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Stops vs. Defined Risk?

Updated: May 30, 2023

Another myth is that setting stops can help you control your risks but does the data really support this?

Using defined risk is a more effective way of managing risk. In this article we will discuss the fallacies of using stops to control risk and how risk can be better aligned with probabilities to manage risk and outcomes.

Is the age old notion that we cut our losses early and let our winners ride really true?

While it’s true that cutting your losses can have the effect of limiting a loss on a particular trade it can also be the reason you have the loss..”

Well if you look at the data, while there is some truth in the statement, on the whole it is false. When you look at weekly price moves on the whole, it is quite clear that while there is very high correlation with a variety of conditions across time and volatility, there is a great deal of randomness in who the moves arrive at those points. The fact that they do is something we can make a risk decision based upon. But if we are to rely on very specific movements we will likely be stopped out before the end result materializes.

It's well known that Institutional investors will shake out investors by moving price to the points where sellers have set their stop limit orders. Virtually all traders have seen stock prices trigger their stop losses only to immediately reverse and go higher. Setting a stop loss may seem like a way of limiting risk but it can also increase risk by severely limiting your win rate.

Using Defined Risk

“Buying or selling an option allows you to predetermine the full extent of both the potential loss and gain with any particular trade.”

Utilizing the QuantDirection method along with options can address this problem by enabling defined risk. Since options have a fixed amount that can be lost which is a small fraction of the underlying price, the trader gains the right to ride the option for the full duration of the expected move. That weighted against a quantitative analysis of the probability of a particular move occurring can give the investor a full risk reward picture.

It is always critical to factor in to the overall risk equation not just the amount that can be gained and the amount that can be lost but also the probability of the gain and loss occurring. It is only with this complete picture can the investor make an informed assessment of whether any particular trade is warranted.


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