How I Think about Stops and Drawdowns
Going red is never fun. I hate it as I’m sure you do. Everyone wants their trade to go something like enter, go green, take some profit off, run some more, take more profit off, and then run for a 10x trade. In reality, that rarely happens.
So, how do I deal with stops and drawdowns?
First, stops and draw downs are very personal. Meaning it comes back to YOUR OWN RISK ADERVSION. Someone else in the exact same trade may be willing to lose 10% of their portfolio but maybe I’m only willing to lose 1%.
Let’s talk about emotions.
All the plans and strategies in the world won’t mean diddly (yes, I just said that) if you can’t control your emotions and stick to your plan. A common example, is you take a trade, it goes against you, and hits your stop but just barely, “I’ll just hang in a bit longer” you tell yourself. A minute later, news comes out and smashes your position down way under your stop. Now you are in a negative spiral. Maybe you revenge trade. Maybe you take a bad trade trying to get it back. Maybe you smash a wall.
The moral of the story, we must assume your emotions are in check. If they are not, nothing will work for you. Fix that first.
I like to think about stops and drawdowns in a few different buckets and sub-buckets. Those buckets also correspond to sizing the trade. They are all connected.
How risky is this trade?
What’s a typical day on this trade look like?
Can the option go to zero quickly?
How much do the option’s premiums/prices move relative to the underlying stock?
What is the option price?
How wide are the spreads and is there liquidity?
If I get stopped out and the trade wins up working out, how will I feel?
If this trade bleeds out due to chop, how will I feel?
If I have multiple positions already open and all the positions go against me, what does that look like?
That’s a lot of questions to answer. As a newbie, you’re still “drinking from the firehose” and, most likely, you won’t be able to process all of that quickly.
Before we get into the questions above, a quick word on the general setup. When people ask, “What’s the most important part of trading?” I always answer emotions. But, the next important thing…I don’t know the answer. They’re all important and interconnected to your tolerance for risk.
For your stops and drawdown pain points to work effectively, the trade must be set up properly from the start. Know your entry, know how you will take profits, is there a specific time of day, etc, etc. Setups can be quite detailed if that’s the kind of person you are. For now, let’s keep it somewhat simple with a real example.
Below is the daily chart for SHOP with the final bar on February 1, 2023:
Let’s say your setup went something like this for the the trading day on the 1st:
I’m going to take a 51 call trade if the price gets over the resistance line at 50. I will only take it if the market is moving upward, and Shopify is showing relative strength to the market and/or the sector. I will watch AMZN as well to see if they help pull each other up. I will be disciplined on my entry and only take it right at a 50 break. I won’t chase.
Pretty simple. I won’t get into the profit taking with stop adjustments. I’ll dive into that further in another post.
Now the setup for the risk side:
If I’m wrong, I will exit the trade at 60% drawdown. I will not add to the position since reversals happen often on SHOP. Given the broader market conditions being somewhat volatile and SHOP having a tendency to reverse, I will make this a small position. Use 1/4 of my normal full size trade.
Again, this can be expanded and put into even more detail. It all depends on you and how you like to think about things.
Now let’s start answering some of the questions from above…
How risky is this trade?FAIRLY RISKY. I WANT TO KEEP POSITION SIZE SMALL AND WATCH THE POSITION CLOSELY IF IT REVERSES HARD.
What’s a typical day on this trade look like?LOTS OF BIG CANDLES. CAN REVERSE OR CAN ROCKET HIGHER. I HAVE NO IDEA WHICH ONE COULD HAPPEN SO PAY ATTENTION TO STOPS AND PROFIT TAKING LEVELS.
Can the option go to zero quickly?YES!!! SIZE SMALL OR SIZE FOR A LOTTO. IF I GET STUCK IN THE TRADE BECAUSE IT REVERSES HARD AND I MISS A STOP OUT, HOW WILL I FEEL? WILL I HAVE SIZED TOO BIG? CAN I JUST LET THE TRADE GO TO ZERO AND HOPE IT COMES BACK TO LIFE?
How much do the option’s premiums/prices move relative to the underlying stock?BOTH SLOW AND FAST, IF THE STOCK CHOPS OR GRINDS, PRICE WILL HOLD OR BARELY MOVE WITH STOCK.
What is the option price?BID/ASK IS 0.77/0.80 FOR THE 51 STRIKE OTM W/DELTA OF 0.34. THIS MEANS A SMALL MOVE ON THE OPTIONS PREMIUM CAN BE A BIG PERCENTAGE OF The GAIN/LOSS OF THE POSITIONS. ONLY NEEDS TO MOVE ABOUT 15 CENTS FOR A 20% GAIN. IN OTHER WORDS, THE PRICE OF THE OPTION ITSELF CAN MAKE OR BREAK THE TRADE.
How wide are the spreads and is there liquidity?SPREADS ARE TIGHT ENOUGH AND THERE IS PLENTY OF LIQUIDITY, BOTH ON MY CHOSEN STRIKE AND MOST OF THE STRIKES AROUND THE ITM. I SHOULD GET FILLED ON ALL SIDES OF THE TRADE WITHOUT TOO MUCH TROUBLE.
If I get stopped out and the trade winds up working out, how will I feel?NO BIGGY. IT’S A SMALL TRADE, IT WON’T MAKE OR BREAK MY ACCOUNT. I WILL PROBABLY FEEL SUPER FRUSTRATED IF I GET STOPPED OUT AND IT RUNS UP 7%. I REALIZE THIS IS A REAL POSSIBILITY WITH THIS TICKER.
If this trade bleeds out due to chop, how will I feel?ANNOYED. BUT IT HAS HAPPENED THE PAST FEW DAYS, SO BE MENTALLY READY FOR THAT.
If I have multiple positions already open and all the positions go against me, what does that look like?I WILL TRY AND EXIT AT MY STOP AND NOT HOLD TO ZERO AND/OR BE SUPER DISCIPLINED ON MY STOPS WITH THE OTHER POSITIONS.
Let’s See How This Plays Out
Right away, I break a rule. I said I was going to be disciplined and not chase. The market was moving fast, and everything looked up, I tell myself, go for it, and I didn’t chase too much. Regardless, a rule was broken.
In the trade:
Ok no problem, SHOP is moving up after a quick retest of 50.00 (which would have given me a better entry if I waited 3 minutes). A little later, yes, the trade is up 25%, things looking good! (BUT, had my entry been precise, the trade would be up about 40%, and I probably would have taken some profits off).
Crap…what’s going on? The market looks like it’s rolling over. Calls are back to breakeven…what do I do? Do I add to the position at my original entry price? Do I let it go to zero? Do I hope it goes back up?
All of these questions come back to your original setup. I know my position size is small and I’m willing to let it go to zero. I don’t add because the market looks like it may be rolling over, but more importantly, I set the trade up not to add. Now, I’m in hope mode. HOPE is a 4 letter word in trading!
The Stop Out:
Man, SHOP and the market are just grinding lower. No upward bounces so far. This is not looking good. I know I’m willing to let it go to zero. Will I be mad if it reverses and this becomes a positive trade? Will I be madder if this trade goes to zero when I see the grind lower happening?
I decide to exit. There’s no strength in the market and everything is grinding lower. I exit at a 50% loss.
The Rest of the Trading Day:
We get a small blip right after I get stopped out. Seems to always happen. But, the market and SHOP continue to grind lower. By mid to end of the day, I’m feeling pretty good about my decision as the original position is approaching 0.
But, the market reverses as does SHOP. It looks like things are going higher. Shoot, what do I do? Do I go back in at the 50 price break again? Do I sit it out? What do I do? What do I do? I don’t have a trading plan in place for this.
Since I don’t have a trading plan for this scenario, I sit on my hands and sit it out. I watch what would have been a really good re-entry call trade go up 60% (a lot of time decay and volatility is out of the market now so the trade makes much more). I become more frustrated my original trade which is now back up 25%, meaning I have a 75% swing on the position from my stop out.
What Did I Do Wrong?
I don’t have my own stats on this (I should track it), but I’m willing to guess more than 75% of my stop outs come back to a late entry. Let’s say you’re late on your entry and buy a call option for $1.10. Had the entry been precise, the price would be $1.00. Now let’s say I take 1/2 the position off with profits at 40%. For my late entry that means a price of $1.54. For the proper entry that’s $1.40. Meaning on a proper entry price, I’m probably thinking about taking my second set of profits off if we get up to $1.55. But with the late entry, my first set of profit levels have not been hit, thus still on the table. I will expand on profit taking on another post.
By being late on my entry, I miss the first profit taking opportunity. Next, the trade goes against me and stops me out.
I’m missing a few things in my trade setup:
What happens if I miss the entry if the market is moving fast? Do I chase? Do I enter on a backtest? I said I wasn’t going to chase, but I didn’t say what I would do if I missed the entry due to the market moving fast. More detail helps in that scenario.
If I do make a mistake in my trade, how will I adjust? If I chase, do I adjust my profit taking levels? Do I size down even further? If I get shaken out, am I willing to re-enter?
There can be many more points to your setup. But it’s important to hit the major ones BASED ON HOW YOU TRADE! The points above may not apply to you because you are super conservative in fast moving markets. Or maybe you take profits at 10%, 15%, and 25%, you would be completely out of the trade and not get stopped out.
The primary goal is to make a complete picture of how you like to trade for your setups and risk tolerance. Sometimes one mistake compounds into another mistake, simply due to not being prepared. That is ok. Things happen. What’s important is to have some hard and fast rules so you don’t get too emotional if mistakes and bad things happen. Your emotions will matter more than your setup.
Lastly, there are a lot of questions above that I can answer in my head in a few seconds. Newbie traders won’t be able to do that. It’s about your experience in making setups and screentime to see how the setup would play out. No one is perfect. I make mistakes every day and I reflect on what I could have done different. And finally, there is no such thing as a perfect trade. Only the perfectly executed trade as it pertains to your setup.
If you have any questions, please let me know in the comments below or shoot me a DM on twitter!