus, the hedge itself was in paper Net profit at this stage.  Had I been stopped out on the original long trade I would have been looking to re-enter at this point since price was still above the earlier swing low (horizontal blue line). As it happens, in this particular case, I would have been forestalled in this because of the next day’s gap opening and left cursing on the sidelines as things developed.

4. The hedge was taken off at this point with ANTO at 1413 which was + 83 (6.2%) up from the hedge point with FTSE at 5767 only + 96 (2.5%).  Thus, there was significant net profit in the hedge itself.

Placeholder

 

1. Long entry at 1080
2. Would have been stopped out at 1060 for -20, but hedged instead with a 
    pro-rata FTSE short at 5618
3. The second dip below the entry swing low nullified conditions, so both the 
    Original trade and FTSE hedge were closed at that point. The original trade at 
    1060 for no further loss from the level it was at when the hedge was entered 
    and the hedge FTSE short at 5578 for a profit of 40 points.   The net profit from 
    the hedge made this a break even trade overall. Pity I shut it down given what
    happened next!!
The main disadvantages to such a hedging strategy are, firstly, that you may not have a suitable hedging vehicle for the instrument(s) you trade. Secondly, your risk is not set in stone as it is with a stop-loss and that may well a major stumbling block to you.
Nonetheless I hope you think it worth a look.

1. Long entry at 1080

2. Would have been stopped out at 1060 for -20, but hedged instead with a pro-rata FTSE short at 5618

3. The second dip below the entry swing low nullified conditions, so both the Original trade and FTSE hedge were closed at that point. The original trade at 1060 for no further loss from the level it was at when the hedge was entered and the hedge FTSE short at 5578 for a profit of 40 points. The net profit from the hedge made this a break even trade overall. Pity I shut it down given what happened next!!

The main disadvantages to such a hedging strategy are, firstly, that you may not have a suitable hedging vehicle for the instrument(s) you trade. Secondly, your risk is not set in stone as it is with a stop-loss and that may well a major stumbling block to you.

Nonetheless I hope you think it worth a look.

Purely an amateur and part-time trader Jon has played the market for over thirty years and more actively since he retired five years ago. He uses the swing technique he describes in his article to keep it simple because he knows he does not have the skill and expertise to challenge professional traders on their own ground. Jon has been a member of T2W since May 2003.

Purely an amateur and part-time trader Jon has played the market for over thirty years and more actively since he retired five years ago. He uses the ...

barjon

Legendary member
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Oops! I've just realised from my records that the hedge I made in the second example was not a straight pro-rata. Thus my statement "The net profit from the hedge made this a break even trade overall" is incorrect. The profit from a pro-rata hedge would have reduced the loss that would have been incurred by the the stop-loss but not expunged it .

btw, the ad obscures the first chart example - so just click on the chart to enlarge it.



jon
 

Masquerade

Senior member
2,543 283
So how do you decide when to take the hedge off? More importantly, what do you if you take hedge off then position goes against you again? Hedge more? Seems deeply flawed to me.
 

barjon

Legendary member
10,249 1,546
I take the hedge off when the original trade is confirmed (as in example one) or, if it keeps going the "wrong" way, when the conditions of the basic retracement strategy cease to apply (as in example two). In the latter cases both the original trade and hedge are closed, of course.

In the first case, if the original trade goes against me again then I close, but I wouldn't be hanging about for it to get to the original stop-loss price.

So far, so good - if it's seriously flawed, then time will tell.

jon
 

tomorton

Legendary member
7,262 970
Food for thought jon, thanks.
I was wondering if your narratives are strictly correct - i.e. you waited for your 'stop' to be hit before hedging? Would you consider hedging with the FTSE from the moment of opening the equity position?
 

barjon

Legendary member
10,249 1,546
Food for thought jon, thanks.
I was wondering if your narratives are strictly correct - i.e. you waited for your 'stop' to be hit before hedging? Would you consider hedging with the FTSE from the moment of opening the equity position?
Yes, that's a possibility, Tom, but then you'd be into an entirely different trading strategy. One that was akin to pairs trading where you'd be wholly reliant on the net result of the two positions and I doubt that the retracement set-up would be the best entry point to use.

jon
 

tomorton

Legendary member
7,262 970
Yes, that's a possibility, Tom, but then you'd be into an entirely different trading strategy. One that was akin to pairs trading where you'd be wholly reliant on the net result of the two positions and I doubt that the retracement set-up would be the best entry point to use.

jon

Thank you - yes, I see it would be a type of pairs trade, so that also means it must be wrong to enter opposing trades on the pair based on the retracement of one. There's no flies on you mate.
 

forker

Senior member
2,688 499
I have always thought of hedging as not taking the equivalent to an opposite trade but rather cross market strategies such as USA dollars and oil or Canadian dollars and oil... Explicitly taking the opposite side does not give an edge in risk at all.
 

oiltanker

Established member
955 89
yes. one must have an opinion that one is hedging. ie i think its going up . its not a neutral i don't know which way its going strat.
 

counter_violent

Legendary member
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I hope that not too many take on board the message. Keep on taking those single trades with stops fellas. Remember, the markets need cannon fodder and plenty of it !
 
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Black Swan

Legendary member
5,613 833
I hope that not too many take on board the message. Keep on taking those single trades with stops fellas. Remember, the markets need cannon fodder and plenty of it !
I violently disagree with your counter theory buddy ;). Last time I checked stops were free..even if used at the xtreme of current price they should be used as a protection singularly (I'm talking FX here, makes a change from just bo11ox eh?)
 

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