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Hi Dave: Let's say I am trading a simple SAR system and I buy a long
breakout with a $4000 risk. If I wait until the short reverse signal, I
lose $4000. If I put in a $1500 stop, haven't I saved $2500- - all other
things being equal. I agree that arbitrary stops have no relation to market
action- - they are more of a psychological crutch- - but they can, and do,
prevent catastrophes. Much more complicated than Gallacher makes it seem.
Regards, Jack.
----- Original Message -----
From: "David Colin" <davidcolin@xxxxxxxxx>
To: <Omega-list@xxxxxxxxxx>
Sent: Monday, September 27, 2004 9:32 AM
Subject: Risk
> List:
>
> I've been thinking recently about the subject of risk and stop losses. We
> always hear that we shouldn't be risking more than 1-2% of our accounts on
> any one trade (risk defined by your stop loss' distance from your entry
> price).
>
> Recently I read William Gallacher's revised edition of "Winner Take All"
> (excellent book, BTW). He discusses at length an idea I have heard echoed
> by some other great traders over the years: the idea that, rather than
> stops being placed according to a 2% risk, that they really should be
> placed "correctly" for your system, which is to say they should be at a
> point where it is "a violation of the reason why [you] wanted to get into
> the trade in the first place" (Tom Basso). For many trend following
> stop-and-reverse type systems I would imagine that such an exit point
would
> be the mirror image of your entry point, rather than 2% from your
> entry. This point seems reinforced by the fact that when I introduce
fixed
> percentage stops (volatilty based as I am using a position sizing model)
> into my own trend following system, the accury (% winning trades) goes
down
> substantially. This tells me that the stops are placed
> "incorrectly." Gallacher states:
>
> ...the severity of an equity drawdown to an account is almost exclusively
a
> function of the size of the position habitually put on in that account.
> Some commentators downplay the exposure issue, suggesting that a trader
> protect himself from "overtrading" by limiting the amount he risks on each
> trade to a fixed percentage of his equity....I intend to show that the
> question of risk percentages is academic and that only exposure matters in
> the long run.
> Let's say...a trader with $20K true risk capital anticipates capturing an
> 80 cent move in soybeans ($4000/contract). The trader has been reading a
> book that cautions him to risk no more than 5% of his equity on any one
> trade. Accordingly, he risks $1000 on one contract, hoping to make $4000:
a
> trade with a risk to reward ratio of 1 to 4.
> Now, imagine this same trader reading elsewhere that he should risk no
more
> than 2 percent of equity on any one trade. If he takes this advice, the
> trader may still trade one contract, but may risk only $400. He is still
> hoping to capture the same $4000...move and is therefore working on a risk
> to reward ratio of 1 to 10 -- or so he may think.
> Let us compare the two approaches to equity preservation....Both are
> equally exposed to a sudden sharp price change, since they are both
holding
> the same position size....The 2 approaches differ only in the amount
> initially risked, and if both pursue the same consistent strategy of going
> for that 80 cent move in soybeans, the strategy risking $400 can expect to
> be stopped out 2 1/2 times as often as the strategy risking $1000; it can
> therefore expect to experience the same magnitude of drawdown over the
same
> period of time.....Risk to trading equity cannot be reduced by reducing
the
> amount risked on each trade. You can drive from Toronto to Miami in one
day
> or spread the driving over three days; it still takes the same amount of
> gas to get there....it is very much a question of paying now or paying
> later....[With stop and reverse systems] it is the market, not you, that
> decides how much you are risking. This...truth is perhaps clearer when you
> consider the operation of reversal systems [ie systems that are "always in
> the market"]....In a reversal system, market action dictates absolutely
the
> amounts that are risked on each new position. Such systems cannot possibly
> risk fixed amounts, and it would be ludicrous to try and constrain them to
> do so. (William Gallacher, "Winner Take All")
>
>
> Please keep in mind that I am assuming you are using some sort of position
> sizing model, and not that you are trading overly large positions for your
> account size and thus forcing your "2% stops" to be arbitrary and
> artificially tight. For myself, I would be using the model:
>
> (.01 x Account Size) / (N * BigPointValue)
>
> where N is the 20 day ATR.
>
> So 2% stops would be equal to 2N for each market traded. So I am not
> talking about trading 10 bond contracts in a 30K account and then risking
> 2% on such a position.
>
> I welcome any opinions, or comments.
>
> Thanks.
>
> David
>
>
>
>
>
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