Trading Stop, A Counter Intuitive Notion
A Guide To Managing Trading Risk
Unfortunately there are scores of novice traders who simply fail to master the counter intuitive notion of the trading stop and as a result, they fail to turn a profit.
All traders make the mistake of hanging on to a trade for too long at some point, so if it’s never happened to you yet, you had better prepare yourself now. Of course, as I’m sure you’ll agree, small losses are better than big losses but the trick is, how do we prevent small losses becoming big losses? Simply by mastering the art of placing initial stops. Remember, the longer you allow a loss to run, the bigger that loss is going to get, and the more difficult it will become for you to apply a trading stop.
Even though we all dread it, trades won’t always go exactly as we’d hoped for, and this is where a trading stop comes into play. Essentially, an initial stop is a predefined exit point that allows you to get out of a trade when it’s not going as planned. Remember, you could unknowingly enter into a trade right at the end of a trend so therefore, you need to have a predetermined point at which you’ll exit. In simple terms, a trading stop is simply deciding to bail out once the price slips below a certain mark.
Becoming a successful trader rests largely with your ability to make decisions which are counter intuitive because when we start taking a loss, it’s virtually second nature for us to hold for too long, in the hope that things will change.
Richard Harding described a trading stop perfectly when he compared it to a red light saying, “You don’t have to stop, but you’d be a fool not to”.
So, just how wide should you set your trade stop? This is a common question, particularly between traders new to the idea of a trading stop, but unfortunately it’s a question which cannot be answered accurately. The reason being, the amount of room you allow for price movement will depend largely on the time frame being traded.
For the most part, traders who focus on short term trading tend to set their initial stop close to the price while traders involved with longer term trading tend to allow more room for movement. The important thing is, once you’ve identified the time frame of your trade, you need to ignore any movements which are considered normal with that particular time frame. The last thing you want to do is end up closing out simply because of some normal trading fluctuation. Remember, a certain amount of movement is normal and is to be expected.
Known as a tight stop, a trading stop which is set very close to the trade entry price runs the risk of triggering an exit prematurely, thus causing you to exit a trade before it’s had a chance to bounce back. A loose stop on the other hand doesn’t carry this risk although it could of course mean a bigger loss. However, this is made up for by the fact that you’re allowing a trade more recovery time before initiating an exit.
What you need to remember is, if you’re constantly setting your stops too tight, you’re going to get stopped out more often than you should be and of course this will have an impact on the reliability of your system. Also, by setting tight stops, you’ll be creating exceedingly high transaction costs, and it’s this significantly high brokerage which can quickly erode a trader’s float, especially those starting off with a small float.
For the most part, this is the primary reason for me always advising my clients to focus on trades with a longer time frame. Longer term trades tend to have much looser stops that short term trades.
