You may have heard that when setting a stop loss you should allow more room for volatile price action; you should widen your stops on the basis of the volatility of the underlying stock. I strongly disagree.
Most often, high volatility is experienced during a tough market environment. During difficult periods, your gains will be smaller than normal and your percentage of profitable trades (your batting average) will definitely be lower than usual, and so your losses must be cut shorter to compensate.
It would be fair to assume that in difficult trading periods your batting average is likely to fall below 50 percent.
Once your batting average drops below 50 percent, increasing your risk proportionately to compensate for a higher expected gain based on higher volatility will eventually cause you to hit negative expectancy; the more your batting average drops, the sooner negative expectancy will be achieved.
At a 40 percent batting average your optimal gain/loss ratio is 20 percent/10 percent; at this ratio your return on investment (ROI) over 10 trades is 10.2 percent. Interestingly, expected return rises from left to right and peaks at this ratio. Thereafter, with increasing losses in proportion to your gains, the return actually declines.
Armed with this knowledge, you can understand which ratio at a particular batting average will yield the best expected return. This illustrates the power of finding the optimal ratio. Any less and you make less money; however, any more and you also make less money.
If your winning trades were to more than double from 20 percent to 42 percent and you maintained a 2:1 gain/loss ratio by cutting your losses at 21percent instead of 10 percent, you would actually lose money. You’re still maintaining the same ratio, so how could you be losing?
This is the dangerous nature of losses; they work geometrically against you. At a 50 percent batting average, if you made 100 percent on your winners and lost 50 percent on your losers, you would do nothing but breakeven; you would make more money taking profits at 4 percent and cutting your losses at 2 percent.
Not surprisingly, as your batting average drops, it gets much worse. At a 30 percent batting average, profiting 100 percent on your winners and giving back 50 percent on your losers, you would have a whopping 93 percent loss in just 10 trades.
If the optimal result is achieved by having a 48 percent/24 percent win/loss ratio at a 50 percent batting average, what do you think happens when your percentage of profitable trades drops to only 40 percent? The following figure may surprise you by showing that the optimal level (gain vs. loss) drops to 20 percent/10 percent respectfully.
If you’re trading poorly and your batting average is dropping off below the 50% level, the last thing you want to do is increase the room you give your stocks on the downside. This is not an opinion; it’s a mathematical fact.
Many investors give their losing positions more freedom to inflict deeper losses. Their results begin to slip, and they get knocked out of a handful of trades; then they watch the stocks they sold at a loss turn around and go back up. What do they say to themselves? “Maybe I should have given the stock more room to fluctuate; I’d still be in it.” This is just the opposite of what you should do.
In a difficult market environment, profits will be smaller than normal and losses will be larger; downside gaps will be more common, and you will most likely experience greater slippage. The smart way to handle this is to do the following:
• Tighten up stop losses. If you normally cut losses at 7 to 8 percent, cut them at 5 to 6 percent.
• Settle for smaller profits. If you normally take profits of 15 to 20 percent on average, take profits at 10 to12 percent.
• If you’re trading with the use of leverage, get off margin immediately.
• Reduce your exposure with regard to your position sizes as well as your overall capital commitment.
• Once you see your batting average and risk/reward profile improve, you can start to extend your parameters gradually back to normal levels.