Hi Larry -

Thanks for the latest SMR. As usual, I found it well balanced and helpful. Regarding your comments about stop loss strategies, I am wondering why you have decided to categorize them as an alternative to asset allocation rather than something that can be used in conjunction.

Personally, I have been following a strategy of my own that is based on your strategy #3, with the addition of a few other rules including a stop loss in the event that the trade goes against me by 5% of the initial entry price. I chose the 5% number after glancing through some percentage charts that I created in excel of strategy #3 trades, and seeing that most trades don't go against the initial buy price by more than 5%. I re-enter again when the price comes back above that 5% line.

What do you think? I would really appreciate any thoughts you might have on this, and why I may not want to use this in conjunction with a good money management strategy. Personally, I always set stop losses, so it was just second nature for me to do so with this.

By the way, another philosophy that I always try to follow is to let my profits run, and cut my losses quickly. I am trying to think of a good leveraged strategy that fits this. Strategy #4 rubs me a bit the wrong way just because it seems to go against this in requires me to cut my profits, and let my losses run. Any comments you may have on these things would be fantastic. I really value your insight and experience.

Thank you.

marc

Marc,

I didn’t mean to present stop loss strategies and asset allocation strategies as an either/or choice. Sure, you could use them both simultaneously.

Your 5% strategy is fine and I’m sure I’ve back tested something similar in the past. I should have kept records of everything that I’ve tested, but I’ve tested so many things I just keep records on the ones I’ve wanted to use and kind of discarded the rest. But it seems to me your 5% strategy should work very much like a moving average strategy. It will work great with the trending markets we have had for quite a while now. If we go into a sideways market, you’ll have to deal with some whipsaws as the market goes back and forth through the 5% line. But what I like best about what you’re doing is that you have a plan. You have an exit plan and a re-entry plan. So that makes it a good strategy in my book.

There must be some kind of misunderstanding about Strategy No. 4. It doesn’t cut profits at all. It simply is a way to determine when to use leverage and when to not use leverage. Other than that it works just like Strategy No. 3. But I’m intrigued by your impression that it cuts profits, because if you think that I’m sure others do as well. So if you could explain what you mean, I’ll be happy to try to clarify it.

Larry

Thanks for the quick reply Larry.

What I meant was that (as I read it), strategy #4 forces me to take profits at 20% below the 200 DMA while not specifying a stop loss. So my profits are cut short at the 20% mark, and nothing is done to limit losses except to trust that the COT historical pattern will continue. In short, the 20% sell rule seems arbitrary, though it no doubt has historical precedent.

I would have expected a rule designed to identify signs of strength in the market indicating a increased level of risk to the short position. I think I was expecting a supply/demand reversal indicator rather than a specific percentage. The rules geared toward long trades give me a similar impression in that there is no stop loss or guideline for profit taking (20% rule or otherwise).

Your strategy is probably much simpler to follow than one that I'd end up with, but these initial impressions have given me reservation.

marc

Marc,
Just to put my two cents in. Taking Larry's advice about ending a short if the price goes below 20% below the 200d SMA boosted the profits of my system considerably. There are 3 times in the last 13 years that that has happened. If you look at the chart you can see that it will get you out (often with a chance to get back in to short again) at a better ending price than you would have otherwise.
Howard

marc,

i think a 5% s/l strat is good. however, if you (or anyone else) is interested in ANOTHER s/l stratgy here's one by chuck le beau that i like.

it's called the "doubly adaptive profit objective".

the basic idea: once you're in a trade (say LONG the SPY) you place a s/l order two 20-day ATR's (average true ranges) below the market.

ALSO...

you look at the ADX (average directional index) and note it's trend. if it's rising you would want to loosen you s/l to 2.5, 3, maybe even 4 ATR's.

the idea is - if you're on the right side of the market and it is trending strongly you want to give yourself more "wiggle room" so you don't get stopped out prematurely. if you're on the wrong side the s/l will get you out.

the ADX line rising means the strength of the trend is growing "stronger" - up or down, it doesn't matter. a rising ADX means the current trend is gaining momentum.

chuck has a strategy of takeing profits - waiting for price and ADX to settle, then re-entering the trade. that goes against your "let profits run" philosophy (mine too). but using ATR in conjuction with ADX for s/l placement DOES seem logical.

fyi, chuck says use 20 day ATR and 14 to 18 day ADX. you can, of course, tweak these inputs.

just another idea - take it or leave it.

-ja

p.s. 5% trailing s/l is certainly easier to do!

p.s.s. strat #4 does not cut profits short... like larry said i think you must be mis-reading it.

good luck.

Marc,

Yes, I forgot about the 20% below the 200 day moving average as it applies to Strategy No. 4. You’re right. In the rare instance that the market gets that oversold it does require one to take profits. That rule is based on a study that was done by a hedge fund manager who looked at it going back a lot of years. And I include it, not just because of its track record, but because it makes a lot of sense to me.

Bear markets behave differently from bull markets. Bull markets are driven by greed. Bear markets are driven by fear. Fear is even more powerful than greed. And when fear sets it markets can get so ridiculously oversold in such a short period of time that the rubber band can get stretched to its absolute limit. And history has shown that the S&P getting 20% below its 200 day simple moving average is pretty close to the limit. It doesn’t happen very often, but when it does I think the edge is in taking profits.

As far as stop loss strategies are concerned, I would love to be able to find one that works with COT signals that comes close to matching the historical performance of the COT strategies as presented. But I haven’t found one. You can use a stop loss strategy to eliminate the 20% drawdowns. But what you end up with instead, is four or five 5% losses in a row. Either way you have a 20% drawdown.

Having said all of that, as I said in this week’s SMR, I think most people are better off with using some kind of stop loss mechanism – for psychological reasons, if nothing else.

Maybe I'll test the idea that Joe got from Chuck LeBeau. Chuck does good work.

Larry

Thanks all for the great feedback and ideas.

Joe and Howard - My only remaining comment is that the COT strategy and even the 20% rule in strategy #4 are based on a historical pattern that someone has identified. So, as long as that pattern continues we are all in great shape. Similarly, the only way our strategies can truly fail is if the pattern fails to continue. What I would like to do is to clearly identify the boundaries of the pattern, and circumstances that fall outside of those boundaries. I don't think anything lasts forever, and I think any system should be self validating.

Larry - Would you mind expanding a little on your comment that a stop loss would translate to more small losses rather than one large one? I'm not sure I follow you there. If I stop and re-enter at the same place, I was expecting to minimize all of my drawdowns and losses to 5% or less per COT signal.

Thanks again for the great responses.

marc

regarding the cot strategy #1 (which is the basis of all the others) i simply believe in the "logic" of it. the pros are better than the amatuers... bet on the pros. it's that simple.

the other strategies are just variations on that theme - trying to finesse the entry, trying to add leverage for more money, trying to avoid large draw-downs, etc. these are all fine pursuits - but the underlying "logic" (bet on the pros) is why i follow this system.

sure, michael jordon MIGHT twist his ankle and some 4th grader MIGHT score a basket against him... ONCE IN A WHILE... but generally, i don't want to bet MONEY on the 4th grader!

however you decide to follow the system is just "po-TAY-toes" vs. "po-TAH-toes" - if you know what i mean

hope this helps.

-ja

Marc,

The problem with forums like this one is that sometimes it's hard to communicate effectively with just the writtten word. And sometimes I have a hard time understanding what other people are trying to tell me and sometimes people have a hard time understanding me.

So I have to ask you a question to be able to answer your question. You said, "I was expecting to minimize all of my drawdowns and losses to 5% or less per COT signal."

Are you saying that once you get stopped out of a COT signal with a 5% loss, you just wait for the next signal? I thought that the idea was that once you are stopped out with a 5% loss, and the market moves to within 5% of your original entry price again, you re-enter and then set another 5% stop. If so, it's easy to understand how you could have a few 5% losses in a row.

Larry

Larry -

The 5% stop loss is always relative to the initial COT signaled buy point. So, if the COT signals a long when the S&P is at 1000, then my stop loss takes effect at 950. I then (hopefully) get a chance to re-enter at 950, but my stop loss will not change after I re-enter, it stays at 950. I see what you mean about this being prone to a whip-saw, but at least on my weekly charts it looks pretty good historically.

marc

Marc,

Okay. You go long at S&P 1000. You set a stop at S&P 950. You get stopped out and take a 5% loss. So far, so good. Even I can understand that part.

But I’m not clear on how you re-enter. Are you saying that you wait for the S&P to move back above 950 before you re-enter and then set another stop at 950? So if, for example, the S&P moved up to 950 or higher you would go long again with another stop at 950? So you end up with a really tight stop?

Larry

Joe,

I like the sound of the "doubly adaptive profit objective" s/l strategy you spoke of. I was hoping that you could clarify a point that I'm not sure I understand.

When you say "you place a s/l order two 20-day ATR's (average true ranges) below the market." Do you mean (using today's SPY chart) that if the ATR = 1.10, one would want to set their stop loss order at 2X the ATR? For example, a 1.10 ATR would equate to a s/l of 2.20?


Thanks,
Russ S.

right.

if the spy 20 day ATR is 1.10 and you entered your LONG spy position today at 116 your initial s/l would be 2.20 below 116 (sounds kinda close, huh?) but you are also suppose to take profits 2.20 ABOVE 116.

to be clear, the "doubly adaptive profit objective" by chuck le beau was never meant to be a stand-alone stop/loss strategy but rather a way to define stops AND set profit objectives.

using the ATR bands to set stops + using the ADX to help determine how many ATR's to use (1.5 during declining ADX and 3 or 4 ATR's during rising ADX) is the basic idea behind this strat. short term systems might use smaller ATR's and long term systems might want to use larger ATR's.

in our example above; you might want to use 4 ATR's. buy long the SPY at 116 with ATR bands 4.40 points below, s/l, and 4.40 above, profit objective! of course you'd need a rule of how to re-enter.

the article was just giving the reader something to consider rather than a clear-cut strategy.

for lots of great ideas about risk mgmt go to www.iitm.com and click on "products" then scroll down to the "special report on money management" written by van tharp. it'll cost ya about $80 i think but it'll save you $80,000 over the course of your career. he has a section about volatility stops and how to manage the volatility of your overall portfolio.

hope this helps!

-ja

Joe,

Thanks for the help, I've got a much better grasp on the strategy behind following the ATR and ADX.

Dr. Tharp's money management report looks like required reading for one interested in maximizing profits, which I would argue we all are interested in doing. I've added it to my "read very soon" list


Russ S