To Stop-Loss or Not?

Risk Management: the Atomistic Approach Versus the Holistic

Dear Readers,

I’ve been putting off for quite some time now a discussion on the topic of stop-losses as it’s a difficult one. It seems the height of irresponsibility not to use them, as the conventional wisdom goes, and yet more often than not [or rather, most often] they are hit in the super volatile market that is Crypto. It is no doubt a frustrating experience for Crypto traders to see their stop-losses continually hit. Not only is their trading account repeatedly ‘clipped’, but neither do they get those solid positions established in what looks to be a promising market going forward. With that predicament in mind, I’d suggest that the conventional wisdom, of say a habitual 5% stop loss on trades [or even 10%], is problematic for unconventional [read super volatile] markets such as Crypto. And yet some kind of risk management is surely called for in such a volatile market. In this article, I’ll look to describe my own strategy of risk management when it comes to trading Crypto, and one where I only sometimes use a stop-loss. Once again think of what follows as a practical perspective of an active trader, and not an abstract and universal norm that all traders, irrespective of their circumstances, should follow. Any insights that I may be able to provide could be integrated into your own style of trading.

The Atomistic Approach

From a conventional angle, the use of a stop-loss makes sense with an isolated trade taken in the abstract. One enters a trade, and irrespective of all else, will exit if it falls below a certain threshold. The difficulty here is the volatility of Crypto. If you were to take this approach, you’d first have to work out a standard of volatility that is ‘normal’ for a particular coin you’d like to trade, and of course with consideration of the time frame you want to trade. A 5% stop-loss? 7 or 8%? For most coins, this kind of volatility to both sides is business as usual - what appreciates up to 10% [or more] can easily retrace that. Accordingly, the entry level in more volatile coins, with increased risk/ reward ratios, becomes crucial. Rather than entering something simply because it has a long term uptrend, the onus is to identify more favorable entry points. As subscribers to my alts page know, I look to find these in either corrections [low-ball offers] or breakouts [breakout bids]. Here, you are looking to use the radical volatility to your advantage - if the entry point is more opportune, then there is less likelihood of your stop loss being hit. So much for using stops-losses that are in themselves a straight-forward enough affair once you buy [though looking for a more favorable entry is another matter where TA becomes essential]. Now to look at not using stop losses.

The Holistic Approach

Personally, I generally prefer not to use stop-losses [though will use them for the odd trade]. The reason being is that they are all too often hit due to the radical volatility. This may at first sight seem a somewhat reckless policy for those whose risk management primarily involves the use of the stop-loss [as above], yet I’ve other risk management strategies in place that mitigate there general non-use. Where the use of particular stop-losses with particular trades could be called the ‘atomistic’ approach to risk management, a consideration of how particular trades fit into one’s overall positions [exposure to the market] could be termed the ‘holistic’ approach. Using a holistic approach, where all trades are contextualized within a greater scheme, may [generally] allow for the non-use of stop losses, which more than often end up costing the trader money. This idea is very much at the core of an earlier article titled ‘The Fool-Proof System of Trading’. The idea being the delineation and management of various layers, where the lower ones were less risky relative and counter-balancing the higher ones. A snippet from this article -

I’ll adopt what I call the ‘layered approach’. The idea being that risk is increasingly managed at the lower layers with the upper layers then freed up for more speculative activity. If one were to dive straight into the upper layer, the riskiest one, without having the lower layers in place first, this would essentially just be the modus operandi of the gambler - a kind of hit and miss approach. With distinctions made between layers, we come again to the idea of a graduated spectrum. At the one end, we have the riskiest form - out and out gambling; and at the other, the least risky form - investing. Note that with investing, there is still some element of risk involved [though greatly reduced relative to gambling]. Also note that trading is something distinct from both the extremes of gambling and investment, and can itself, lying as it does on a spectrum, be further sub-divided into riskier and less risky forms. 

Here we have the idea of layers, with different kinds of trades and investments belonging to distinct strata. In the present article specifically on trading [and with the swing and position trades for USD in mind as discussed in the above article], I’ll take this general idea of layering further, applying it just to trading. For the sake of simplicity and clarity, I think the ETH chart as proxy for the alts will be useful in illustrating the way in which risk can be managed more holistically, i.e.; without the use of stop losses.

The ETH chart here just provides a scaffolding with which to illustrate an idea. Here you have a mean of prices/ cyclical curve drawn on the long term logarithmic scale. A relatively conservative eventual price north of 10K is projected with an equally conservative time frame…. all in fitting with the mean of prices/ cyclical curve. Overlaid on this is a sub-division of the cyclical projection into three parts. A position trader would have entered heavily [and did] after an extended period of price in the bottom tier. Being a position trade it is almost a hold/ investment [for the multi-year cycle], and is yet still to be considered a trade as is to be sold on the spike [given the likelihood of another cyclical correction]. This is also almost an investment in so far as it’s based on the hypothetical of the cycle playing out [never a certainty], and so the trade in this layer is weighted appropriately - not too heavy, not too light [see ‘The Weight of Trades’ article]. Once these trades are established, with price moving up into the second tier, one is to a certain extent freed up to now swing trade the volatility for USD - the lower heavy positions counter-balance [act as ballast against] your riskier and shorter term trades. And remember, with the swing trade the risk is always being out of alts not in them [in case price explodes northward after selling]. This is how the trades bought at a lower level mitigate the risk of your selling at the higher level. Of course, for late comers, the same principle could well apply to the upper two levels [as has been discussed for the two lower levels here] - establish your positions now, and then swing trade for USD at the highest level…. where you’d eventually also sell all [or most of] your positions. Given the above chart, the ETH trader may decide to sell a swing while price is high, and be fine in doing so [read anxiety free] as has long positions established at the lower level. Of course this applies right across the alt board - a trader, for the sake of clarity, may decide to hold ETH completely as a position and choose to swing trade another alt coin altogether, and one perhaps even more volatile and amenable to the swing trade. No doubt, the more coins one engages in, the more one would keep a certain coin a position, and another a swing.

But Dave, the reader might say, what if prices reverses? What if the whole market reverses in an extended correction? To which I’d reply that such a correction is built into this system; indeed, such a correction is the very rationale for such a system. Taking our ETH chart once again as our alt proxy, the position trades are well in the money, and can absorb a solid multi-month correction should it come [looking at how price is currently over-extended as compared to the curve warrants a consideration of this]. And what of the swing trades bought at higher levels? Again not to much to write home about here - if one’s trading the volatility for USD, you’ll be selling a good chunk of them while the going is good. Ideally, you’d want to see your trading account, consisting only of swing trades, equaling in USD terms the value of your Crypto longs. Here you have a complete hedge against your longs/ positions, and good hedges are your risk management par excellence.

It’s been my aim here to illustrate the way in which an alternative strategy, one suited to the super volatility of Crypto, may act as an alternative to the habitual use of stop-losses. As we all know stop losses are very much a double edged sword when it comes to risk management in this market - just as often they work against the trader/ investor as for them. Accordingly, they are problematic. In saying that though, I wouldn’t go so far as to dismiss them altogether. As opposed to habitually and dutifully using them, I’d suggest being more judicious in your use of them [never an either/ or for the pragmatic trade, always this and that given the context]. Maybe one is engaging in a riskier or heavier trade than usual, and so decides a stop loss is warranted. Or perhaps one is looking at massive gains on a trade, and wants to consider a ‘stop loss’ [or a trailing stop] to look in those USD profits, which the objective of the swing trade. But then that would be the topic for another article.

Until next time,

Stay safe out there,

Dave the Wave.

For information on subscribing to my alts page, feel free to send a direct message to @davthewave on Twitter.