Trade probability

Some people claim that they can make market entries with 70% accuracy. How ever what ever the entry probability is, it is not the same as probability to WIN. This is because people use stop loss and exit strategies that change the outcome.

Let’s say you can make entries that are 70% right, you are right that the market is low for the day and for the week. You are right that there is a upside, and it’s going to be reached within couple of days. So the entry is very profitable, everyone should take that 70% entry.

The problem comes how people use it. They calculate that they can risk only little portion of their account. The account is small and this stop loss is then placed very close to the market action(noise). The trade entry probability has no change to reach the 70% change because it has 90% change to hit the stop loss before it can launch up from that level.

You would reach the full 70% probability only without stop loss, or with very wide stop loss. You need a stop loss, there is no doubt about that, but you have to understand how it effects and destroys your accuracy.

So you need a stop loss that protects you, but doesn’t lower the entry probability too much.

To make a good stop, you need:

-A good entry, prefer buying during low days or after days of market going down, also buying close to support levels gives better entry points as you can place the stop loss under that support. If you buy during high days, your stop loss is going to be hit if the next day is down.

-The stop needs to be bigger than the market noise. or the stock noise. If the stock moves 20cents up and down everyday. You cannot expect to make a good entry with 10cent stop loss.

-Problem is that when people take losses, they start to limit their losses, so if the stop loss is hit couple of times, they tighten the stops and make it even more probable to be hit. At the end they have totally destroyed their accuracy with that too tight stop. It’s fundamental to understand how your stop effects your accuracy. Changing your stop is changing your accuracy. You may be limiting your losses, but destroying your system accuracy to a point where it doesn’t work anymore.

-also stop loss needs to be determined by the trade time, if you are trading intra day or just couple of days, you can use quite tight stops, but you cannot use the same stops if you want to hang on for the long term. Just look at the 2-5 year chart and see what kind of stop loss would have kept you in the market and how little entry points your current stop loss level would have provided when you look at this long period chart.

-The market doesn’t know your account size, so setting stop loss according to your account size is not working very well. You should determine the position size so that the loss is not too big for your account size. If the stock needs 10% stop loss, you cannot use so big position. You needs to small position that  10% stop loss hit is not going to effect your portfolio more than 1-2%. If you try to enter that stock with 2% stop loss, that stop is going to be hit. Your entry accuracy has very little to do with it.

-JP

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