Tight Stops and Risk/Reward Ratios

Cameron just left a question for me in the comments to last night's recap. He asked:

I'm looking at your way of thinking about the market. One of the biggest questions I have, though, is regarding your stops.

You said you set your stop at just .20 over your short dollar amount. With all of the intra-day fluctuations, how can you know that it wouldn't have gone up, say, .25 and then nose-dived? It's a perfectly plausible situation.

Said another way, I can place a buy order with a stop, but we easily have 1% swings in a day. If a swing occurs, I have automatically sold for a lower price, only to see the market go back up. Therefore, I'm encouraged to set much broader stops. You set yours for only .20 over the buy price, though, which is why I'm confused.

I often get asked variations of this question, so I thought I'd put my answer in its own post. This was my response:

I couldn't have known that the stock wouldn't have shaken me out. But I also wouldn't have known if I'd have been shaken out if my stop was 50 cents or even a dollar higher. That narrow range candle just provided me with a tight stop. I like tight stops b/c they give me a better opportunity to get high R-multiple winners.

But to your point, how tight of a stop is too tight and will practically guarantee being stopped out? It's hard to answer that question but I generally shy away from any stop that's less than 0.5% of the stock price. I normally like my stops to be about 1% of the stock price. In general, I'm more comfortable with somewhat tighter stops on the QQQQ b/c of how liquid it is and b/c it's less volatile than an "in play" stock would be.

Also, note that I didn't pick a 20 cent stop out of thin air. I went with what the previous candle told me was resistance.

The key thing to remember is that I'm on the hunt for high R-Multiple winners. Because of the way I size my positions (the percent risk model), the tighter my stops the higher the potential reward. In other words if I think a stock has potential to move $2 I'd rather have a 20 cent stop than a $1 stop. Risking 20 cents to make 200 cents ($2) would give me a 10R winner vs only a 2R winner if I had risked $1. (If R was 1% of my equity that would be a 10% gain vs a 2% gain.) For a real example of this see the DGX trades I posted on my Narrow Range Bars post.

So there' a trade-off at work here between stop size and risk/reward multiples. The tighter the stop, the better chance you have of getting a high R winner but you also have a better chance of getting stopped out. Your win ratio is likely to be inversely proportional to how tight your stops are -- looser stops should lead to a higher win rate but also fewer high R-multiple winners.

It's also key that you don't pick your stops willy-nilly. I always use the support/resistance levels that the charts dictate to me.