V.10:5 (225-228): Using Probability Stops In Trading by Nauzer Balsara, Ph.D.

Using Probability Stops In Trading by Nauzer Balsara, Ph.D.

Does controlling losses by using predetermined stop-loss points help? To find out, Nauzer Balsara selected randomly moving average crossover systems and ascertained the best stop-loss points to use. Then he tested the system over different data. We present his results.

The goal of risk management is conserving capital — getting out of a trade without incurring too much of an unrealized loss. The question here is how much is too much? An unrealized loss arises during the life of a trade, representing the difference between the current price and the entry price. An equity reduction or drawdown during the life of a trade results from a reduction in the unrealized profit or, conversely, an increase in the unrealized loss on a trade.

When confronted with an equity drawdown on an active trade, a trader must choose between two conflicting actions: liquidating the trade in an attempt to conserve capital, or continuing with the hope of recouping losses on the drawdown. An unrealized loss might possibly be recouped by continuing with the trade instead of being converted into a realized loss on liquidation. However, if the trade continues to deteriorate, the unrealized loss could multiply. The aim is to be aware of equity drawdowns while simultaneously minimizing the probability of erroneously short-circuiting a trade.