Trading Stop, A Counter Intuitive Notion

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.

I'm sure you've had a few occasions when you've "hung in there" a little too long, but you needn't feel bad because it happens to all traders at some point. Now, we all agree that a small loss is better than a big loss so let's just remember; every big loss starts off as a small loss. The beauty of a trading stop is, when we're experiencing a loss, it allows us to nip it in the bud, before that loss escalates into a big loss. The bigger a loss gets, the more difficult it becomes to apply a trade stop.

Basically, a trading stop is a predetermined exit point. When a specific trade fails to perform has you'd anticipated, a trading stop is the point at which you pull out of the trade. Remember, trading is vulnerable to various trends and we can never be 100% certain as to when a trend will change. For all you know, you may enter into a trade just as the trend is about to change, thus the need for a predefined exit point. In other words, if the price drops below a predetermined limit, you exit.

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.

As Richard Harding once described it, an initial stop is like a red traffic light. While you could of course ignore it, you'd certainly be asking for trouble if you did.

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.

Generally speaking, short term traders tend to set their trading stop relatively close to the price while long term traders allow the price a little more room for movement. Remember, the markets are never static so some fluctuations are to be expected. The reason I'm pointing this out is because once you've determined what time frame you're trading, you need to ignore the fluctuations which appear. If you don't, you could end up closing out unnecessary.

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.

As you can see from what's been said above, tight stops have certain disadvantages. For example, tight stops can have a negative impact on the reliability of your trading system due to you being stopped out all too often. Additionally, your overall transaction costs will increase significantly and for anyone starting out with a small float, the last thing you want is a system which costs you a fortune in brokerage.

Because stops are looser on long term trades than they are on short term trades, I nearly always advise my clients to opt for a trading system with a slightly longer time frame.