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Wiggle Room

2/13/2018

Good traders have stop-out points for trades, the point where you’re “wrong.” The aim is to experience a paper-cut. i.e., a minor loss, as opposed to getting your arm chopped off having a trading catastrophe.
A good methodology suggests a clear-cut point where your trade thesis has broken down, you admit you’re wrong and it’s time to move on. Having said that, the market has a certain amount of randomness and “natural vibration.” Some of us at PTL give our trades a little extra “wiggle-room” to account for this. Over time we’ve found this keeps us in trades where we would have normally gotten stopped out, thereby avoiding a loss in exchange for a win where we typically get 2:1 or better on a trade.
Of course, trading records need to prove this is worthwhile so that the periodic extra wins pay for the tradeoff in building in extra room in the trade, and then some. Naturally, there’s no “free lunch.” The tradeoff in doing this takes one of two forms:

You assume extra trade risk – instead of having $0.50 of risk on a 500-share trade, for a total risk (“R”) of $250, you allow for $0.60 of risk for the same share quantity, i.e., R = $300. So here you experience a bigger loss if the trade fails.
You keep your R constant, and you “pay” for the greater trade cushion by adjusting the position size. In the above scenario, you reduce the shares traded from 500 to 400, so you still have about $250 of trade risk. But since you trade 20% fewer shares, your potential profit for hitting a given price target is reduced by that percentage. So here you pay with a lower trade-profit

AT PTL we’re fans of method-2. Having a relatively constant R between trades allows us to intelligently plan our trading over time. Each of us has a trading batting average, i.e., the percentage of the time we’re right, and an average reward to risk ratio for an average trade. If you take those two elements and combine them with “R” and a financial trading objective over some time-period, it’s a simple process to plan how many trades you need to place in a week or a month to achieve that $-goal. Within this scheme, we apply this methodology to plan activity for different trade styles, i.e., scalps, intraday and swing trades.
To arrive at the wiggle-room amount we start with 10% of the standard daily ATR (dATR). Once we have our basic stop-out point based on the core principle/trading strategies we use, we then add on 10% of the dATR or an adjusted fraction of that. Our rule-of-thumb is that the additional cushion should be no greater than 20-25% of the initial stop-out amount. So if you’ve got a “basic stop” of $0.50 and 10% of the dATR is $0.20, we add on $0.10-0.12 to the trade beyond our core stop, since those amounts are 20-25% of $0.50.
We’ve found this methodology works very well for us and enhances our P&L. To evaluate its potential for what you do, over the course of a month or two, be mindful of the instances when you’re stopped out and determine:

If the trade truly crashed and burned, or
whether you got stopped out, price didn’t move beyond the stop-out point, and then the trade (almost) immediately turned out around and did exactly what it was supposed to do. If your find that this happens more than infrequently, look at your stop-outs and assess the ratio of crash-&-burns vs the quick turnaround scenario just described. At that point you’ll be able to run the numbers and get an idea of what we describe here might aid be worth introducing to your process.

This works here for us because we have clearly defined price zones where our trade is working, and once it goes beyond that zone we’re stopped out. At that stop-out point we build in the little extra room that we’ve found over time definitely improves our P&L versus the “basic” stop. Your mileage may vary.
Give it some thought!