Managing Risk

Today, we are going to talk about managing risk

What’s the first thing that comes to your mind when I say “manage risk”?

I can guess…

Stop losses!

It’s the “industry standard” answer for managing risk…

Do they work?

Absolutley!

If a trade is working against you, a stop loss does exactly what it says it does, stop the losing. And that’s definitely a good thing! Limiting loss when a trade doesn’t work in your favor is a good thing… most of the time.

Sometimes, though, it’s not such a good thing.

False precision is something I brought up a long time ago in my book, Inventory Trading. I have traded with stop losses before so it’s not something that I am unfamiliar with. I intra-day trend trade futures and very regularly use stop losses in that situation. They are helpful when used properly. Do I always use them the right way? No.

The most common placement of stops is recent highs and low. If you are in a buy trade, it’s a recent low usually that draws your attention and if a sell trade is on, a recent high seems like the logical place to put your stop loss. I mean, if that level is invalidated, you have to be wrong… right?

The enemy of stop losses is two fold: volatility and the need for liquidity.

Volatility is easy to understand in terms of being problematic for a set stop loss. The faster and more violent and whipsawy (probably not a word but whatevs) price action is, the less likely it is that your stop loss is going to do what you would like it to do.

The need for liquidity is the big reason stops are difficult. How many times have you been in a trade, a buy trade for example, and you buy at the V bottom on a pullback to whatever level you have deemed valid and put your stop loss below the low created and it gets tagged just before making new highs… Nothing is more frustrating!

Why is that though? Big levels require massive energy to run through. If its a buy trade, recent highs and longer term resistance levels then the market needs as many buyers as possible to push to new highs.

But the game might be a little different than you think. The stop loss you put in below that recent low, is actual the fuel to run to the higher levels. Your stop loss order, which is a limit sell order if you are long and a limit buy order if you are short, is what market makers use to flip their positions. When you are long and have a stop loss below recent lows, price moves down to those lows and runs beneath them for sometimes a split second and then shoots to the moon higher. Why, because the market structure shifted. While your limit sell order was in the market to protect you, the market makers were on the other side of that order getting long, buying what you were selling and then letting it run higher. You were the liquidity for the market and more specifically the market makers.

So, I know what you’re thinking… “is there anyway around this??I don’t want to be a sucker for the market makers!”

There is. It’s what I do all the time. It’s inventory trading.

A hedged portfolio of long and short positions, slightly leveraged one direction or the other based on technical setups THAT ALLOW FOR TIME BY USING SMALL POSITION SIZES.

That combination is the what beats the market makers at their own game. Using very small position sizes relative to your account and allowing for time to be on your side is the exact opposite of traditional stop loss theory. Stop losses allow you to over leverage your trade size and be ok if the trade works against you. But small trade sizes and the knowledge that time is on your side allows me to go weeks with positions on my books, inventory, and never lose any sleep over it.

In fact I just made so much money on the USD/JPY ramp and the GBP/USD flash crash.

I didn’t need a stop. I needed small trade sizes, good technical understanding and time. That’s how I manage risk in the FX markets.

Happy trading, friends.