Irrefutable Law of Trading Success #10: Stops Kill Performance

When I work with traders, traders are oftentimes consumed with the idea of where should their stop level be and this makes sense. Traders are trying to be disciplined. They're trying to be disciplined and have a risk point and honor it by using a stop order. But what's interesting about this is that when you actually go through and research it, you find that most of the time, stops actually kill performance. And why is this? Well, in the prior rule, in the prior laws of the ten irrefutable laws, we talked about positive reversion. We talked about positive reversion entries, positive version entries and exits, versus negative reversion entries and exits, when we use a stop, it is a negative reversion exit. This means that when the stop is triggered, at that moment, you're selling a low, you're selling a low of some sort.

When you talk to professional traders, professional traders do everything possible to not use stops, they want to enter an exit on positive reversion. They want to try and sell high, not sell low. A lot of pros, when they get to a point where they're wrong, rather than just puke it by a stop, they will work to try and sell high, we talked about this concept that there are, we call them protocols. You can be in a trade and go into an exit protocol. What this means is, is that the idea of your trade is essentially come to an end and now you're going to work out of the trade, preferably by selling high. Sometimes we will sell low, but rather than having a stop in the market, we might be working something on closed, close of a bar, close of a period. If the market can close through our level, we're getting out. This is proving to us that we're wrong if the market can close through a level, that's a different story than it just traded lower level for a moment and coming back. 

Now, we have positive reversion, selling high, and we have selling low on close. Now a third way to address this is by the use of options. This is what we're always preaching about, we're always trying to replace having underlying trade on with options, and primarily long options or long spreads in which we have limited risk. When I'm in a long option, or a limited risk strategy, option strategy, I do not need a stop because I know the most I can lose. The market could trade through my level and I can take my time because I know I can't get killed. And if it closes through, like I said, well, then we get out of our option position. Or in some cases, we don't even need a stop at all. If it trades down through that level, who cares, we know what we can lose, we're totally fine losing it. Remember, the concept of a stop is to essentially try and avoid catastrophic losses and this makes sense. But there's things that we can do, through the way that we manage our positions, to mitigate this. Selling high, selling on close, using option strategies in place of underlying. Now, if you're able to do this, you'll find that this can have a significant improvement on your performance. I encourage you to take a look at this and I'm gonna go deeper in this in a future session. But one of the things I want you to do is if you use stops, I want you to look and see how do you do it by getting out on the stop versus using another technique like we described. Another technique might be let's say your long, you might have a faster moving average. And so you might say, Well, if the market trades down, I'll get out when the market trades up to my average, to my moving average, then I'll sell it. We have a lot of different ways we can do it but that's one of them. Okay, so you can check that out. 

Another thing I'll say about this topic of stops and then I'm going to leave it here is that price action stops tend to be a lot better than stops that are based off of some percentage away or some part. Some amount of ATR away or points away from your level. Mathematical stops tend to be bad, price action stops, because they're based around the specific Buy Sell interaction in the market, that's something that can create really good stops. Look, I do use stops, I do use stops, but I tend to use an initial stop and then I tend to stay out of the way. The ongoing stops are tend to be problematic. If I get long, and I get long on a price action low, I'll have my stop below that low and I'm okay with that. Now, if the market rallies, I'm not going to keep moving up my stop, I'm going to use my option positions, I'm going to adjust my strategies, I'm going to sell high, I'm going to do things like this, why mitigate the use of stops throughout the management of that position. Even with the initial stop, in many cases, I will be able to replace that stop order with an option strategy. And in many cases, I will work that stop on close, if the market can close through my level I'm out. Now that might mean I take a bigger loss. Sometimes I might lose one and a half R, maybe even two R, but I'm okay with that because the biggest thing I want to know as a trader is I want to know when I'm wrong. If I'm wrong, I'm okay. It's when I'm not wrong, when I have a stop that's too tight and market comes through and comes right back. I go and I was never wrong. That's not what I want to do.

Where are you with this? Go back and look at your trades, go back and look at your stops and look at an alternative exit option or model and see how would you have done if you exited differently than just having the stop in place. This can be a really big eye opener. It's Trader Tip Tuesday and what do I do on Tuesdays? I come to you with tips like this, like the 10 Irrefutable Laws of trading success to help you take your performance to an elite level. We wrapped up the 10 irrefutable laws of trading success next week. We're moving on to something fun. I'll see you next Tuesday.