In the MAE diagram you can see how all trades behaved and if there are any special points to consider when looking for a good place to set a proper risk stop loss. The MAE diagram can give you a hint that the “optimal” stop value is somewhere between 0.2%
and 1%. However MAE does not tell you directly what the optimal value is to set this stop. For this reason we now look at the task from a different side by performing system tests in the following way. We add a risk stop loss into our trading system and vary its distance in reference to the trade’s entry point in a wide range from 0.01% up to 1% in steps of 0.01%. At the time of writing the British pound was trading near US$2.00 and at this rate a 1% stop distance corresponds to 2 cents. Two cents are in other words 200 pips and mean $2000 in your pocket. Therefore the fine 0.01% step means 0.02 cents or 2 pips ($20 in your pocket) in these market conditions.
How to develop a trading system step-by-step – using the example of the British pound/US dollar pair
Figure 3.13: Ratio of total net profit/maximum intraday drawdown as a function of the stop loss distance in per cent. LUXOR system tested on British pound/US dollar (FOREX), 30 minute bars, 21/10/2002-4/7/2008, with entry time window 9.30am-1.30pm GMT. SLOW=44, FAST=1.
Including $30 S+C per RT.
The tests give you important statistical figures for each stop level: net profit, maximum drawdown, biggest losing trade etc. You can draw diagrams of these figures dependent on the set stop loss distance. We do this here for the ratio of total net profit/maximum drawdown (NP/DD), see Figure 3.13. We do not take the total net profit alone because it does not tell you much about the system’s risk, whereas the ratio NP/DD gives a meaningful estimate. Let’s look at this ratio for all performed trades as a function of the stop distance. This graph tells you that stop loss points positioned too closely reduce the NP/DD ratio drastically. Obviously many trades are stopped out just at the beginning and the slippage and commissions do not allow gains with so little risk.
When increasing the distance more and more the system becomes profitable, but for all stop distances below 0.15% the NP/DD ratio is still decreased and stays below the ratio of the breakout-system without stop loss. However, if you set the stop futher away from the entry point and allow the trades more room to develop you get a nice improvement of the NP/DD. Any added stop in a broad range of values between 0.2-0.5% range
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useful distance – this value is placed in the middle of this stable parameters region. The 0.3% corresponds to 60 pips or 600 US dollars with the British pound trading at US$2.
It is important to mention that you cannot find a stop loss level that improves the overall net profit for every trading system or market. Usually profits are reduced by the boundaries which are imposed by the stop losses, especially in more choppy markets (e.g.
in stock index futures like S&P 500 or FTSE 100).
Let’s have a short look how the 0.3% risk stop loss affects the performance graphs of our trading system (Figures 3.14A and B). The detailed equity curve seemed not to have changed very much. The nearly unchanged profitability of the trading system is confirmed by the system figures (Table 3.4, left two columns). The total net profit is improved with the stop loss only slightly by less than 1% from $115,000 to $116,000, whereas the average trade net profit decreased a bit from $128 to $113.
So, the profitability of the trading system stays nearly unchanged with the inserted stop loss. But let’s check if the risks of the system are now under better control.
Figure 3.14A: Detailed equity curve, B: underwater equity curve with 0.3% risk stop loss in place. LUXOR system tested on British pound/US dollar (FOREX), 30 minute bars, 21/10/2002-4/7/2008, with entry time window 9.30am-1.30pm GMT. SLOW=44, FAST=1. Including 30 $ S+C per RT. Charts from TradeStation 8.
A
How to develop a trading system step-by-step – using the example of the British pound/US dollar pair
From the underwater equity curves you see that the maximum drawdown of the trading system is now reduced from 10% to 5% (compare Figure 3.14B with 3.9B). A look at the trading figures confirms this observation (Table 3.4, page 82).
After inserting the risk stop loss the maximum intraday peak-to-valley drawdown is much reduced from $18,894 to $11,266. Even more importantly, the largest losing trade is now reduced to only $810 from over $2500 when using the system without the stop loss in place. This significant reduction by nearly a factor of three helps you to control your risks, especially when trading the system with more than one lot in a bigger portfolio.
You may ask why the biggest loss was not reduced to about $600, which corresponds to the 0.3% in today’s market value, set by our stop loss. The reason was a gap which inhibited an execution of a trade at the exact stop price but at a US$250 worse price.
Although such bad executions usually happen less than 10 times within 1000 trades, which is insignificant and well covered with the $30 slippage and commissions calculation, you have to keep in mind that this is always possible in general with every trade. Finally, we want to point out that the system’s market exposure with the inserted stop was reduced for the first time. Whereas without any exit in place the system was in the market 100% of the time, this risk exposure is now reduced to 73%. The remaining 27% of the time while the system is not active can be used to invest the money somewhere
B
DrawDown (%)
11/30/03 1/23/05 3/12/06 4/29/07 6/15/08
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