Tough Talk about Risk Management

10/13/2011 4:00 pm EST

Focus: STRATEGIES

Michael Toma

Author, The Risk of Trading: Mastering the Most Important Element of Financial Speculati

Professional risk manager Mike Toma reviews critical concepts including proper stop-loss placement, execution, and an overall approach to understanding and overcoming risk in the markets.

Even brand new traders have heard that you need to put in a stop/loss to minimize your risk, but where do you put it and what does it actually mean? Is there a right way to do it?

Our guest today is Mike Toma to talk about that. So Mike, we all know we are supposed to place stop losses to minimize our risk, but what do we really mean there? What is the way that you do it?

Well the first thing to do is to really use stop/losses. If you are a trader and you are implementing that as part of your plan, you should be commended for it. It really is important to preserve your accounts, especially during the learning curve.

The other question is “where do we put it?” It is a challenge. We have talked about this before, too, and sometimes the more answers you give just stimulates more questions in “Where do I put my stop?”

I try to use a rule-based methodology in where to put it. My first rule is I don’t want to place my stop above an area of support.

So I want price to break what I perceive as an area of support, whatever my plan set-up rules say to break it and say “You know what market, if you want to stop me out, you have to go through this barrier to do it.”

I am all for traders keeping tight stops, and in ES futures, you will see one-and-a-half points or two, six ticks. I am all for preserving capital, but you are really beating yourself because the market randomness will continue to get you.

All right, and is it a hard stop where I’m always two points away determining my risk, or is it a percentage of my account, what do you recommend?

I really try to stay away from a percentage of account, because it really doesn’t tell me anything. It just says “I am willing to lose this amount of money.” Well, the market doesn’t care about how much money you are going to lose.

Also what I look at too is a term called “maximum favorable excursion.”

The last thing this industry needs is another acronym, but really what it does is if you take the average stop of where your price would have been stopped out before it hit your target, so say if you have a target of five points on the ES futures, if you took a series of trades and said “You know what, before I hit my five-point stop, the average price where it would have been hit (my stop/loss) would have been, say, five points or four points.”

Now I know this is at least the amount of room I need to give before I can execute that trade.

People talk about average true range and it sounds like it is a little bit like that, where if the S&P is moving five points a day, you don’t want to put the stop within that because it could come down within that range and stop you out.

Exactly, and what I sometimes see traders doing is say “Well, I am going to keep a two-point stop because I don’t want to risk that much,” but what you are really doing is playing into the market’s hand.

The market needs this much amount of room, on average, at least historically, to fluctuate before it can hit your target. If you are going to put your stop tighter than that, you are just a sitting duck.

Now say, well, I may only lose so much on a trade, but what that is doing is slowly depleting your account, and where you are thinking you are doing the right thing and then half your account is gone.

Does it take more risk to put more on the table? Yes, these types of concepts do. What that may require is for you to wait for price to come down more to a level so it allows you a proper risk/reward.

Does that mean missing out on some trades that would have been successful? You betcha. It is frustrating; this business isn’t easy, but if you do that, have patience, and you will find soon enough that these rewards are starting to pay off for those small losses that you have.

I have heard some people say that if you are constantly getting stopped out, you are just not picking your entry point properly; you need to re-evaluate what you are doing. For the most part, it should be working, going in your favor right away. What are your thoughts on that?

Yeah, execution really is everything. I think it is a combination of execution, where that entry point is, and also where your stop is.

Now you could write a book on “proper” execution points. Really, your execution in relation to your stop is very critical. Where I have certain support areas, I will actually put my entry just below that, so I’m looking for that probe, and if I miss it and it bounces and the market takes off without me, I am okay with that.

Maybe three or four years ago I would be a little frustrated, but now I just realize it is part of the business. The market isn’t going to try to get my stop, they don’t know where my stop is, but if they are going to get there, they are going to have to beat my support range; a support level which I have done historical assessments on, so this is the best that I can bring to the table. If you want to stop me out, break through my support.

The market will always give you another chance.

It always will.

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