Stop losses are an essential part of any risk management system because they help traders resist trading on emotions. Whenever you open a trade, you should always set a stop loss. If you stick to your plan and don’t move them, you’ll find you won’t ever let your losses run too long. Remember these rules:
1. A stop loss should be considered and decided before a position is entered.
2. A stop loss should be placed immediately at the time of entry.
3. A stop loss amount should not allow more than a 2% loss of your account balance—for day trades and scalp trades, a stop loss should not allow more than 1% loss of account balance.
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rss4 Trading Fears
As Mark Douglas points out in his great book about trading psychology is that the majority of traders lose because of wrong thinking, misplaced emotions, and wanting to be right. We know fear and greed drive the market prices far more than fundamentals do. However fear makes traders do the wrong things at the wrong time. Here are four great examples of fear over ruling sound trading strategies.
Here are more thoughts about these four fears:
The fear of being wrong: Traders fear being wrong so much they will hold a small loss until it becomes a huge loss. Even adding to the loss in the hopes of it coming back and getting to even. Don’t do this, holding on to a loser after it hits your predetermined stop loss is like being a reverse trend trader. Do not be afraid of being wrong small be afraid of being wrong BIG.
The fear of losing money: New traders hate to lose money, they do not quite understand yet that they will lose 40%-60% of the time in the long term. We should come to expect the small losses and wait for the big wins patiently. Many times traders fear this so much that they have a hard time taking an entry out of fear of losing. If you can’t handle the losses as part of the business, you can’t trade.
The fear of missing out: The opposite of the fear of losing money is the fear of losing potential profits. This causes traders to watch a stock go up and up, miss the primary trend, then not being able to take it any more and get in late just in time for the trend to reverse and lose money. Trade at your systems proper entry point do not chase a stock because you are afraid to miss out on some profits.
The fear of leaving money on the table: When your trailing stop is hit get out of the trade. If your rules tell you to get out after a parabolic run up and stall then exit. You must be disciplined on taking money off the table while it is there. Being greedy for that last few dollars when your system says to sell could lead to major losses of paper profits. Let your winners run but when the runner gets to tired to continue: bank your profits.
A Method to Measure Risk and Return
Placing a trade with a predetermined stop-loss point can be compared to placing a bet: the more money risked, the larger the bet. Conservative betting produces conservative performance, while bold betting leads to spectacular ruin. A bold trader placing large bets feels pressure or heat from the volatility of the portfolio. A hot portfolio keeps more at risk than does a cold one. Portfolio heat seems to be associated with personality preference; bold traders prefer and are able to take more heat, while more conservative traders generally avoid the circumstances that give rise to heat. In portfolio management, we call the distributed bet size the heat of the portfolio. A diversified portfolio risking 2% on each of five instrument & has a total heat of 10%, as does a portfolio risking 5% on each of two instruments. Our studies of heat show several factors, which are: Trading systems have an inherent optimal heat. Setting the heat level is far and away more important than fiddling with trade timing parameters. Many traders are unaware of both these factors. COIN FLIPPING One way to understand portfolio heat is to imagine a series of coin flips. Heads, you win two; tails, you lose one is a fair model of good trading. The heat question is: what fixed fraction of your running total stake should you bet on a series of flips?
Four Basic Contingency Plans
- Initialstop loss
- Establish in advance a maximum stop loss.
- The moment the price hits the stop loss, I sell the position without hesitation.
- Re-entry
- When the market experiences general weakness or high volatility, your stock can undergo a correction or sharp pullback that stops you out. However, a stock with strong fundamentals can reset after such a correction or pullback, forming a new base or a proper setup… Often, the second setup is stronger than the first. The stock has fought its way back and along the way shaken out another batch of weak holders. If it breaks out of the second base on high volume, it can really take off.
- If the stock still has all the characteristics of a potential winner, look for a reentry point. Your timing may have been off. It could take 2 or even 3 tries to catch a big winner.
- Selling at a profit
- Once a stock amasses a percentage gain that is a multiple of your stop loss, you should rarely allow that position to turn into a loss (e.g. stop loss of 7%, if you have 20% gain, move stop to breakeven or trail stop to lock in majority of the gain).
- When you have to close out a trade, selling into strength is a learned practice of professional traders. It’s important to recognize when a stock is running up rapidly and may be exhausting itself. Or you can sell into the first signs of weakness immediately after such a price run has broken down.
- Disaster plan
- Plan what to do if your Internet goes down, or power fails, or your stock gaps down, company investigated by SEC, CEO embezzled funds.
The Ten Most Foolish Things a Trader Can Do
In the spirit of April Fools Day here are the ‘Ten Most Foolish Things a Trader Can Do’. In no particular order of foolishness.
- Try to predict the future movement of a stock, and stay in it no matter what.
- Risk your entire account on one trade with no stop loss plan.
- Have a winning trade but no exit strategy to get out, no trailing stop or exhaustion top signal.
- Ask for and follow the advice of others instead of trading with your own trading plan, method, rules, and system.
- Trade your emotions instead of signals: buy when you are greedy and sell when you are afraid.
- Trade your opinions, not a quantified method.
- Do not bother to do your homework on trading, just jump in and trade, you are smart, you will figure it out.
- Short the best and most expensive stocks in the stock market and buy the cheapest junk stocks.
- Put on trades you are 100% sure are winners so you do not even need a stop loss or risk management.
- Buy more of a trade that you are losing money in and sell your winners quickly to lock in small profits.
Do not trade foolishly my friend.
Ten questions to ask yourself before every trade
Does this trade fit my chosen trading style? Whether it is: swing trading, momentum, break out, trend following, reversion to the mean, or day trading? Does this trade fit into the parameters of who I am as a trader, or is it just based on my own fear or greed?
- How big of a position do I want to trade? How much capital am I going to risk? Am I limiting my risk to 1% or 2% of my trading capital? Knowing where my stop will be how big should my position size be to limit my risk?
- What are the odds of my risk of ruin based on my capital at risk?
- Why am I entering the trade here? What is the entry trigger to take the trade? Is this a quantified entry on my trading plan?
- How will I exit with a profit? A price target or trailing stop? (more…)
EXIT in Trading
Exit– The exit is critical to being a successful trader. Let your winners run and your losers run out quickly. Two factors determine your exit, the Target and the Stop loss you have set on entering the trade.
1. The Target is determined by the type of market and the trading history of the stock.
2. If the trade proceeds in your direction move the Stop loss keeping it tight.
3. It the trade continues to move, you may want to take your money off the table!
4. Profits should be taken before reaching a S/R. SO WHAT if it continues to run after you left!
5. Take Profits quickly and often! And remember discretion is the better part of valor.
6. The two most important factors in determining the Stop loss are the last S/R and providing enough margin for the trade to be successful. You must balance these against each other.
7. The Stop loss can be predetermined by your maximum loss limit but understand a small loss limit can positively impact your probability of success.
8. I must balance courage and common sense when staying in the trade. The money may be better used in another trade.
9. Remember small losses are the key to success in an environment where you may be wrong greater than 50% of the time.
10. Don’t give back, remember you can always get back in!
11. Don’t change my rules and therefore my settings.
The 7 Best Ways to Exit a Trade
In trading the money is not made in the entry, it is in the exit. The art of the exit is crucial to a traders success in the markets. Profits can disappear if you do not take them at the right time, small losses can become huge losses if you do not cut them. Small profits can become huge profits if you let them run until they truly stop. Keeping capital tied up in a trade going nowhere and just letting it sit there can cause you to miss out on other great opportunities.
So what is a trader to do?
- Use stop losses, only risk 1% of your total trading capital on any one trade, when you have lost that 1%, get out. Position sizing, stop losses, and understanding volatility is key.
- Enter trades right at break out points to new highs or off key price support levels or key moving average support levels. If it loses that support later and fails to retake it quickly then sell it.
- Buy when a stock is one ‘R’ multiple above a key support level, sell if it falls back and loses that support level. (One ‘R’ multiple = 1% of total trading capital).
- Use a ‘stale’ or ‘time’ stop: Set a time limit on how long you will give a trade to move a certain amount, if it fails to move enough fast enough, get out.
- Volatility stop. The market or your stock has a big expansion in its daily price range or starts moving against you the full daily range. You either cut your position down in size or get out due to increased risk.
- You trail a stop loss behind your winner, when it reverses and hits that stop you sell. A trailing stop can be a moving average or a percentage you your gain.
- You sell your position because you have found a much better trade with a better probability of success or a bigger upside.
The key above all else is always to have a plan to get out of every trade before you get in. Before each trading day begins think about what you will do based on the price levels your open trade is at.
Aim Small, Miss Small
As many of you already know, one of the biggest factors in successful trading is how well you manage the trade – that is the stop-losses you place, the amount of capital that you put to work, where you take profits, and how you protect the profits that you already have. You could, no doubt, write many books on each of these subjects, but for now, I’m going to focus on a small, but critical aspect of risk-management and my inspiration comes from the movie “The Patriot”, which happens to be one of my favorite movies of all time.
In the clip below, Benjamin Martin (the father) asks his two young boys, “What Did I tell ya ‘fellas about shooting?” and they replied, “Aim Small, Miss Small”. Every time I hear those words I tell myself how true they ring across so many spectrums of life. As an avid hunter, if you just aim the gun at the direction of the game you are targeting, you are bound to miss. However, if you pick out a tiny, specific area of the animal, whether its the upper-right side of the chest, or some other smaller area, you have a much better chance of hitting your target. In fact, the smaller the target area, the lesser amount of margin for error you have in missing.
So how does this apply to trading, you must be asking? The stop-loss that we set in relation to our entry price is a reflection of our “Trading-Aim”
When I trade, I look for setups that are as close as possible to a desirable stop-loss. By desirable, that means I’m not just picking a spot that is 1 or 2% from my entry price for the sake of it being so, instead, if I am long, I am going to look to place a stop-loss somewhere underneath a critical support level, and if I am short, then I am going to place a stop just above an area of resistance. So the place that I choose for my stop-loss is that of a strategic area and a point to where I know, that if it hits the stop, I know that my thesis is no longer valid and therefore, I must exit the trade. (more…)
7 Scariest Things A Trader Can Do…..
- Taking a trade with NO EXIT STRATEGY that is a horror movie. It is dangerous to not have a stop loss when you enter a trade becasue if a trader thinks they bought in at a great price the price starts looking better the lower it goes, and terror of all terrors the trader adds more to the trade! It only takes one mistake letting one trade run into a huge loss and add to it to blow up an account.
- Shorting the strongest stocks in the market during a bull market is scary as they continue to go up.
- Going long a stock in a death spiral due to a business misstep or earnings decline is like riding a roller coast that generally ends up much lower when the trade is finally closed.
- “Going all in” on one trade, with this plan all it takes is one bad trade to blow up your account, those are scary odds.
- When you are losing you go from your trading plan to “plan B” “hoping” maybe even praying for a reversal. When a trade turns you religious and leads you to pray it is definitely time to get out!
- Asking for others opinions instead of following your trading plan or methodology is very scary, time for homework not tips.
- It is terrifying to watch someone fight a trend instead of follow it. The bigger they go against the trend the scarier it gets. They are trying to stand in front of an elephant walking and tell it where it should be going.