I thought I’d share some recent email Q&A on the topic of active versus passive trade management. There is so much more that could be written on this subject. Hopefully you’ll find this initial email question and reply to be of interest. Feel free to share your thoughts as well if you agree or disagree. As mentioned in the reply, nothing in trading is black and white.
I really have found your site helpful as I try to set the foundation for a career in futures trading.
A couple of questions about stop and profit target management. I’m not a probabilities expert, but can’t one make the “argument” that once the trade is actually put on, accepting anything less than the initial risk/reward outcomes actually interferes with the probabilities and in the long run can neither help or hurt because even decisions to adjust are subject to probabilities and will even out over time?
In other words, tightening my stop may help me some and hurt me some, but isn’t it likely to be a wash over the course of 1000 trades? Also, once the trade is set, even if stops are immediately adjusted, the full risk of the initial stop was incurred once the trade is entered, so the possibility full reward should be allowed to occur. As an example, with a 9 profit and 5 loss stop, as soon as I enter a trade, I am assuming a 5 tick risk. It doesn’t matter that I tighten the stop, the risk was already undertaken. So, for my ratios and probabilities to work in the long run, shouldn’t I just let the trade be what it will be?
Thanks for your perspective and continued success.
Brilliant question. Thanks so much. 99% of my inbox is filled up with ‘Which should I use – a 20 period MA or a 50 period MA?’ Occasionally though I get a question that really makes me think – and makes this process all worthwhile. Hopefully my quickly typed answer can do this question justice.
Should we use an active or a passive trade management style? This question really gets to the heart of who we are as a trader and how we believe the market works.
Are you a mechanical / systems trader or a discretionary trader?
A mechanical trader who has conducted extensive backtesting and identified a pattern which provides an edge over a larger sample of trades, should NOT be using any discretion to actively manage their trades. Their edge is based on the fact that historical performance shows a positive expectancy, so trade management should be conducted EXACTLY as in the testing. This will either be holding until the stop or target is hit, or will be in accordance with some fixed rules for stop movement.
If that works for you, great. Stick with it. It doesn’t work for me.
Systems traders generally see this game as one of probability. Although probability is a feature of the game, my beliefs are somewhat different, and this difference means I’m (psychologically) a discretionary trader and therefore unable to trade this systems approach.
Systems testing is done over a very large sample, and while there are great methods of ensuring reliability of data through back and forward testing of different samples from different market environments, it’s still a large sample; and within that large sample you’ll find considerable variability – periods of underperformance and periods of outperformance. Systems traders need to persevere through the drawdown that comes from the periods of underperformance. Any one system may extend it’s period of drawdown for quite a while, maybe a whole week, maybe a month, maybe longer. And this could be quite normal – within the expected variability of results.
There’s several problems with this, for me.
Firstly, I don’t trade over a large sample. As a short timeframe discretionary trader, I’m aiming to grind out a living day to day. I hate a weekly drawdown. And even more so I hate monthly drawdowns. Each day I’m trading in a small subset of the larger sample. Whether it’s a period of outperformance or a period of underperformance is unknown, until the market can be looked back at with the benefits of hindsight. My goal is to manage the day’s opportunities as best I can at the time. If better yearly result could be statistically obtained by sticking to the original stop or target, then that’s just too bad for me. That doesn’t help me today. So, I choose active management in order to get the best result I possibly can over a small sample. I’ll leave the ‘hoping’ to achieve a longer-term statistical average result to those with more patience and deeper pockets.
Secondly, and perhaps more importantly, I just don’t believe in the ability to apply a mathematical model to the markets. Yes, it does provide good approximations, but I’m just not happy staking my money on approximations. While systems traders believe in a probabilistic market, my belief is better described as an ‘uncertain’ market or an ’emotional’ market. A subtle difference, perhaps. Yes there are probabilities, but the probabilities themselves shift.
To blindly trade systems or patterns and to hold till the preplanned stop or target, is to place your faith in the fact that the future market will be similar enough to the past markets in order for the edge to still be intact. Trade management is a matter of ‘hope’, based on trust in the power of the setups or patterns.
Market movement though is a function of orderflow imbalance, and this orderflow imbalance is the result of traders decisions and actions. While future orderflow can be somewhat influenced by the setups or patterns, this systems method is limited in its ability to take into account the context of the market in which the pattern is occurring, or the psychology of the current market. Both factors which will also have a great influence on future orderflow.
So, ‘hope’ doesn’t work for me. Like in most areas of my life where I’m a bit of a control freak, my beliefs as to the nature of the market require me to actively manage my trades.
My entries are not based on any belief in the power of the setups, but rather on my assessment of the underlying forces of supply and demand, the market context within which the current pattern is occurring, the potential future actions of other traders, and my assessment of high probability and low risk opportunities within that environment. This gives me a trade idea which is then executed.
This is a key difference – my entry is not based on a pattern based entry trigger, but rather a discretionary entry based on a ‘feel’ for the underlying forces of supply and demand. Therefore, my edge does not exist in just blindly holding till the stop or target. My edge exists only while my original trade premise is valid.
If I therefore enter a trade, and the trade does not act in accordance with my original idea, the edge is gone (or at least its likelihood is reduced). So, it’s time for me to work the best exit possible and then reassess and/or wait for the next opportunity.
This is not blindly just moving the stop or target out of fear. It’s a realisation that my original assessment of the future net orderflow is either no longer valid, or was perhaps even entirely wrong.
End result… I accept that sometimes I would have achieved better results by simply holding till either the stop or target. However, other times my active management approach will yield better results, because for example I’ll recognise a stronger than expected orderflow and be able to extend the target. Maybe it works out even over the next year or so, maybe not. It doesn’t worry me either way. I don’t actively manage my trades because it’s optimised for better results. I do so because it’s the optimal trade management approach for both my market beliefs and for my psychological needs.
Why hold a trade that moves to one tick from your target and then drives all the way back to your stop, just because taking it earlier would ‘destroy’ your edge? I just don’t get that. If you assess the market environment has changed, and bearish pressure is reducing the likelihood of the price pushing that one tick further, take profits.
As with everything in trading though, there’s no black and white. If the systems approach works for you, stick with it.