Why there can be only one number to rule them all.
There comes a point in every relationship when things are not so nice. Couples argue, kids fight, friends can have different opinions, and business partners may fundamentally disagree. It is perfectly normal, actually healthy and productive for most relationships to have periods of adversity according to modern theories in psychiatry. However, if we cannot reconcile our differences, breakups can be very costly, divorces can get very messy, acrimonious business arrangements are difficult to break, and the rates at law firms only ever seem to be going up.
In trading, this is not the case. There you can break up with anyone and anything in an instant and it is all thanks to one wonderful thing: the stop loss. It is a sacred number, one which we have sworn to uphold the minute we put our capital at risk. It is the only number that matters and tells us when we have lost so much that we must relinquish the chips and sell all that we had. Clearly, the decision as to where to set the point of no return is up to us and different investors have different thresholds for pain, but the principle stays the same and we must determine when enough is enough before we enter a trade.
I can already sense that which must be on so many readers’ minds: What if we can’t get out at our chosen stop loss? Maybe the volume is too low, or we would move the price if we sold all at once and perhaps the volatility is too high. All very valid points, however, the rules are very clear on this: if you know that you may not be able to get out when you want, then do not enter the trade. The thing is, we can all choose our instruments of destruction. For those trading the Nasdaq versus others that buy and sell lean hogs futures, the differences in execution are very clear and one adjusts the size of bet accordingly.
So, if things are so simple and we can control our risk so precisely, then why do we still get such unwelcome news from some professional managers that have lost more than they should? Because sticking to the rules is hard and we can get emotional about our trades. If we like it at x, then we must love it at y, and by averaging down we can cut the time in half to make back the money we lost. Active managers can break the rules, by design, that’s the whole point and they get paid if they are right more often than not. Systematic strategies don’t have that luxury and they can only ever do what it says on the tin. I know where I would put my money.