I am often asked to explain the use (or lack thereof) of setting stops, and the psychology behind sticking with a losing position.
Most of our clients and trading room members know I don’t usually put on a stop. My typical response, when asked, is: “Stops are for traders that don’t understand order flow.”
Stops really are for rookies. Why? Because only rookies put enough into a trade that requires such urgent risk measures. Stops, for me, indicate an apprehensive entry into a position. At the same time you enter a trade, you are also telling the market, “beat me up if you want to, but only this much.”
In my opinion, it’s a losing psychology where the market wins almost every time. Let’s back off stops for a minute, because the basis for using or not using stops actually has nothing to do with stops at all. It has to do with position size relative to your account size (Margin to Equity, aka M/E).
This ratio is probably the most overlooked aspect in trading. In my opinion, most traders put far too much of their capital at risk and as a result are far too leveraged — and they have no recourse but to use stops because they have no more money to enter with a better position.
For those that don’t know, your Margin to Equity ratio is the amount of margin you put up for a contact divided by your account size. So, if you have $25K in an account, trading one ES contract ($6,000+ margin) is an automatic ratio of 18%. With that kind of account size, at most you could trade five contracts before being put at risk for margin calls or automatic position closings. Granted, the intraday margin is lower, averaging $400-1000+ depending upon your broker.
For me, the important thing when entering a trade is to allow the market room to move in case I am wrong. Then to ask myself, “was I simply too early or am I just flat out wrong?” If the answer to that question is “flat out wrong,” I close my position immediately and move on. Doing so means that my opinion on the direction of the market has changed and I no longer have the same strategy.
If the answer is “I’m too early,” then it’s infinitely important that I have capital available to add to my position in a way that betters my position — sometimes multiple times. If my M/E ratio is too high as a result of my first entry, what money do I have left to add more positions? The answer is none, and I’m in a losing position that I can do nothing about.
So, now that the reasons for the lack of stops and the focus on M/E has been covered, how do I use that M/E ratio to determine what amount of contracts to trade at what times? The general rule for larger institutional traders is that for every $200K in an account, begin each trade with 1 to 5 ES contracts (e.g., $1M account, begin with 5+ ES contracts).
To most of you, that must seem like an enormous waste of capital that’s just sitting in cash. But take a step back for a minute, take off the greedy sunglasses and let’s look at this. We’ll focus on the possibility of being wrong in a moment but let’s first assume you are right about your trade and you make 10 points. 10 times 1 contract times $50 per point = $500 in profit. That’s a 0.25% return on your portfolio. I cannot say this enough but trades that result in 0.10% to 0.50% returns are the cornerstone of what consistently profitable (CP) trading is built on.
My L-T (all trade set-ups) average trade performance is:
- Losses greater than -0.50% = 3.33% of the time
- Losses between -0.50 and -0.10% = 7.00% of the time
- Between -0.10 and +0.10% (break even) = 21.33% of the time
- Gains between +0.10% and +0.50% = 35.00% of the time
- Gains above +0.50% = 33.33% of the time
Now what happens if the first trade is wrong? Go back to the question from before: “Am I too early or just wrong?” If I’m just wrong, close and walk away. If I’m too early, I now have plenty of opportunities to increase my positions size with a better entry, because my M/E was so low on my first trade.
This now brings me to what’s called the S-curve entrance. The S-curve entrance is exactly what it sounds like. It’s a parabolic shaped curve that doubles my order size with every new entry. Example contract sizing:
- 1st trade = 5 contracts
- 2nd trade = 5 more – 10 total
- 3rd trade = 10 more – 20 total
With each increase in size, the entry point moves into a better position and the exit point becomes easier to obtain (because you don’t need much of a move to make the overall position a profitable one anymore). Entering 3 to 4 times sometimes means that my first 1-2 entries resulted in losses while my last one may have large gains (resulting in a nice overall gain). Everyone can adjust these numbers however they would like to, but in general, this is how my entries will look when having to add positions multiple times. This kind of entry and flexibility would not be possible with the use of 2 to 4 point stops or an initial margin to equity ratio that represents too much of your account.
With each new entry, I again ask myself again: “Am I still too early or am I just wrong?” And the loop of adding more or closing a position continues until the time comes to close the trade profitably with a nice gain. I do, however, remove my first 1 or 2 trades once the market allows me a B/E exit on the front entries.
So, I don’t use stops. I don’t trade with large position sizing (initially) and I don’t panic when I’m initially wrong.
Stephen Vetterol is a Founder and Portfolio Manager with Benchmark Wealth Advisors, LLC (RIA) and their sister education company FXESTrader.com. He has 20+ years of successful trading and strategic asset allocation experience.