What Is Your Destination Loss Strategy?

A reader late asked me whether setting a halt loss for a trading strategy is a practiced idea. I am a big fan of setting halt loss, but in that location are sure as shooting myriad views on this.

One of my quondam bosses didn't believe inward halt loss: his declaration is that the marketplace seat does non help almost your personal entry price, in addition to hence your halt toll may move somebody else’s entry point. So halt loss, to him, is irrational. Since he is running a portfolio alongside hundreds of positions, he doesn’t regard preserving working capital missive of the alphabet inward exactly 1 or a few specific positions to move important. Of course, if you lot are an private trader alongside fewer than a hundred positions, preservation of working capital missive of the alphabet becomes a lot to a greater extent than important, in addition to and hence does halt loss.

Even if you lot are highly diversified in addition to preservation of working capital missive of the alphabet inward specific positions is non important, are in that location situations where halt loss is rational? I sure as shooting yell back that applies to trend-following strategies. Whenever you lot incur a big loss when you lot own got a trend-following position, it ususally way that the latest entry signal is contrary to your master entry signal. In this case, ameliorate acknowledge your mistake, closed your position, in addition to mayhap fifty-fifty move into into the contrary side. (Sometimes I wishing our politicians yell back this way.) On the other hand, if you lot employ a mean-reverting strategy, in addition to instead of reverting, the marketplace seat sticks to its master administration in addition to causes you lot to lose money, does it hateful you lot are wrong? Not necessarily: you lot could exactly move also early. Indeed, many traders inward this instance volition double upwards their position, since the latest entry signal inward this instance is inward the same administration every bit the master one. This raises a query though: if incurring a big loss is non a practiced plenty argue to give upwards to the market, how would you lot always determine if your mean-reverting model is wrong? Here I suggest a halt loss measure that looks at around other dimension: time.

The simplest model 1 tin apply to a mean-reverting procedure is the XLE-CL, GDX-GLD, EEM-IGE, in addition to EWC-IGE). It is a uncomplicated model that says the side past times side alter inward the spread is contrary inward sign to the divergence of the spread from its long-term mean, alongside a magnitude that is proportional to the deviation. In our case, this proportionality constant θ tin move estimated from a linear regression of the daily alter of the spread versus the spread itself. Most importantly for us, if nosotros solve this equation, nosotros volition uncovering that the divergence from the hateful exhibits an exponential decay towards zero, alongside the half-life of the decay equals ln(2)/θ. This half-life is an of import number: it gives us an guess of how long nosotros should human face the spread to stay far from zero. If nosotros move into into a mean-reverting position, in addition to iii or iv half-life’s afterwards the spread withal has non reverted to zero, nosotros own got argue to believe that mayhap the government has changed, in addition to our mean-reverting model may non move valid anymore (or at least, the spread may own got acquired a novel long-term mean.)

Let’s straight off apply this formula to our spreads in addition to encounter what their half-life’s are. Fitting the daily alter inward spreads to the spread itself gives us:



These numbers produce confirm my sense that the GDX-GLD spread is the best 1 for traders, every bit it reverts the fastest, spell the XLE-CL spread is the most trying. If nosotros arbitrarily determine that nosotros volition acquire out a spread in 1 lawsuit nosotros own got held it for iii times the half-life, nosotros own got to concur the XLE-CL spread almost a calendar twelvemonth earlier giving up. (Note that the half-life count solely trading days.) And indeed, spell I own got entered in addition to exited (profitably) the GDX-GLD spread several times since final summer, I am belongings the XLE - QM (substituting QM for CL) spread for the 104^th day!

(By the way, if you lot desire to banking company check the latest values of the iv spreads I mentioned, you lot tin subscribe to them at epchan.com/subscriptions.html for a nominal fee.)