Stocks & Commodities V. 31:8 (16-23): Trading Without A Backstop by Anthony Trongone, PhD, CTA, CFP

Stocks & Commodities V. 31:8 (16-23): Trading Without A Backstop by Anthony Trongone, PhD, CTA, CFP
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Trading Without A Backstop by Anthony Trongone, PhD, CTA, CFP

Untangling The Web

Stop orders minimize losses, but they can also misfire. Here’s a statistical model applied to the spiders that quantitatively measures the profitability of protective stop orders.

The consensus among market strategists is that traders should always use stop orders with long positions. In fact, sometimes even questioning the absence of protective orders invites criticism; evidently, this is a contentious topic. During my presentation for Technical Analysis of Stocks & Commodities at the 2013 New York Trading Expo, the daytraders attending agreed they often found stop orders somewhat meaningful; they were, however, also quick to acknowledge that these orders can just as easily misfire.

The main reason supporting the use of a backstop is to offset your position before a minor loss turns into a devastating setback. Besides insulating you from further loss, it also offers the psychologically calming effect of knowing that your downside exposure is fixed.

Although the premise for minimizing loss appears to be a sensible strategy, the basis for this recommendation comes from subjective theory, not empirical evidence. Thus, the discussion often skirts around this issue by giving us platitudes such as “never let a small loss turn into a big one.” Rather than accept this at face value, I prefer to construct a statistical model to quantitatively measure the profitability of these protective stop orders.

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