SCOTT WELSH TRADING BLOG

Are Stoplosses Overrated?

Are Stoplosses Overrated??

Jan. 29, 2020

I’m really starting to wonder about stoplosses.

And targets.

Since the beginning of time, we’ve been told to use stoplosses.

If we don’t, we’re just asking the market to take all our money.

For example, what’s the oldest and most researched trading methodology of all time?

Trend following.

What do trend followers do?

They use stops (cut your losses and let your winners run).

But as I do more and more research, I’m seeing two major problems with stoplosses.

The first is psychological. Have you ever been in a winning trade and then had a big spike move down to your stop loss level, only to have the bar immediately retrace back up and head easily to what would have been your target?

It’s frustrating beyond words. And it’s probably unethical. Are the brokers hunting out stops for some nefarious profit-making reason? It sure feels like it. Living thought a spike-down stoploss is enough to make a trader want to quit the game.

You know what solves this problem forever? Not having a stoploss.

The second problem with stops is over-optimization.

What’s the most important thing to our trading and our financial future?

It’s that our system performs as expected going forward.

And what ruins a system’s future performance? You guessed it: over-optimization!

Having a stoploss is basically arbitrary. A mild market can get by with a small stop loss. A noisy market needs a big stop. What if a mild market suddenly turns into a noisy market? All the stops will get hit and profitability will plummet.

What if a mild market stays noisy? Then our system is ruined.

A stoploss can be over-optimized, poorly thought-out, and rendered obsolete with a regime change.

Now, we’re not talking about buy-and-hold (yuck) or taking a bunch of trades when price moves against us (no-stops trading). We’re talking about taking positions that have definite exits.

But the exits are ideas, not numbers.

Let me explain.

The RSI is probably my favorite indicator and testing has shown it might be the most profitable indicator. When RSI goes Oversold, for example, that means something. It means price has moved downward in a statistically unsustainable fashion. If something has dropped dramatically, it probably won’t continue to be dramatic. It’s probably exhausted and ready for a move up.

That idea makes sense, and it also shows itself to be true on the charts.

All we need now is a stop and a target and we have a system! Right?

Not so fast.

What if we don’t use a stoploss at all?

Instead, we’ll simply get out when the dramatic move downward has reversed (which is very likely) and moves a reasonable amount upward.

What’s reasonable?

Since RSI has a 0-100 scale, asking price to move past 50 seems fair. Once it gets past 50, it’s starting to accelerate. If we think about it, once it goes past 50, the next logical thing to happen is an eventual move down. Up until 50, it probably is still bouncing back. After 50, the move is starting the process of stalling out.

So, there’s our system.

  1. We’ll enter a trade Long when RSI (set to default length 14) drops into Oversold (30).
  2. We will not use a stop or target.
  3. We will exit once price has closed above 50 on the RSI.

The big advantage of trading this way is the potential robustness. There is nothing to over-optimize.

We’ve entered logically and exited logically. We’ve used reasonable ideas and taken curve-fitting completely off the table.

If there’s nothing that can be broken or become obsolete, then, theoretically, our system should continue to perform far into the future.

That’s the advantage if we choose to follow this line of thinking.

But does it actually work? Or is it just a bunch of silly hypothesizing?

We’ll find out in the next email.

Talk to you soon.

 

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