Trading: Master the Counter Intuitive Notion

Master the counter intuitive notion of the trading stop and you'll do what so many novice traders fail to do - turn a profit.

How many times have you held a position too long? Everyone has at some point in their trading career. Over the years I have learned that it's much easier to take a small loss than a big one and the important thing to remember is that every big loss started out as a small loss. The art of placing initial stops is to catch a loss while it remains small. It only gets harder as the loss gets bigger and your ego gets more and more squashed into the ground.

The initial stop is a predefined point at which we exit a position, should the trade not go in your favour. When we enter a position, we don't know at what point in the trend we are. We might be entering just before the trend changes. Who knows? Accordingly, we need to set an exit point. It's like drawing a line in the sand underneath the price and saying, 'If the price falls below this line, then the stock hasn't done what we thought it was going to do, therefore we'll exit the position.'

Being a successful trader requires making decisions that are counter intuitive and one of our natural tendencies is to hold losing positions too long. That's why it's important to place an initial stop.

I remember Richard Harding giving me a cracking bit of advice: "You're protective stop is like a red light. You can go through it, but doing so is not very wise!"

One of the most common questions I receive when traders are first introduced to the concept of an initial stop is 'How wide should I set my stop?' Or, in other words, how much room should I give the price to move? Unfortunately, there really are no definitive answers because it largely depends on what time frame you're trading.

If you're a shorter term trader, you're going to have an initial stop that's set closer to the price. If you're a longer term trader, you'll give the price a little bit more room to move by setting your initial stop wider.

Once you've identified what time frame you're looking at trading, your initial stop must ignore the normal fluctuations within that particular time frame. That is to say, you don't want to have to close out of a position just because the price moved as part of its normal trading volatility.

A tight stop is an exit point situated not too far below the entry price. An initial stop that is set too tight can be triggered too early and the trader would be kicked out of the trade before it has a chance to rebound. A much looser initial stop will not trigger exit from a trade. The loss can therefore be bigger but this is compensated by the trade having the potential to climb that previously wasn't possible.

Setting tight trading stops has its drawbacks. First, by having tight stops you'll decrease the reliability of your system because you'll get stopped out more often. Second, and probably a little bit more importantly, by setting tight trade stops you'll dramatically increase your transaction costs. To give yourself a fighting chance, especially if you're starting with a smaller float, you'll want to trade a system that doesn't chew through brokerage.

Consequently, this is one of the major reasons I steer my clients into trading systems over a slightly longer time frame. Trading stops are likely to be less tight over a longer timeframe.

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