Line Your Own Pockets

Michael: 00:00

Okay, everyone. Welcome to another episode of Line Your Own Pockets. Today, we're actually answering a question from our YouTube comments. So remember, you can comment and we read and sometimes respond via text, and sometimes we respond via video if it's a good enough question. So I'll let Dave read the question here.

Michael: 00:18

But, while he's reading, I've got something I have to, I have to put on here. So for audio only listeners, I am currently wearing a tinfoil hat for Dave to read this question. So so go nuts. I love that. Didn't even tell him I was gonna do that.

Michael: 00:35

So

Dave: 00:36

Alright. So the question is from Arthur Derochev. It's a couple of months ago responding to one of our podcasts. And it said, we consider discussing one of your future episodes, the topic of how to avoid being stopped out by algorithms and how to figure out the most logical location to put a stop loss. I love this topic because there's a certain phase you go through as a trader where you start hearing people talk about how people are going for your stops or these algos are going for certain people's stops and, know, you may be targeted, so be careful.

Dave: 01:26

Right? What do you think about that, Michael?

Michael: 01:29

Oh, man. So this is gonna be a fun one because I think we're gonna agree here, but I just I still think it's gonna be funny anyway. I'm gonna say there is a certain amount of that going on, but not in the way that you think about it. Right? So first of all, I think any any conspiracy theory generally just gets debunked by saying how many people would have to keep the secret in order for it to work.

Michael: 01:54

Right? So the way I look at it is saying, so if if the market makers, the algos, the citadels, the the Ken Griffins, the scary names, if they knew where your stop was, it would have to be them, everyone who's worked for their company now, everyone who's ever worked for their company, and never having exposed the code or the the algo or whatever that knows where everyone's stop is. So that's kind of gonna be right off the bat as I think it's a lot of BS, but I think there's, like, psychological reasons why people think it happens, and I think that's gonna be important to look at. Now, just in case you have a different opinion, I don't know, maybe we'll have to cancel this podcast if Dave's like, oh, no, they know where my stops are. They've put a camera in my house.

Dave: 02:41

Yeah. I think it's so I think it's all BS. And the way I think it gets propagated out there and the way people become so susceptible to it is for, I think, basically two reasons. One is you have some pretty well known gurus out there, some of which we know personally, Michael, that put this out there as a reason that certain things happen. And it's like, it puts out the They're presenting as if, hey, I'm in the know.

Dave: 03:21

I have this deep knowledge that nobody else does. I'm sort of in touch with this underground world that maybe you're not a part of. So, you know, come join my trading room or, you know, you should me. Right?

Michael: 03:34

And it's funny as you describe that, that is always the same with all conspiracy theories. Right? There's a certain level, I think, of a human's wanting to be a part of an exclusive club. If I know this thing that no one else knows, and that kind of puts me square into this club and makes me feel better about what's going on even though, right, the guy who invited you to the club is is also just kinda making things up.

Dave: 04:01

Yeah. I think it's a good you know, another place you see a lot of conspiracy theories is political theory, you know, politics in general.

Michael: 04:11

I I have not noticed that at all being on Twitter being and as the Canadian looking down at you guys, there's definitely been there's been none I don't know what you're talking about.

Dave: 04:20

Yeah. It's one thing could almost believe that the smartest hedge funds in the world could pull off something like this. But when you step back and think about the moon landing, there's some people that think that's a big conspiracy and it never happened, right? Well, have you seen, have you met, do you know politicians? I mean, these aren't the smartest cookies in the world, right?

Michael: 04:46

So

Dave: 04:46

not only would you have to be really smart to pull it off, but you're right. You have to coordinate a lot of people, and nobody can defect. It just takes one person to defect and spill the beans for it all to fall apart. So

Michael: 05:00

Well and and I think before we go too far, let's let's go back and let's try to figure out why people believe this. And and it's I think it's obvious why, and I think it's we've all had it happen. And it's all when you have a stop out at a price, and your stock goes right to that price and then reverses. Right? And I think the problem is is we have something in our brain as humans where we remember all the times we got screwed really bad and not all of the other times.

Michael: 05:30

So you remember the time that you had a stop out at ten bucks, and it went to, like, $9.99, and then it ripped all day, it would have made you thousands of dollars. We don't remember the times that are way more plentiful where it went to 8, right, and your stop was good, or, you know, it went to $9.50 and hung out there for a while and all of these things. So through just random chance, you put out a stop, the price goes exactly to that stop loss and then moves off it, and we cement that in our mind is that's the bad thing that's occurred, and then we go from there. So I just want to just kind of go and say, hey, there's a reason that's based around actual experience that people believe this. They're just wrong about what has occurred and how often it occurs and why it's kind of happened.

Michael: 06:16

Right?

Dave: 06:16

I I think that's definitely true. And I think it's even deeper for why people are so susceptible to it. And that's that you know, there it's human nature to, like, want to blame somebody else. If you've done all this work, you've created this idea, you've executed the trade, and it just went against you, and you were so close, the tendency is, well, I want to blame somebody else. That's the sign of a hobbyist trader.

Dave: 06:51

There's a phase you go through where you need to fully embrace and fully take responsibility for your own trading no matter what. Like even if your broker's platform screwed up and cost you a lot of money because their platform failed. Still, that is nobody else's responsibility but you. You have to be able to control what you can control. And a lot of these factors are out of your control.

Dave: 07:21

So, I think that's part of what You want to blame somebody else. And that's a phase you go through that the quicker you get through that, the better off you're going to be.

Michael: 07:32

Well, and and that's life. Right? We we all know the people who, regardless, you ask them how they're doing, and then it just in a offhanded, how you doing, bud? And then there's a twenty minute rant about how the world's out to get them and everything's bad and and this kind of and that because you're right. That attitude, as soon as I see that in a trader, in my head, I know that there's there's no chance.

Michael: 07:54

Right? And, you know, maybe they shake it off and they move on, but as soon as you're blaming the algos and the hedge funds and the this is someone who worked in the hedge fund space for ten years and worked in the prop firm space. I've seen the inside of these buildings, so there's nothing there's nothing conspiratorial going on because they all hate each other. Right? Hedge fund a is competing against hedge fund b that's competing against hedge fund c.

Michael: 08:18

So I it's a 100% right of saying, I just want to pass what I'm doing onto some other body out there, and then that makes me feel better about what's going on. But I I could not agree more that that is the absolute worst attitude to to have as a trader because you have to do. And we like book recommendations here. I think a really good one I remember reading a while back was Extreme Ownership by this Jack O'Willick guy. He's just basically going through he was a military guy back in the day and and was in a couple incidences that really went poorly and cost lives and everything.

Michael: 08:53

He just talked about how he had to own every it's a great, great book, so it's a really good one to read.

Dave: 09:00

Yeah. I've heard that name, I suspect that is a good book. And, yeah, that's take ownership as quickly as you can. I mean, that's the way to do it. I mean, you just think about the sort of the mindset you would slip into if you allowed yourself to believe that somebody was out to get you or this was happening.

Dave: 09:20

Think what happens to your path to confidence there for your strategy. Like you have no path. If you're blaming somebody else, then you're saying to yourself, okay, well, there's nothing I can do here. I can't scale up in this strategy with a lot of size because there's this unknown force that's out to get me and get my stock that's here all, 100 share position and $5 stock. Right?

Dave: 09:50

Okay. Let's be real.

Michael: 09:53

And and But yeah. That's the other thing I think that should help disprove it to you is that a lot of people right? Say you're trading Microsoft. I I've I've actually heard an example of some guy who had 200 share order out in Microsoft. They they came and got my stop.

Michael: 10:07

It's like, okay. So just think of the mechanics behind that. It would have cost some fund millions of dollars to move that stock, the 20¢ it would have taken to hit your stop for a $100 and then come back. So this company would have lost, like, hundreds of thousands of dollars just to smite you. And and I really like that path of confidence idea because it's it's pure defeatist.

Michael: 10:31

If the market is rigged and there's an algo out there that's looking at what you're doing and taking the other side and all this kind of stuff, just stop. There's no point. There's no point doing it because you would always be against this system that if you believe exists and you believe is kind of manipulating the market, then this isn't the game for you. You should go do something else. Right?

Michael: 10:53

Invest in index fund and call it a day. Not, you know, disparaging. It's not a bad thing. It's, to be honest, what a lot of people should do. But if there's no way to win, if there's someone out there who's watching you, then there's just there's you're right.

Michael: 11:07

There's no path to confidence. There's no way out. Right?

Dave: 11:10

Yeah. Well, I've got several thoughts about this. Even if you knew it was true, even if well, even if you even if it was true that there was this conspiracy where people go after stops. Okay. Yeah.

Dave: 11:30

There you go. Let's put on the tin his tin foil hat again. So even if you knew it was true, that doesn't mean you should necessarily quit because I think there are things you can do to minimize it, even if it's true. Like there's, it's not an all powerful force. There's no way it could be an all powerful force because they would need, like you said, they would need to invest a ton of money to get your silly stop.

Dave: 11:57

So, But even if you thought it was happening, you could still do stuff to prevent it and to avoid it and maximize or optimize your strategy in such a way to minimize this. And that's So, by selecting stops that are optimal.

Michael: 12:19

So let's go yeah. Let's go down that road a little bit. Now, the one leeway, I don't I don't even know if you'll agree with this or not, that I will give these people is that although they're not haunting your stop and they don't know where you are, they don't know where, you know, your 100 shares are, I think some of this may occur if you're doing something that's obvious. So for example, if I am a market maker, right, and I do want some liquidity, and I know that, you know, above yesterday's high or yesterday's low, there might be some action there. Maybe I'll kind of give you that on the margins that if you're putting your stop in a very obvious place where the the market maker believes, doesn't know, but believes there's hundreds of people who've also put stops there, maybe.

Michael: 13:05

So it's kind of like, if I could put half a tinfoil hat on, I would do that. So I think, you know, the solution that we can come in, we'll talk about optimal stops is okay. Let's not first of all, let's not put our stop where everyone in the world would. Maybe that's one place to to keep an eye on. Right?

Michael: 13:23

So when we're talking about putting an optimal stop down, and let's, again, put the hat tinfoil hat on and say they are looking for you. So what's the selection criteria for a stop then?

Dave: 13:34

Okay. Let's back up a little bit to the example you gave earlier that if you've traded for any length of time, you've had happened where your stock gets hit to the very exact penny, and it goes the other direction. And so I remember seeing an article written by a very well known trading publication. Everybody on this podcast would probably have heard of this. And it was about a trader who had this experience where their stop got hit.

Dave: 14:06

Oh, man, they were so frustrated. And here's what they were going to do do some research and prevent this situation in the future. And my initial reaction was, that is the exact wrong approach. Because if you have an optimal stop set, you are guaranteed to have this happen pretty frequently, right? And it's so it's not a bad thing.

Dave: 14:32

It's actually a good thing when this happens because you've selected a stop that's really close to optimal and probably is optimal. If you have the optimal stop set, this will happen to you frequently. And that's kind of what you want. Of course, it's frustrating, but that's a sign that you've set it pretty dang well. Right?

Michael: 14:54

Yes. So this is a clarifying that and and couldn't agree more is that if your stock is turning around at roughly the area that you have a stop loss at, that means that you're picking the direction of your trade correctly and that your stop is makes sense even though it was hit this time, but it's in an area that is you could see worlds where it got really close and then reversed just as easily as touched it to the tick and just reversed. And by knowing that that's happening frequently, you're knowing that, okay, at least I'm in the ballpark. I'm in the area of where I should kind of do or die again in or out. Because if it surpasses that area, likely it's it's gonna continue, but at least I'm onto something.

Michael: 15:39

And if I want to kinda try a little bit as well. So yeah, it's it's general zone. You're you're on you're on the right path.

Dave: 15:48

Yeah. And if this isn't happening happening to you on a pretty regular basis, then you should revisit your stop. You probably are leaving a lot of money on the table by not having it optimally set. So if it's too far away, like let's say you have one that's too far away, so this never happens to you, right? Then you're leaving a lot of money on the table because if you had a smaller stop, you could be taking a larger position size.

Dave: 16:14

Right. And your system would be way better. I mean, this is how you scale trading systems, is figuring out optimal places to put the stop and sizing your position based on it. So if this is not happening to you, then I think there's a problem. Like this should be a good thing that this happens to you and you should recognize it as such.

Michael: 16:37

And I and I think it goes back to that pain thing that we the pain avoidance that we always talk about is that people don't like to get stopped out because they they kind of in their brain look at it as like a a failure or bad thing. But you're right. You should be getting stopped out frequently. Right? The best trading strategies have somewhere in the neighborhood of a fifty fifty win rate, whether it's 60% or whether it's 40%.

Michael: 16:59

And if your stop is too tight, you're gonna be wiggled out of trades that would be good anyway, and that's bad. But if your stop is too loose, you have to trade such anemic position size that you're not going to make any real money on the strategy anyway. So you want to find that happy middle ground where you're getting stopped out enough that you are able to size up and still be comfortable where where the stop loss and everything is, but you're not getting stopped out on every single trade. So what is that that middle ground in that zone? And I think that kind of leads to more selection criteria.

Michael: 17:33

Right? Most people may put their stop in obvious places. Right? So, you know, I know that in the beginning, I did a lot of my stops on, you know, prior days high or a low or or or something like that. And I think the question you gotta ask yourself is that optimal?

Michael: 17:51

And the only way you know is by going through and testing the data and seeing, you know, if you loosen it a bit or tighten it a bit or or move it around, use it based off ATR volatility or something like that, how much does it change that strategy's overall results in the long run and then not be too worried about, right, yeah, you got stopped out these three times to the tick and then it reversed on you?

Dave: 18:14

Yeah. So the the way that I approach this is so I wrote a post on this. I think you could search for Dave Mabe, How I Choose Stops, and this article should pop up. It's basically the approach I take. So basically what I do is create a backtest, like the same logic, except for there's no stops or targets.

Dave: 18:37

There's only a time stop. And there's a couple data points to include in your backtest that allow you to figure out the optimal stop to use. One of them is called maximum adverse excursion. And that's like a silly, fancy word that all it's pointing at is, what's the point during the lifetime of the trade where it was least profitable? So imagine if buy stock at 100, during the course of the trade, it goes down to 99, it goes up to 102.

Dave: 19:13

Then by the time your time stop is reached, it's 101, say. Well, the maximum adverse excursion, the point at which the trade was the most against you was 99. So when you can capture that per trade, you have a great way to optimize across the entire strategy in aggregate. And so you can know exactly the point at which to use. And there's three graphs I look at, and you can go to that post and see it, that show you, that tell me exactly what the win rate would be, exactly what the total profit would be, how often the stop is being hit.

Dave: 19:57

And I can see at different levels iterating on this maximum adverse excursion exactly what it would be to be optimal. And I can choose one. And there's some trade offs there, but that's the right way to do it. And once you do it that way, you don't have to worry about any of the conspiracy theories, right? You know that you've chosen one that's going to work across a large number of your trades.

Dave: 20:23

Any one trade doesn't matter, Right?

Michael: 20:25

Yeah.

Dave: 20:26

And that's the right way to do it.

Michael: 20:28

And do you do that just, you know, might as well just keep going down this this hole because I like this. But is that how you build every strategy? Because I was just the way you're describing, that's how I do it, where I want to build at first naked, I guess you could call it, no stop loss, no profit target, none of that. Just a, like you mentioned, a time stop. Easiest to describe, I think, for day trades is if I buy the stock here based off these criterias or sell the stock here based off these criterias, what is the probability that it is higher or lower at the end of the day and by how much?

Michael: 21:01

And then after that is done and somewhat optimized and looks good, then I start to do this kind of work of of stop optimization where I build the the setup, I guess, entirely in its entirety before I'm even thinking about stop loss or profit target because I just want to know. And there's some things you do when you're you're back testing, like if if the profit is being hurt by just a number of, you know, tail events, a number of large losses, then as you're building, you kind of put those aside because you know a stop loss will just naturally take care of it whenever it's put in. But, yeah, I just the way you described it, I'm like, that's that's how I build everything. So do you do everything like that or do you do some combination?

Dave: 21:48

Yeah, I think for most every strategy I trade, I'm always thinking about that approach. Sometimes, I mean, some strategies, there's not a specific right answer and right path for every strategy. But I think for the most of the strategies that people would be thinking about that are listening to podcasts, I think that's a great default approach. I think the more interesting question is, do you select the stop before you do optimization? Or do you do optimization first and then select your stop?

Dave: 22:28

I think that's an open question. Don't think there's a right answer to that.

Michael: 22:32

I That was gonna be that was gonna be my question to you because I've done generally, I'll do both. So and what I mean by that is I will create two like, I'll branch it. Like, so this is the base strategy. This is the strategy with the most amount of trades. It's just the the the summation of the idea that I have, essentially.

Michael: 22:52

And then I do it both ways and then take a good long think about it. Right? So I will I will do an optimization naked, and then do that by maximum adverse, maximum favorable excursion, which I should just clarify that it is generally done with like an ATR or using a prior day's range or something like that. It's not a percentage or dollar amount. I think we could I don't know if we did a podcast, but if we didn't, we should about how everything should be normalized.

Michael: 23:19

I think there's still a lot of people who don't normalize that kind of data. So I'll do that first. I'll do the optimization first, and then add the stop loss, and then I will do the other side where I add the stop loss and and maybe the profit target first, and then I'll do the optimization, and then look at what the differences in the optimization was. If it's all the same all the way down, doesn't matter anyway. If I end up at the exact same point going in both directions, then I know it doesn't matter.

Michael: 23:47

If I end up in two completely different points, then it just creates a question for why. And then I try to figure out a way to get, you know, to that similar points again and just keep going kind of until I get there.

Dave: 24:00

Yeah, I like that approach. Like I said, like I said, I don't think they're either one of those approaches are right in every situation. But I think that's in general a good way to do it because you're gonna be pointed to some things that are really interesting. The difference was that, so I run the cruncher on a lot of my strategies and I'll do it with and without a stop. And you get some very different answers based on it.

Dave: 24:28

And that's really super interesting because that's going to point you to the why, why is that happening? And when you figure that out and dig in and see why that is, that can lead to some other strains of thought, perhaps some other strategy ideas for the ramifications that come from that.

Michael: 24:49

Yeah, you always get the most interesting responses when you end up in two different locations based off the methodology that the the sequence of optimization versus putting your stop. When they end up at the same place, that gives a lot of confidence of just saying, okay. Yeah. Right? The strategy kind of works just regardless of how I approach or how I skin this cap.

Michael: 25:11

But when you get to two different locations, that's kind of the eyebrow raising, you know, why and what can I learn from that?

Dave: 25:19

Yeah. And you think about exactly what's happening when you include a stop versus not including a stop. What you're doing is think about the ones that the big losing trades that would have got stopped out for amount X, but they went a long way against you, right? When you put a stop in there before you optimize, you're basically saying you're basically counting those trades the same as ones that just barely stopped out and then went in your favor, right? Yeah.

Dave: 25:55

Well, that doesn't make a lot of sense, right? To treat those the same. Like, why would you do that? Like this one went against you and it went way, way against you. Right?

Dave: 26:04

But including a stop, treat those exactly the same way statistically. And that's a trade off you make for simplicity and for using stops in general. So that's one big advantage of not using stops in your backtest. So you can see like you're valuing those in a way that makes more sense to the original idea. But what you end up with there is big outliers.

Dave: 26:35

Like you said, you end up with really large outliers that can skew the results pretty dramatically. So, I mean, one thing you could do there is have some floor well beyond your stop, but at a level that basically cuts off the outliers and see what that does. Lot of times you'll see I've had some outliers and some strategies that I've tested where literally one trade, it was such an outlier, it flipped the edge, like the edge was on the opposite side when you included this, which was crazy. That's a huge outlier. Yeah, you can see some dramatically different results when you play around with this.

Michael: 27:25

And, you know, just for the the swing trading crowd, one method to do that that I always like as opposed to using stop losses, do based off the close of a bar. Right? So when a when a bar closes in a certain condition and under a moving average or or volatility trailing stop or whatever, then you exit on the next bar. And the idea there is that you you get a lot of that that wiggle out of the way. Like you mentioned, the ones that would have come and hit the stop that day and then rallied to the end of the day and then closed strong.

Michael: 27:58

By doing that, and I guess you could do that from the intraday point of view as well, depending on the bars you're looking at, you're saying instead of just exiting at a certain price, exiting based off a certain criteria, you know, when a bar closes. You're not just saying, I'm going to stop out at this price, I'm going to stop out when this condition occurs. And in that case, I find sometimes that just leads a whole another kind of rabbit hole and a whole another couple questions to answer, because sometimes that's a little better, right? A moving average crossover is your exit or something like that. What you get there is you don't get like the really hard defensive line of, you know, I'm putting my foot down, if it violates this price, I'm out.

Michael: 28:38

So you get, you know, some larger than expected losses, but you you trade off. And and like we talk about with everything in trading, a lot of it's like a trade off. Like, generally speaking, stop loss is what you're doing is you're lowering your win rate and in hopes of increasing your profit over over time and more importantly, smoothing that profit over time. That's essentially what you're doing with the stop loss.

Dave: 29:02

Yeah, well, I think about it a little bit differently. I think about it as stop losses are always suboptimal or they should be. Should be like if you back tested your strategy without a stop, it should be better than when you test it with a stop. But stops are like the way mere mortals can actually execute a strategy. It's how you make it tradable in the real world with your human nature and psychology.

Michael: 29:37

Well, it's funny.

Dave: 29:38

If don't use stops, then, yeah, you're gonna be you're gonna have some swings that are rough to deal with.

Michael: 29:44

And that's in the Market Wizard books with Marston, who we've had on the podcast and and builds real tests that I use for back testing. He talked a lot about that. He had immune reversion system and he was more of a swing trader and he said, you know, it worked way better without a stop loss. So he took the stop loss off and it worked great for a while and then it just got, too much to stomach. Right?

Michael: 30:05

So it goes back to understanding that you're you're a human. Right? And you have to be able to get up and punch the buttons. And, you know, if you're an old man, then you probably have kids to feed and a and a house to pay for and things like that. So, yeah, it's understanding what amount of pain, which is kind of what I mean when I'm talking about the smoothness of the equity curve, what kind of zone can I take in order to come back in the next day and do the same thing over and over again, even if at the end of the day, would have made, you know, a couple more bucks without a stop loss?

Michael: 30:41

Well, what would that have taken off off my life expectancy in return?

Dave: 30:45

Yeah. I mean, I think it's, know, yet again, I'm going to mention path to confidence. You don't really have a path to confidence if you're not trading with a stop loss. Yeah, you could do that. But are you going to be able to get to meaningful position sizes that are going to produce really meaningful profits?

Dave: 31:06

Are you going be able to scale that up to a size where that really makes some serious profit for you? Probably not. And that's precisely because of the tail risk you would have with that. So yeah, a better path to confidence with stop losses, even if it's suboptimal.

Michael: 31:30

So what do you think? And we're going, like, way off the beaten path. I'll pull us back into the question in second. But what do you think about account level stop losses for, like, days? So I'm thinking of, you know, my days in the prop firm game and and that kind of thing where they basically say, if you lose x amount of money in a day, it just shuts you down entirely.

Michael: 31:50

I know you can do this with Interactive Brokers and and other brokers where you can kind of call in and say, hey. If my P and L ticks under x amount of dollars per day, shut me down. My immediate reaction when I think of them is probably the same thing, probably suboptimal, but really good if you're the kind of trader who you're worried about yourself kind of going on tilt and and doing something stupid. But, know, what do you what do you think about that when someone says, oh, if I lose a thousand bucks in a day, I I just shut it down and move on to tomorrow.

Dave: 32:23

Yeah. I think if you're a risk manager and you're managing traders, that's an obvious thing to do and you probably should do it. The way I hear other traders talking about it though, is a way to set that in an optimal way across their strategies to improve their P and L or smooth out the returns. And for that, I don't like it because when you do that across aggregating these, you're like some sort of account level stop across a bunch of strategies, you're making the assumption that all of your strategies are basically correlated in the same way or related to each other or care about what the other one's doing. That's just not going to be the case.

Dave: 33:16

To make that assumption, I think is a mistake. It can maybe smooth out your returns a bit or like make you feel better, but I don't think fundamentally it's the right way to treat your strategies. And you should be coming up with strategies that are not correlated, right? So that's the of the whole game. So treating your account like that and doing this aggregate thing across these aggregate things that are strategies of, it's like multiple layers above the actual signal, which is the signal is the important thing about strategy and about trading.

Michael: 34:02

Well, agree with that. And it's just something to my mind, it makes sense that it's in the prop firm space, I guess, because they're trying to manage risk across a whole bunch traders and it's someone else's money. But yeah, when I see people do that, personally, it just never made sense to me. Again, unless there's somebody who, you know, will take a big hit on the day and then, you know, go back at it and do something dumb on tilt. It doesn't bother me as much as the people who just stop trading when they hit a certain dollar profit on the day.

Michael: 34:33

That just that kills me. I just that hurts me. They they're like, I wanna make a thousand bucks a day. So when I hit a thousand bucks, I get out. Like, well, what if that one day you would have made 10?

Michael: 34:43

Right? Just based and off some you're just cutting based off arbitrary. I think we talked about before people who draw moving averages on equity curves and things like that, and they use the equity curve in order to try to make a decision. It's yeah, you're you're assuming that there is trend to your strategy that, you know, that it you have to kind of account for, you have to assume that your strategy is is going to work or not work, you know, in in some sort of linear fashion fashion, which generally isn't gonna be the way it's gonna work one day and not the other and and that kind of thing.

Dave: 35:17

Yeah. So, you know, it's just funny you mentioned this because just today, I wrote a message to my newsletter about a question that somebody asked me about Monte Carlo simulations. And that would be a good way, like if you think that you're doing like trading off your equity curve, and you're setting a stop or something or like sizing based off of moving average of your equity curve or something, a good thing to do would be put it through a Monte Carlo simulator, which is going to randomize the trades in the equity curve, which is what you want. Whatever magic strategy you come up with to do this finagling with your equity curve is probably going to fall apart when you do a Monte Carlo simulation.

Michael: 36:04

I think

Dave: 36:06

that's the right way to think about it.

Michael: 36:07

Just to explain to the people again if they don't know what a Monte Carlo simulation is, it takes the same trades that you already have in your equity curve, and it randomizes the orders. And the idea is that you could, in theory, have a good ish strategy, but if you randomize the order enough, you could go bankrupt. Right? And in theory, now, if the strategy is good enough, it should never happen. But the idea is that, you know, what happens if you took, you know, 10 losers in a row or, you know, 15, like, just randomizing the number of trades so it it's grouping to make sure that path dependency isn't the thing that makes your equity curve looks good.

Michael: 36:43

A lot of brokers, again, I know are a lot of backtests. I know RealTest does it by default, and it just shows you. What you're looking for is that depend even when you randomize your strategy enough, it's still profitable. It's, you know, somewhat better, a little bit worse. It's whatever.

Michael: 36:57

So what Dave is basically saying is that if you if you run it and you say, I'm gonna use a twenty day moving average on my equity curve, and if a cross below that, I'll stop trading it. Well, that's all well and good, but as soon as you randomize the the trades in the order that which they were taken, that would get triggered at the weirdest times, right? It would get stopped out. And the way I look at that is you're probably doing it probably the same people do that as the same people who system hop. Instead of building new systems, they jump from one system to another, and they're probably leaving that system at the worst possible time.

Michael: 37:33

And it's like, I'm gonna leave this system, this mean reversion system, and then all of a sudden you leave it at the very bottom of a market, which you could never predict anyway, and that would have been the system that makes all your money. It's really another proponent for multiple systems as opposed to system hopping is because you don't know which system is gonna perform well that day or week or month. But if you have enough of them together, your hope is that they're uncorrelated enough that you have one day where one system at least is is making it so you're not getting completely destroyed.

Dave: 38:05

Yeah. I think a lot of these ideas, you know, account, like, whatever you're saying, like daily daily max loss or daily minimum gain or whatever. They're really just sort of security blankets. It's not that there's no value there, but look at them for what they are. They're making you feel a little bit better about the risk you're taking and your strategies, but they are really just security blankets.

Michael: 38:40

What's the same as the the dreaded I'm gonna move my stop to break even? Oh, that one gets me. It's like, why? Yeah. Well, because I'm up a bunch of money and I don't wanna lose money now.

Michael: 38:49

Like, how scientific of you? But I that is one of those things like, you know, how people say you can see the Great Wall Of China from space, and you can't see the Great Wall Of China. It's just something that's one dude said once and then everyone else. It's the same with, oh, you know, when I'm up a bunch, I I take half and I move my stuff to break even. It's the same you're doing something.

Michael: 39:08

And listen. If it if it makes you feel good enough that you can continue on this game long enough to realize it's very suboptimal and you shouldn't be doing it, then I think that's fine. It's when I see, like, you know, ten year traders still doing it. You're like, is that you can't think of a more optimal way to to manage a position than to quickly get to a point where you don't feel any pain. It just seems yeah.

Michael: 39:34

Security blanket's a good way to do it.

Dave: 39:36

Yeah. It's because they've, they've got a target out there. And sometime in the past, they've had a trade that almost hits their target and came back and stopped out. If you But look at that, if you back test for that, you're gonna see that you get you're gonna need to have some of those to get the big winners. Right?

Dave: 39:57

So it's you're gonna have

Michael: 39:59

to It's stomach funny. So what you described is the exact same thing as the person who says they came and got my stop loss, and then they ripped it. Right? It came it came 2 pennies from my profit target, and then it pulled back a bunch before I my time stop trigger and I closed it. But you don't hear the same conspiracy nonsense around, you know, I had a a target at 10:25, and it got to 10:15 before it reversed.

Michael: 40:25

And that's I think that's funny that it's the exact same market mechanism, and you could see a world where you could just plug in the same evil actors in there who stopped the price before it got to a certain your certain level. But it never seems to work like that, especially if the trade closed in a profit anyway because of the end of the day or the end of your time stop. It's only when it's a a loss, which should tell you a lot about the psychological mechanic that makes people think this way.

Dave: 40:52

Yeah. Or or, you know, when your your target gets hit exactly to the penny. You don't think, wow, man, I was really lucky there. You think, man, I'm a freaking genius. Right?

Michael: 41:03

Yeah.

Dave: 41:04

So it's but you really like, there's there's luck involved in a lot of this. So

Michael: 41:09

Well, and it's I would say there's probabilities involved. Right? It's the you're we're testing for kind of an average and a norm knowing that there's extremes on both sides. So just if you do a 100,000 trades, there will be in that subset hundreds of trades that get within a couple pennies of a stop loss and then reverse just through random kind of natural block.

Dave: 41:33

Yeah. You're guaranteed to have that happen.

Michael: 41:36

So I guess to summarize, there is no one there's they didn't install a camera in your house. They're not looking over your shoulder. They don't know where your stop loss is. Now there may be some you know, I generally know there may be stop losses in this area. I still don't think that they would care too much unless it was within a cent or 2, but it's they're it's not your problem.

Michael: 41:58

I think is the biggest kind of takeaway is that if you're losing money trading, it's not because they're hunting your stop losses. Right? It's they, you know, again, the conspiracy theory, even if you still wanna believe it, it's still not the reason. Right? The reason is you're you're either running suboptimal strategies or you're not following those strategies.

Michael: 42:19

And I would say if you take losing traders, it's one combination of the two. They just don't have a strategy, period. They watch a video on TikTok, and they say, I'm gonna trade like this. Yeah. Or they have a strategy, and then there's something that's stopping them from actually executing and following that strategy.

Michael: 42:34

It's not Yeah. The boogeyman or Ken Griffith.

Dave: 42:37

Yeah. And and when when you have a good process for creating a strategy and selecting a stop loss, you don't have to worry about any of this crap. Right? There's no like, you know you're doing it in an optimal way and let other pretenders worry about these conspiracy theories like you're doing it in an optimal way and let things play out the way that you design them to and expect them to.

Michael: 43:02

So we just wanna give I just wanna a takeaway. So let's just give a couple tips on how to potentially we talked about, you know, using the MFE, MAE as as a stop loss. Just wanted to add a couple ideas for people to to kind of take away to when they're working on their strategies. For me, it's always to use normalized stop losses. That's like my one of my biggest this is like a big pet peeve episode for me airing.

Michael: 43:28

I must have slept poorly last night or something. But, you know, the people who say, oh, I risk 10% on the stock on a position or or, you know, oh, I want a stop of 25¢. Like, these don't make sense. When you're thinking of stop losses, you should always normalize it somehow to how that asset moves. So, again, simple ways to do it are, you know, ATR or or volatility or just look at the range of, you know, the average bar.

Michael: 43:54

Right? If your system's triggering off fifteen minute charts, say, okay. What's the average range of the last x period of fifteen minute candles? I'm gonna use some multiple of that for a stop loss. And, you know, like Dave said, eventually just forget it with the rest.

Michael: 44:08

Right? Find something that works across the entire back test, and then each individual trade, just don't worry about.

Dave: 44:16

Yeah, I think that's well said. Yeah, the other thing I would say, the big takeaway here is when this happens to you and your stock gets hit by a penny, it's a good thing. Like you should be thinking about that as a good thing. I think that's the big takeaway here.

Michael: 44:32

Yeah. And, yeah. So I guess I can I can throw out my tinfoil hat then? Guess I don't need it anymore until the next Use

Dave: 44:39

it for something else. Yeah.

Michael: 44:40

Use it for something else. Well, I do have a lot of woods in the back. Maybe I'll go hunt for Bigfoot and see if he's he's hanging out back there. But as always, again, we appreciate the question. This was really fun just to to kinda joke back and forth.

Michael: 44:52

But on on a topic that is I it's insane how how much you see this. It's it's something that I'd say if you polled the trading audience, 30%, maybe, probably believe that they're hunting your stop losses at all time easily.

Dave: 45:08

Yeah. Yeah, if you still think that's the case, please let us know. I'd like to hear what you take. Hey, I'm open to the possibility that it's happening. Maybe I just I'm not I don't have enough experience or I'm not in the know enough to to know about this vast conspiracy.

Dave: 45:27

But, yeah, happy to happy to hear.

Michael: 45:31

Well and, you know, maybe we take the other side of it. Right? Maybe if you know the conspiracy, how about you introduce me to the guy running the show? I'll I'll make him my bud, and he can tell me where all the stop losses are. And right.

Dave: 45:42

So Well, thanks for Arthur for

Michael: 45:46

Yes.

Dave: 45:46

Writing this question. This is great. Good job.

Michael: 45:48

Yes. And again, we read all the comments, right? And we we kind of respond to them and and sometimes if they're great like this, they might make it in in a podcast episode. So make sure you're doing your comments and and letting us know and giving us giving us feedback. But as always, I'm Michael Noss.

Dave: 46:06

And I'm Dave May. Thanks for joining us on Line Your Own Pockets.