How to Think About Stop Losses

I think stop hunting is real, but I think it’s nowhere near as big a thing as some people make out. So yeah, if you have your stop in the market, there’s a chance it will get triggered and there’s a chance it will get triggered at the absolute low of the day. It’s happened to me. I’ve had stops in the market and the market’s literally come down, touched my stop, I’ve been out and then it’s just gone straight up for the rest of the day and then gone on to be a winning trade.

So is that real? Yes, absolutely. Does that mean you shouldn’t have in market stops? Not necessarily. What it means is you should test. whether you should have in market stops. And here’s where backtesting is one of the things that backtesting is so powerful. You can code a stop loss in your trading system to be in the market.

So if it gets touched during the day, you’re out. And you can code your stop so that if it gets touched during the day, you get out the next day on the open. And you can code your stop loss so that if it closes below the stop loss level, then you get out at the open the next day. So there’s lots of different ways to code your stop.

And backtest it. Now, if you do it each of those different ways and you backtest them all, you’ll find out which one works best for the market and the system that you’re trading. What’s interesting is that a lot of the time it is better to exit next bar on open than it is to exit on an in market stop.

Why is that? Because the market panics and so it collapses, but the next day people have had time to take a breath and realize the world wasn’t ending and often the stock bounces. Not always. But often when you start to think about your trading as a portfolio of systems and each system has a portfolio of stocks in it, you don’t worry so much about each individual stock, you think about the system.

The system performance is what matters. And so if the system performs better by exiting next bar on open, even though sometimes you’ll have a stock that hits the stop loss and then the next bar is way down because the market was right and it keeps collapsing and you have a bigger loss than you would have had on that trade if you had of, than if you had of exited in market, every now and then that’s going to happen, but on average, you might find that the market tends to bounce a little bit by the open and you can get out at a better price.

So the system might perform better. If you change your stops to next bar on open, but you’ve got to test it and see. I had one system system in Hong Kong and just by changing the stop to next bar on open, I got a 40 percent uplift in expectancy just by making one simple change. Now, that’s not true of every system and it’s not true in every market.

You’ve got to test it. This is why backtesting is such a powerful skill to learn. But that was like, whoa, That’s amazing! Like easy change, less work, I don’t even have to place stops, I just run my backtest at the end of the day and it tells me my stock got hit and I exit next bar and open. So I had less work, it was quicker to run and the profitability was dramatically improved.

Score. That’s why backtesting is so powerful. So yes I have some systems that have in market stops but actually most of mine don’t. I’m not recommending that’s right for everyone. The challenge with backtesting is that it’s not always right. Next bar on open exits after a stop loss is that you’ve got to take the exit, right?

If you’re not disciplined, this is a real problem. It’s oh, my stop got hit. Oh, but I think it’s going to turn around. I might just hold on, right? I’ll just wait. Oh, look, it’s bounced a bit. Let me just hold on and see if it keeps going up. These are the psychological games that you can play with yourself to completely screw your trading.

So if that’s the sort of thing you’re going to do, if you’re not going to be disciplined, then having an in market stop is better because that takes you out and you’re done. You’re out, right? You can’t argue with it. Your psychology can’t screw it up. But if you backtest it and you realize that exiting the next bar and open is better and you’ve got rock solid confidence in your strategy because of your backtesting and because you’ve done it over and over again, And you actually execute that trade every time next bar and open, maybe that’s the right way for you, but you’ve got to be disciplined whichever way you go about it.