Recently, a trader asked for help at futures.io in regards to sticking to their daily loss limit. I have had, unfortunate, experience with this problem, as well. However, I think I have a good understanding and solutions developed by carefully breaking down the ways this problem can occur and their variations. I wanted to recap my analysis here for your benefit.
The first question is whether or not a daily loss limit is useful. There are several arguments I want to present that a daily loss limit is extremely valuable for the discretionary trader and probably useful even for many systems. The first and most obvious reason that a daily loss limit is valuable is that if you know you’re only going to ever lose $x per day then it makes it easy to trade regardless of the conditions. That’s important psychologically. The second argument is that if you were reading the market well then you would not hit the loss limit, at any rate. So, the loss limit is a signal that you may not be reading the market correctly or that the market is somehow abnormal. A third argument is that if you can limit the size of your losing days and you’re able to be profitable most days then you can quickly move toward consistent profitability. There are also cases where a daily loss limit won’t help. Even if we believe all losses aren’t serially correlated and each trade is an independent event and we determine that a large loss won’t impact us psychologically there is still the possibility for abnormal markets.
So, if we can agree that a daily loss limit is a good thing, perhaps even critical for the discretionary day trader. The question becomes why have some traders, like myself, exceeded their daily loss limits.
There are 3 distinct ways one can go over a daily loss limit:
- A single trade or position takes you over the limit.
- A series of trades or entries takes you over the limit typically without your being aware. This is typically a fast sequence of trades. It is possible to even move from a significant profit to a loss. These trades must be serially correlated, i.e. all losers.
- You consciously make the decision to risk going over the limit after carefully evaluating the situation.
Given each of these (3) causes, I wanted to break down how each of these develop and how we can minimize the risks as traders.
How does a single position take one over the limit especially if you have an automated stop loss attached to your entry? This is the most serious way of going over the limit because you can continue to lose even without taking any actions. The ways that this can happen are as follows:
- You pull your stop loss on a trade that should have been limited in $x in risk because you have a new thesis that develops or was already planned or you have a series of signals that indicate new positions can be opened on a given position. These positions were intended to be taken off for small profits but the market provides no opportunity. You are suddenly down more then you wanted to be and do not want to take a full loss on a full sized position: so you pull the stop more. This is generally a case of trade frequency mismatch or can be viewed as a concentration risk. The solution is to (1) view each trade as an independent and statistical event, (2) you may want to give the position the max risk instead of pulling the stop– so you can only tighten it, (3) know the max stop for any trade according to your plan.
- You open more contracts then normal on the idea you will stop it out for break even or a small loss but either due (1) to sudden movement your default stop is hit or (2) failure to act. This problem is generally one of illusion of risk free trade. The solution is to set the stop in advance. This can also happen if you trade different/varying contracts and you do not have a default size button. Solution is to take off the extra contracts quickly or tighten the stop.
- Due to order entry mistakes, rejected stop, or orders left on by mistake, you have a position on without a stop loss. You don’t take it off immediately and the market makes a violent move against you creating a large open loss. Often, this can start with a small mistake such as mistaken entry, you think okay I’ll give a minute to avoid taking a loss and then it hits you. The lesson is close the trade immediately. Do not play around. And always check platform for any working open orders before closing for day.
- You forget to check for reports or news and your stop loss or stop limit is blown. This is more a significant risk of trading when there is poor liquidity such as after hours. The solution is to always check for reports and/or do not trade the pre-market or after hours when reports are often released during poor liquidity. In addition, utilizing exchange stop is recommended.
- You hold a position over the close or over the weekend. This is not an issue for day traders. Swing traders, on the other hand, may need to manage their risk by exposure in addition to stops and/or use options or decrease size for at risk holds.
How does a series of trades take one over the limit and how do we avoid it? First, this is probably not be going to be an issue unless you are a high frequency scalper. The primary problem is not being aware. The solution is to slow down your trading so that you can be aware of why you are making trades and what your current risk is. A run of losing trades normally is most likely going to be result of, one or more of the following factors:
- The market is serially correlated and you are trading the wrong side. Wrong direction. One solution toward this would be to alternate your long and short trades to try to remove the possibility of serial correlation especially if you had a losing trade.
- Your estimate of regime and/or volatility is off. This would be a case where your stops are being hit more then your targets. Wrong volatility or regime forecast. A solution might be to evaluate ways of setting stops and targets based on conditions.
- Random run of bad luck. No direct solution but increasing your win rate should reduce the probability.
Finally, we identify the case of consciously exceeding a daily loss limit. This is the least risky way of exceeding the loss limit. Unlike the the first example where a losing position is on and over our risk and can continue losing without our taking action. In this case, we have to take action. Secondly, unlike the second example where we made several trades, taking action, but weren’t cognizant were were over, we are consciously making the override in this case. As a result, arguing against consciously overrides is more difficult to argue objectively. However, some the of the reasons I outlined earlier suggest it may not be wise such as the possibility for abnormal markets.
The argument against consciously overriding might be that is the risk outweigh the benefits. For example, we cannot know if the market is abnormal or not or that we are reading the market correctly. More over, if we are confident in our ability to trade profitably then we should not feel anxious to try to capture opportunity. The final argument is that even if we are reading the market correctly and we are sound psychologically that going over our limits might push us into a state where we are not. The real deciding factor may be personal knowledge of whether or not we can recover on the same day after a poor performance. If we can then the best solution would be to both break up the loss limit by time of day, increase it, or to consciously decide in advance the reasons that you will allow for overrides. For example, one place where I can see an override is that if we have a system trade setup that is not discretionary. This might be an acceptable override or perhaps we do not count them in the same risk allocation. The key is that this should be spelled out in your plan.
