Tight Stops
By Dave Mabe
Here's a question from reader John L. on tight stops and optimizing. (Name used with permission)
John L.:
I have been running into the same problem over and over with the day trading strategies I am developing. The stops on many trades are set very tight, whether on a %, ATR, or absolute basis.
These also tend to be the most profitable trades in the tests. I have not started trading live yet, but I strongly suspect using such stops is not workable Live.
I have played around with using a minimum value, pushing my entry further away, and other things. Curious if you'd be willing to share if you deal with this and how?
Dave:
You're right to worry about this.
Most traders use stops that are too tight.
I think there are a variety of reasons, but one is that if your backtest's position sizing is based on the distance to your stop, you get a wide range of share sizes for your trades.
If you're not careful, the high end of the share sizes can be unrealistically large.
When you go to optimize your strategy with the Cruncher, it will (correctly) select rules to essentially focus on those large trades.
This phenomenon is similar to backtesting with compounding turned on, which selects for recent trades that are way larger than the older trades due to the account growing over time.
It's important to get this right earlier in your process, to avoid big headaches down the road.
Accidentally setting your expectations too high is easy to do, so it's good to be skeptical and try to imagine how your backtest might be optimistic.
Here's one thing you can do to gather more info without risking a dime.
Create two different versions of your strategy with different position sizing techniques.
One with slightly more aggressive sizing and the other with less aggressive sizing (looser stop).
Now watch a few trades come through in real-time and paper trade them.
Paper trading won't give you perfectly realistic fills, but you should be able to get a sense of which of your position sizing approaches will work better by watching trades come through in real-time.
There's something about watching trades in real-time that allows you to pick up on nuances that you don't see in the backtest - even if you don't have money on the line.
Try this and see if it helps.
Thanks for the question, John.
-Dave
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