Bits for Thought #1: Good Stop (loss), Bad Stop (loss)

Bits for Thought:
....are the philosophical premises that precede any quant project or idea, no matter how simple. Yep!, your are right, they are more important than quant itself, because they help to set up problems properly before we mess them up with our stupidly complex quant. Quant, by the way, ends up being adding and subtracting and actually not much more than that, a thorny issue that we, quants, of course will never admit.


So here comes our first BFT on stops (the so much overlooked problem): Good stop, Bad stop.


The Good Stop Loss is the one that if triggered is for a good forward looking reason, in which case will be located somewhere between the High and Low of the next trading bar (yep! otherwise it won't be triggered!!). If it's not triggered, the good stop is the one that is located right above the next bar high (for a short position), or right below the next bar low (for a long position). In this case they minimize the ex ante risk of our position.


The Bad Stop Loss is triggered for no good forward looking reason, meaning it exits us from a winning trade too early. In this case it happens to be located somewhere between the H and L of the next bar when it shouldn't. If it's not triggered, the bad stop is the one the leaves us open to an infinite (or lets say high) amount of risk when looking forward to the next bar. A bad stop for longs is way below the next bar L, and the one for shorts, well above the next bar H. The reason it is bad is because it leaves us unnecessarily exposed to risks, even when these risks end up not materializing. This is of extreme importance because when a rare event (war, terrorist attack, statistical glitch on US GDP data like in july'11....) hits the market, it might find you unprepared.


By now, "Good stop, Bad stop" should have been enough to open your mind to the true depth of this problem. If you conclude that this is a multidimensional problem with a huge number of alternative solutions, then you are right. The only thing we did was to chose the one that fitted best our requirements (in statistical terms) without overoptimizing. The result... ExtremeStops. Remember, there is always something you have to give up, a trade off.

#1 Edition April 9th 2012

Short position stops have been triggered several times of late, signalling that the upward trend although weak its still alive. As you can see there have been a couple of times in which we have been left out of the market in case we didn’t have strong conviction views or re-entry procedures

Long ExtremeStop: as of past week’s close the stop goes up to 1391. Means it is willing to take less risk in case we decide to go long. If the market opens badly it will be triggered

Short ExtremeStop: goes up by a whole lot to 1434, pointing that it is willing to take some risk of being short

This alone would already tell us the there is somewhat more risk to the downside. But here comes DPTA to provide some more guidance on what to expect. First a short intro on how to read the chart. The chart provides the probability of a strong movement around the trend for the next few weeks. As you can see it always adds up to 100%. The colours represent how much danger we should expect: light and dark blue are good for those who think they should stay long. Orange and red have the opposite meaning. In between, representing low chances of change in the trend in force (whether upwards or downwards) we have green. 

So, reading all together: 1) expect some volatility typical of a narrow range-bound market  2) wait for a return of the SP to the 1400 zone in the first place and 3) after that  the risks are slightly biased to the downside, with a decent chance of breaking the 1390-1380 area. 

Conclusion:  Although there is not much to reap from a long position stay long with a stop in 1391 just in case. Its to early to strongly bet to the downside, but if the probabilities confirm it, in a week or two we will find an improved market setup to bet to the downside.


Note: more explanations about DTPA (Dynamic Technical Probability Assesment) and ExtremeStops will be available as we have time to write them up for you 
Note 2: Always keep in mind our disclaimer issued in our first post (31/03/2012)

 

What’s this all about?

What’s this all about?

This is about sharing value added tools for decision making, more specifically wealth management and capital preservation. You know, there’s a lot of noise out there. No wonder we fail when we try to make efficient trading and market decisions in the mid of all this hustle and bustle. So, what’s the solution? Simply stated, build tools that provide a denoised signal and that simultaneously help us to keep our emotions under control. 

In this blog we will periodically (weekly) release 2 of these “awesome” tools. Both will be helpful devices for analyzing the risk/reward of being long/short the SP500 (cash). The reasoning we come up with is easily applicable to the futures contract or the ETF index, but to tell you the truth we expect you to do it all by yourselves. So lets get started.

Tool 1: ExtremeStops


It is very well known that stopping losses is probably one of the most important problems to solve if you want to be successful in keeping your capital. They won’t turn a bad decision into a good one but at least they will help us preserve our capital so we can shoot again and remain playing the game. If they are so important, How come they are so overlooked? Why is the market space brimming with unsophisticated analyses that never go beyond a trailing stop or a bollinger band? Yes, everybody works with this crumby tools without even questioning whether or not they suit our purposes. The fact is that these stops don't answer correctly the question we make in the first place, and therefore are inadequate for what we want. 

Lets state what we want first. We need a market level that in case we are wrongly positioned stops our losses helping us to avoid the almost sure losses that are coming next. If there aren't more losses in the pipeline why stopping ourselves out?  So the right stop loss is the one that is triggered for a good reason, more losses are coming. Neither trailing stops nor bollinger bands contain any logic that efficiently deals with this problem. They do of course stop our trading but not necessarily help EFFICIENTLY increase our chances of success. 

ExtremeStops deal with this problem by generating 2 stops (most of the time asymmetric) per bar (week) trying to avoid being triggered if whats coming for the next 1-2 bars (weeks) is not “bad enough”. So, as you see we pushed them to the extreme to be as accurate as possible, but be careful, it is a sort of optimization problem (not exactly but close) and if you push too much you will end up ruining the whole idea. Since it is a statistical procedure it is not flawless, but still increases the efficiency of our decisions  dramatically. Why two stops? Because at every given bar there might be two opinions on the market (long/short) and we don’t know which one is correct beforehand. Both opinions deserve to receive some help to remain in the game, don’t you think. Now wait a minute...is this a kind of ex ante risk control procedure? Yes, exactly we work out the chances of success before we engage in the trading decision. But thence it follows that you should have little faith in ex post VaR procedures and the like. They only serve the bureaucrats purposes (back office) and don't belong to the ex ante risk control discipline as we want it. Ok, ok, maybe we were to tough in this one, all those procedures provide some insight for those combinations of assets we use to call "portfolios", but it is always ex post and with no real value for the trader or asset manager day to day job of preserving capital. We will talk about that at another time.



One last comment on stops. Remember that stop losses require a careful assesment for reentry. You should have your reentry criteria always ready to shoot. In case you don’t have any, start thinking. The next tool will provide some (only some) insight in this respect.



Tool 2: Dynamic Technical Probability Assesment (DTPA)



DTPA assesses the chances we have in the next few bars (weeks) of the market (SP500) going above or below the latest average trend. The source of information is very different from the one we use with ExtremeStops, so we are covering a different need here that is also independent in nature (complementary). DTPA takes market metrics and returns probabilities. By its own, this tool is capable of describing what sort of waters are we entering into for the next few bars. Since DTPA output is so simple it does not deserve more explanations but an example that will be available in our first release (after Easter holidays of course).



It is inescapable that the combination of ExtremeStops with DTPA deserves at least a piece of your time if what you want is preserve your capital. Although we know it is not really necessary we have to write the next few lines anyway, just a mere formality.


Disclaimer: We hold no responsibility for any of your trades, you are liable for what you do with your money under management and you are supposed to take care of it by yourself. We make no claim or whatsoever that these tools are infallible, so there will always be a chance that provide a wrong signal or probability that does not match with the real market experience. The service is provided as is with the only aim of helping the decision maker when he comes to grips with the turbulent markets we are living these days. We are also not making no offer or solicitation to buy or sell securities, securities derivative or futures products of any kind, or any type of trading or investment advice, recommendation or strategy. We do not commit to any regular update of our figures, charts and information, and therefore we are not liable if we don’t want or can’t release the information in its due time. Also keep in mind that exiting successfully from a position depends on market conditions in which liquidity and breadth play a relevant role. The absence of liquidity might ruin part if not all of your exit strategy at certain times of extreme stress. If you don’t accept these conditions please don’t read this blog anymore.