There are a number of topics that slip-slide over my desk daily but the one that feels like a slug making it way across the garden path leaving it’s slimy, gooey, grime is, “how the markets are rigged against retail traders.”
Anyone who has been in this business for any length of time can tell you with 100% certainty the markets are rigged, and not in our favor.
Plain and simple, the markets, specifically the exchanges, are totally geared towards screwing you, dear trader.
The most egregious way is stop losses
I used to always put in stop loss orders.
It was just part of the trade.
I would enter a trade and then immediately put in a stop loss order.
It was as second nature to me as slipping my little pinkies into soft slippers before touching the hard, cold, tile on the bathroom floor in the morning.
But I was getting stopped a lot so started to pay more attention.
I would watch my stop loss order being filled then, in pure and utter amazement, watch the price reverse course and take on the characteristics of the Dukes of Hazzard running from Sheriff Rosco P. Coltrane.
I was immobilized with a feeling of a bride left at the altar. I was just as angry as the aforementioned bride would have been so I set out to answer the question:
What the heck was happening?
“Early on, I did quite a bit of testing with stop-loss orders (and trailing stops as well). My conclusion was that they hurt the results of the vast majority (almost all) trading systems, or resulted in over-fitting of stop parameters. So, I decided not to use them, and not to incorporate the option into systems. I later confirmed this with others. Howard (Bandy), for example, also says that they almost always hurt performance.
Please note the above statement is talking about perfectly executed stops where:
- other participants such as brokerages or ECN’s did not have knowledge of stop points
- stops were triggered by executed order prices
In practice, stops perform even worse because the above two conditions do not hold true.”
I’m sure I’m getting some head nods in agreement, however, I’m just as sure there are more out there ready to tar and feather me who still believe stop losses are as necessary as the air you breathe. If you are in the latter category, please read on.
1. Market Makers Run your Stop Losses
A game that market-makers played (these days, it is with computer algorithms) is “run the stops,” (I call this game “Dukes of Hazzard”) when the stock is forced low enough to trigger a large cluster of stop-loss orders (usually at round numbers or well-known support and resistance levels).
After the stock is sold at a popular stop loss price, the stock reverses direction and rallies. Here is how one market maker put it,
“we big boys are takin’ out all the suckas that are sittin’ in the corner with their thumbs in their mouth all worried that they trade is gonna get stopped out. Then I come along and, BLAM take those stops out and let the momentum take off as I start collectin’ chedda …..”
That was an actual comment from a market maker. I’m not entirely sure what this dude is saying – I don’t talk his lingo – so I’ll try to translate. …
On second thought, Nah, I’m not going to even try.
2. Don’t Think Liquidity Will Overcome Manipulation (I mean direction)
Often during the middle of the day, you will see stops get run, typically below obvious support levels,
This is due to the tendency for liquidity to dry up during the middle of the day, meaning that much less volume is needed to move a stock.
But I can hear ya’all saying, “I only trade stocks that trade millions of shares a day” the implication being that the stock is too liquid to manipulate.
I’m wondering if you know a dirty little secret?
Did you know the vast majority of volume takes place in the first and last 30 minutes of the trading day?
50% or more of the day’s total volume takes place during these periods.
That leaves 5.5 hours of relatively light volume, where the price can be manipulated (I mean directed) towards pockets of stops.
Low volume periods during the day allow easier price manipulation (I mean direction) and the ability to “clear out” areas where stops congregate.
Someday watch the volume of one of your favorite stocks throughout the day. You’ll be amazed as to how few shares change hands, especially around noon.
3. Stop Losses can be Triggered Without a Trade
Let’s say ABC is currently trading at $20.50, and you have a stop market order to sell at $20.00.
The stock drops the next day but its low is $20.04 so you say, “Whew, I’m safe.”
You go looking for ABC on your broker’s platform and lo and behold you cannot find it.
To your amazement, you see you were stopped but at $20.05. What? So how was a $20.00 stop triggered? Here’s how.
When you put a stop order in, what you are doing is placing a market order, which for lack of a better word, is in a “suspended” state.
It is not active until the price hits your stop, or trigger price.
Once that is hit, your market order is then live, and acts like any other market order. But what you might not know is that there does not actually have to be a trade at your stop price in order to trigger the market order.
Only a QUOTE needs to be shown at your stop price in order to trigger your market order.
Bet ya didn’t know that heh dirty little secret did ya?
4. Studies reveal Stop Losses Hurt Performance
As well as Bruce Robinson’s and Howard Bandy’s observations, Larry Connors and Cesar Alvarez have done hundreds and hundreds of tests looking for the optimum stop loss level.
They ran their tests over eight million trades going all the way back to 1995 with just a simple pullback methodology.
They, first of all, ran the tests without stops and then they put in stops of 1%, 3%, 5%, 7%, 10%, 25%, and 50%.
What they saw all the way through was that no matter what stop they used, it hurt the performance.
No one in the Connors Group expected that even a 50% stop lowered the performance vs having no stop at all, which they thought was crazy.
It didn’t matter where the stop was, it lowered the performance.
Their research revealed this over and over again.
The Connors Group
The Connors Group hasn’t used stops in its short-term trading with equities and ETFs for years with positive results.
It can be done – protection can be done in different ways.
Careful position sizing (like we do at QiT) is one way for the best protection – it’s a form of insurance.
If you are using proper position sizing, no matter what happens a trader should be at a point where “there is no way one position could blow me outta here.”
The other way to protect yourself is with a Dynamic Stop.
One last point on Connors Group research, it was not done under the conditions of #1, #2 nor #3. And if it had been, the results would have even been worse.
Traders can no longer use the old trading idiom of “always use stops” when trading equities or ETFs (this does not hold true for options or futures) for you are no longer playing baseball with 4 bases and three outs.
You are playing a game where you have no idea what the rules are.
We have to be able to modify the traditional trading rules when it comes to stop placement and trade management.
And even more critical is the ability to think on different levels, as if you were playing 3D chess and checkers on a Starship’s hologram with Dungeons and Dragons thrown for spice.