Part 2: The Money Management Exit

Chuck LeBeau
chuck@traderclub.com
http://www.traderclub.com

In Bulletin #29 we emphasized the importance of exits in general and pointed out that it is the exits and not the entries which actually determine the outcome of our trades. Now that we have established the importance of exits we will be more specific and write about various types of exits. Probably the simplest and most critical exit is the money management exit or the classic "stop loss". This is the exit that protects our trading capital and prevents ruin.

To trade futures and other leveraged investments without a money management stop is certain ruin. Well-known trader and author Victor Niederhoffer lost tens of millions of dollars of his client's money when he traded his fund down to zero and some twenty-million beyond. No surprise there. The inevitable outcome of an investment with this ill-fated trader was clearly determined years ago when Niederhoffer wrote:

"I have never used stops, even to bail myself out. Somehow, having a fixed rule to exit provides my adversaries too great an advantage. " - Victor Niederhoffer, from "The Education of a Speculator", page 376

Niederhoffer's demise was no surprise to industry professionals. The only speculation was on how long it would take for him to go bust. To his credit, he lasted longer than was generally expected. Niederhoffer's paranoia about money management stops is not uncommon among naive beginners but it is an attitude that is rarely seen among seasoned professionals. The first priority in trading must always be to preserve our trading capital from the risk of catastrophic ruin. Everything else becomes secondary to this objective.

Note carefully how we have stated this goal. We did not say that our goal was to eliminate or reduce the risk of loss. Reasonable losses are an integral part of the trading process. Good traders accept losses as a cost of doing business. In fact I have observed that good traders probably take more losses than bad traders do. The critical issue in this discussion is the size of the losses that are acceptable. Catastrophic losses must be avoided at all costs and these losses are easily avoided by always employing a simple money management stop.

Niederhoffer mistakenly assumed that he was such a good trader that he could violate the cardinal rule of trading and not use money management stops. The truth is that good traders actually need money management stops more than bad traders do. Bad traders are going to fail very quickly whether they use money management stops or not while good traders will survive and prosper indefinitely. The better and longer you trade the more likely that you will eventually encounter a potentially catastrophic event.

The money management stop commits a trader to a pre-defined loss point that a trader can accept and the stop will allow him to exit a losing trade unemotionally. The trader who uses a money management stop knows from the outset that he can only give the trade a limited amount of room to move against him, and after that, he will cut his losses by exiting the trade according to his plan. This is a tremendous psychological advantage. Having a fixed point to exit a trade with a loss removes a great deal of stress in dealing with any losing position. The trader with his stop in place always knows exactly when he has to exit and avoids the pain of having to watch the loss grow larger and larger day after day.

This psychological advantage of money management stops also helps the trader before he takes a trade. Suppose the system called for us to take a trade in a specific market tomorrow, and we had an unknown and unlimited potential for loss. No knowledgeable trader would be willing to take such a trade. However, if you have a money management stop and know exactly what the worst loss could be beforehand, it is psychologically much easier to pull the trigger and confidently enter that trade. We already know and are prepared for the worse case scenario and we have determined that the amount of risk is acceptable to us. Money management stops give the trader the benefit of a worst loss estimate on any trade. This knowledge gives us the confidence to enter the trade and the psychological preparation to accept the loss should it occur. Of course money management stops may not always predict the exact amount of the worst loss, since markets can sometimes gap against the position and cause a much larger loss than planned. However in most cases the money management stop is a reasonable indication of the worst loss likely in a trade.

Over the course of this series of articles about exits we will describe a few of the basic money management stops that all traders should be familiar with. We will describe the basic Dollar Stop in this Bulletin and describe other recommended Money Management stops in subsequent bulletins.

The Dollar Stop: The simplest money management stop is a stop that is positioned a fixed dollar amount away from the entry price of a trade. Dollar stops are easy to implement and most trading software allow for easy incorporation of dollar stops into any trading system. Simple as this may sound, there are incorrect and correct ways to use a dollar stop in your systems.

The incorrect way to use dollar stops is to figure the maximum amount you can afford to lose in the trade, and then set the dollar stop accordingly. Unfortunately, the market does not make adverse price movements based on how much money you can afford to lose.

The correct way to set dollar stops is to use market characteristics and system testing statistics to determine its placement. For instance, dollar stops should not be placed too close to the markets because random price movement will cause the trade to be stopped out prematurely. Neither should dollar stops be placed too far away from the market, since that means you are willing to take a much larger loss than is necessary. In our experience, dollar stops should be placed based on some volatility measure of the market. For instance, if the average daily range of a market is $1,000, it is recommended that the dollar stop on that market should be at least $1,000 if not more. This amount should keep the stop out of the random price movements while maintaining its function of capital preservation. Again, it must be stressed that adequate system testing and analysis must precede the implementation of any dollar stop to ensure proper performance.

It is important to understand the volatility characteristics of the market you are trading and not to blindly use a fixed dollar stop for all markets, nor even for a single market if that market has changing volatility characteristics. The challenge then is to develop money management stops that are adaptive to current market volatility conditions.