Learn The Benefits Of Trading Stop
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.
A question which is commonly asked by traders when they first hear about the concept of an initial stop is, how wide should a stop be set at. The truth is, because it depends primarily on the time frame being traded, there is simply no one single answer.
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.
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.
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