Master the counter intuitive notion of the trading stop goes hand in hand with turning a profit. Fail with one and you’re bound to fail with the other as well.
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.
So, what exactly is a trading stop, or an initial stop? Basically, it’s the same as saying that once the stock price falls below a certain point, you’ll pull out. In other words, a trading stop is a predetermined exit point. What you need to remember is; when we enter into a trade, we don’t know if we’re entering at the beginning of a trend or at the end of the trend, hence the importance of an initial stop. If the trend is near the end, then by having an initial stop in place, we’ll be able to pull out before a small loss becomes a big loss.
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.
To a great extent, an initial stop is much the same as a red traffic light, in that you could always choose to ignore, although that of course would not be a very wise thing to do.
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.
As I’ve mentioned already, the exact amount of room you choose to allow for movement in traders money management depends on the time frame of your trade. For example, if you trade short term, setting your initial stop close to the price is recommended. On the other hand, if you trade long term, it’s recommended that you set your initial stop wider, thus allowing for more movement. However, you also need to realize that once your time frame has been determined, it’s important that you ignore normal market fluctuations within that time frame. There is always a certain amount of volatility in trading and you don’t want to close in on a position, simply because of normal fluctuations that are to be expected.
When a trader sets an initial stop just below the original entry price it’s known as a tight stop. The downside of a tight stop is that it can bring about a premature exit when a small drop occurs. Essentially, this could see you leave a trade even before the market has had any time to recover. The opposite applies to a loose trade entry which has been set to allow for more movement. While a loose stop does carry some risk of a bigger loss, it also allows some time for trade prices to recover.
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.
Essentially, this is perhaps the main reason why I advise clients to go for a trading system over a slightly longer time frame. The stops on short term systems just tend to be too tight in the vast majority of cases.