Trade Management Protocols​

Every Tuesday Chuck releases a new Trader Tip video on YouTube. This week we will discuss how there are many ways to manage a trade, but you want to manage your trades in a manner that reflects your personal psychology. The way you manage your trades will have a significant impact on your profitability. Many traders utilize what we call negative reversion strategies for both entries and for exits, and this is typically sub optimal and has a negative impact on profitability. The big thing we want to remember is that your psychology plus your system equals your equity curve. Let's dive in! 

You can read the episode transcript below or watch the video that follows.
If you have any questions, please reach out to us. We look forward to being a continued part of your trading education!

Today we're going to talk about trade management protocols. Now in recent weeks, we've been talking about the importance of exits. That exits are far more important than entries. That every great trader I know, is great at exits. So today we're going to talk a little bit about the mindset of trade management, and trade management protocols.

One thing it's important to remember is there are many ways to manage a trade, but you want to manage your trades in a manner that reflects your personal psychology. The way you manage your trades will have a significant impact on your profitability. Many traders utilize what we call negative reversion strategies for both entries and for exits, and this is typically sub optimal and has a negative impact on profitability. The big thing we want to remember is that your psychology plus your system equals your equity curve.

Your Psychology + Your System = Your Equity Curve

Your psychology is either going to improve your system or it's going to harm your system. If it's good, it's going to be additive, and your equity curve will be higher. If it's poor or weak, it's going to be a subtraction or a negative, it takes away from your system.

One of the best books that I've read in recent years I highly recommend. I was like when I read this book, it was so much like how I think about things. The book is called Alpha Brain. How group of iconoclasts are using cognitive science to advance the business of alpha generation by Stephen Duneier. Stephen Duneier, in his own right is one of the most fascinating people I've ever seen. He set several different world records in completely different disciplines, and he talks about how to maximize your time and your potential. But anyways, in this specific book, he was talking about cognitive science and how to think about managing trades. So here he is, setting up a trade looks probably somewhat similar to a trade you might do, who has a trading range, and he's basically looking to buy the bottom of the range and for the market to oscillate to the top of the range. That's what he's looking forward to make on the trade. So this is the upper end of expectations, this is the lower end of expectations. This is the underlying.

Notice what he did here, he puts his stop outside the lower end of expectations. That way, something will have shifted if he gets stopped out, and notice on the top side, he's putting a take profit, just inside the upper band of expectation. So if it trades up to his target, he's already out. This is a great way to think about managing your trades.

We don't want to get out unless we know we're wrong. People get out for all these other reasons. They're scared, they're nervous, they don't want to give the money back, they have the need to be right bias, all these sorts of things, and they get stopped out of trades that they frankly just ruin them. If they just stay back kept their stop or their exit below the lower bound of expectations, they never get taken out.

What do most traders do instead of unwinding the position? They move their stop loss up, thereby effectively rebalancing the risk reward. While it may appear to be rational, it is not. If you follow me, this is one of the things I pound on all the time. Moving up your trailing stop is usually a big problem. Everybody says, I've moved up my stop by most traders safe bullshit, you're pretty much guaranteed you're gonna get stopped out. Think about what he's saying here. It's really fascinating. The reason is, is that the upper and lower expectation bands represent discrete moments. What that means is the probability of the market trading just above the upper band, is disproportionately lower than the probability of trading just below. In other words, it's going to trade below the upper bound not above the upper bound.

If you want to set a high probability, take profit, set your exit or your take profit inside the upper band. Does that make sense? We see this year when we take this graph and we turn it on its side. Here's the upper bound, we take your take profit inside. Here's the lower bound, we have it just outside.

On the other hand, the probability of spot trading just below the lower end of your expectations is also disproportionately lower than the probability of trading just above the lower end. Therefore, you don't want to be stopped out while your view is still in effect. If you think you're right, you want to get out when you're wrong not until then.

You should set your stop loss just below the lower end of your expectations. If you were to raise your stop loss with the objective of rebalancing the reward to risk, you're shifting the probability of triggering that stop loss from very low of getting triggered to very high. So while you are reducing the magnitude of your potential downside, you're almost guaranteeing you're going to get stopped out. Here's our distribution, and we had our exit over here. Now we moved it, and now look where it sits, it sits right in the middle of the distribution, this is why it's so likely it's going to get hit. So when people move up their stop, they move it up into an area that's pretty much guaranteed it's gonna get hit, it doesn't help. It makes it worse.

So what Stephen is saying is that the rational decision would have you reduce your position, and the momentum traders are loading up and loading up when they're stopping out. If you are an investor who expresses a view based on fundamentals, momentum trading is completely incompatible with your approach. In fact, it's downright corrosive. Do it often and often you'll find yourself saying, Well, I got my view, right, but it didn't make any money. How many of you have nailed your view of the market and lost money doing it? I've done that. I know what it's like.

Another element I want to share with you is it stops hurt. Now you hear me talk about this a lot, but this is from Larry Connors, from the book, Short Term Trading Strategies That Work: Larry said, "For many years, I advocated the use of stops in trading. If you look at any of my published work until 2004, you will see the words “use stops” alongside most strategies. ​ In early 2005, we started running tests with the hope of identifying the optimal stop levels to use. What came back though was completely the opposite of anything we ever imagined. We’ve run literally hundreds of variations of stops tests and they all come to the same conclusion – when it comes to stocks and equity indices – stops hurt."​

What you see here is a no stop the trading strategy, which is basically a stock is above its 200 day moving average, and we go long at a 10 day low, and we get out when it reverts to the mean. You can see 236,000 trades 70% Winners average profit a .58%. Now notice, if he starts instituting stops at 1, 3, 5, 7, 10, and 20%, immediately, the average profit loss gets crushed, percentage of winners gets crushed, and the trades go up because you're getting stopped out going back in and getting stopped out and going back in where if you don't have a stop, you're just in til the trades over. You can see that basically using a stop, you have to have a gigantic stop before it's even close to having no stop.

No matter where the stop is placed, that hurts performance, the tighter the stop the worst of performance. Okay, so with stocks reverting as they do, you can see from hundreds of 1000s of setups that the stock will drop, the stock gets hit, and then the stock reverses and proceeds to rally, but without you on it. Now I have some very specific views on this that we're kind of beyond today. I do use initial stops in some cases. This is why I love options because I can build trades. I don't need an initial stop if I so choose. But I have very specific ways that I manage this and I absolutely avoid ongoing stops. They are a big problem.

Here's just an example. We have our upcoming Matrix Money Machine workshop starting at June 10, and you can go to Vantharp.com or enter.tradingmatrix.com. To sign up for this workshop. We teach a system called a Simplified BB Gun. We have a bunch of different samples, but here's one of them. I want you to notice that the Simplified BB Gun with the stop is 232 trades 85 cent expectancy 50% win rate average win to average loss to 2.7. This is an excellent system.

Look what happens if you get rid of the stop expectancy goes from 85 cents to $1.06. The win rate goes from 50% To 66%, and the average one loss actually goes down to 1.5. This is a better system. You can see the STOP hurts.

I encourage you to think about this issue and how are you choosing to handle it? Do you have a stop? Do you tighten your stops and have trailing stops? Do you understand how you can use options to replace this stop? We had a trade in Occidental Petroleum OXY that we bought calls, trade didn't work, we would have got stopped out underlying, but because we were long calls, we didn't get out, and then all of a sudden late last week, the market turned and took off, and today OXY was gapped up higher. Now it faded a little bit into the day, but the point is, we're still long with a trade that's now working that if we just had our stop, we'd have been out a week ago. This is one of the advantages that it does.

Are you prepared to use options? Do you use options and options structures to limit your risk and frame your trades to have big winning Rs? This trade management protocol is huge, and this is one of the big places where you get to act elite. You get to act like a pro. So check it out.

Remember, we do a Trader Tip Tuesday every Tuesday tune in next Tuesday, where I will teach you different ways to think about trading that will help you up your performance to an elite level. I'll see you next Tuesday, and look up the matrix money machine at Vantharp.com or enter.tradingmatrix.com. Have a great week. God Bless. Bye.