We trade a style of trading known as high probability statistical trading. We’re looking for high probability trades based upon historical patterns which have occurred numerous times. This style of trading has been successful for us for a number of years, as well as for many traders who follow this style.
One part of how we trade is we do not use stops on our short-term equity, ETF, and e-mini trading (we do with our day trading and our options trading). The reason we do not use stops in our short term trading is because we’ve run numerous tests over the years (some published) which show stops tend to hurt the performance of most mean reverting strategies. We feel that as insurance (stops are a form of insurance) they’re expensive and there are better ways to protect a portfolio. Also (and this is every important) stops do nothing to protect a portfolio from overnight risk. If you buy a stock at 60 and the next morning it badly misses its earnings, the stops do nothing to protect you. You had full exposure and you’ll be sitting on a healthy loss at the opening. Between this fact and the many test results confirming this, there are other ways to potentially protect your portfolio.
1. Position Size: Lowering position size lessens risk. If 50% of your money is in a stock and it loses 1/2 its value overnight, you’re down 25%. Not an easy amount to overcome quickly. But if 5% of your portfolio is in the stock, and the same thing occurs, it’s a 2.5% loss. Much easier to make back 2.5% than it is to make back 25%.
2. Lower exposure within sectors. Buying all energy stocks and ETFs at the same time is essentially buying one thing. If energy prices rise you likely win, if they fall you likely lose. The diversification is a mirage. You were basically long one thing (energy) and as that went, your portfolio went.
3. On longs, consider buying way out of the money puts for catastrophic protection (I know a number of professionals who use this strategy). And on shorts buy way out of the money calls. This insurance will protect you from the “Black Swan” and is better than a stop because it protects you from the overnight risk.
4. Remember that currently the markets are highly correlated. Buying a sector ETF in the U.S. today often has a high correlation to a country ETF thousands of miles away from the US. Many ETFs are overbought today as the RSI on the SPY was 95 last night. In our universe we follow dozens of ETFs including country fund ETFs and they are showing the same characteristics. Most moved up together and most will continue to rise and fall together. Buying or shorting many likely means you are buying and shorting the same thing, but you have heightened your risk as you have more capital invested that is highly correlated. Diversification today is partially a myth due to these correlations. Therefore proper position sizing and understanding correlations are more important today than it’s been in many years.
5. And finally, even though the markets are overbought it does not mean they cannot become more overbought. If you’re short the SPY here, imagine how it will feel 10 or 15 points higher if a massive short covering occurs. If the pain is to great, it may mean you have too much personal exposure. If the pain is bearable, you’re likely correctly positioned. This is the psychological part of trading. It doesn’t maximize returns…it allows you to trade your strategies and maintained a balanced mind frame.
One final note on stops. If you’re comfortable with them, use them. We haven’t used them for a number of years because of the statistical results and we are more comfortable protecting ourselves using other ways as mentioned above. But, if you like them and you’re profitable using them, then keep doing so. There are lots of profitable traders who do use stops and again, look to find the place which makes you the most comfortable and at the same time hopefully the most profitable.
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