From the June 2013 issue of Futures Magazine • Subscribe!

Setting stops the Bayesian way

Using the spreadsheet

Editor’s Note: The interactive Excel spreadsheet for this exercise can be found at futuresmag.com/Bayesian. Please go to our website and walk through the Excel spreadsheet to get the most out of this discussion on how best to set stops.

The calculations are performed using an Excel 2010 spreadsheet available for free download at www.futuresmag.com/Bayesian. The first trade is the gold trade just discussed. The forecast was short-term bullish because:

  • The fundamental news appeared positive. Many central banks around the world had joined the Fed in printing money, most recently the Bank of Japan.
  • The market had fallen to near the lower part of the previous year’s trading range. Momentum indicators were starting to turn up, and other “risk-on” markets were breaking out.

Refer to the spreadsheet. Using the left-hand side of the worksheet “GoldETF,” the initial setup and progress of the trade is in “Input data” (below). Many traders have a hard time assessing purely statistical concepts such as standard deviation. So instead, forecast the point you think gold is most likely to go to (which I call the mean) and a 50% range to this forecast. In other words, assume you thought GLD had a 50/50 chance of winding up between (170 + 7) = 177 and (170 – 7) = 163. The spreadsheet uses this to calculate what it needs.

This forecast was wrong. Instead, the downward momentum re-accelerated. The trade was stopped out in week three as the mean of that week’s posterior was below the assumed path. The stop even was triggered on an up week. This is because, unlike conventional stops, the analysis doesn’t just look at the last price, but at the path of prices since trade inception.

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