Bennett McDowell’s A Trader’s Money Management System: How to Ensure Profit and Avoid the Risk of Ruin (Wiley, 2008) is an elementary text. But there are a couple of points that even more seasoned traders should be reminded of, both covered in his chapter on stop-loss exit rules.
McDowell claims that the value of having an initial stop in place is that the trader can then unemotionally determine the best exit possible for the six main types of risk. I don’t agree with his justification for initial stops. For instance, if a trader is in a long position and the market drops like a rock, he can only pray that his stop doesn’t get hit miles away from where he placed it. He can’t unemotionally determine the best exit possible. But, that criticism aside, let’s turn to the various kinds of risk a trader may face.
1. Trade risk, determined by position sizing. McDowell repeats the mantra of never risking more than two percent of one’s capital on any given trade.
2. Market risk, over which the trader has no control. Since market risk can far exceed trade risk, McDowell suggests that a person never trade with more than ten percent of his or her net worth.
3. Margin risk, where a trader can end up in hawk to the brokerage firm.
4. Liquidity risk. Here McDowell recalls the plight of Enron shareholders in 2001.
5. Overnight risk. The dreaded gap open for traders who sleep.
6. Volatility risk. This is a risk factor that traders sometimes ignore; as a result they get stopped out over and over again.
Once a trade is on and the initial stop is in place, what kind of trailing stop should a trader use? (I know that many traders don’t believe in using trailing stops, but I’m not addressing that issue here.) McDowell offers a few possibilities.
1. Resistance stop. The name is a little odd, but the concept is well known, however difficult to implement in real time. That is, in a trend place stops just above or below countertrend swing highs or lows.
2. Three-bar trailing stop, which McDowell recommends for a market that seems to be losing momentum and where a reversal may be imminent.
3. One-bar trailing stop, to be used under two circumstances. First, once price reaches the trader’s profit target. And second, in the case of a break-away market where three to five bars have moved strongly in the trader’s favor and he wants to lock in profits.
4. Trend line stop, where the trade is exited once prices close on the opposite side of the trend line.
5. Regression channel stop. Similar to the trend line stop, the trade is exited when prices close outside the channel.
Money management and stop placement are critical to a trader’s success, and I expect to return to these themes many times in this blog. So stay tuned.