Stop Loss is an automatic order that closes our
trade once the price reaches a specified level. Usually, when opening an order, we
have a choice of entering our stop loss level.
There are 2 types, if we place a sell order then we
need to place a stop loss at a certain distance above our entry price. If we
place a buy order, we need to place a stop loss at a certain distance below our
entry price. For Example, let’s say on EURUSD the price is at 1.22432 and we
want to sell so if we want a 20 pip stop loss. We place it at 1.22632.
Using a stop loss in this way is a method of only
risking a small amount of typically between 1% - 5% of our total trading
capital per trade. And hence also limiting the losses on our account which puts
our minds at rest when trading. The most important part of trading is
psychology or put another way it is about how you react to that price when it
triggers your signal. Or put another way it will affect how you perform as a
trader.
When I trade, I usually risk about 20 pips per
trade. This means if I am trading at £1 per pip then my risk is £20 and means I
would need a total bank of £400 if I were to feel comfortable taking that
trade. I would not feel comfortable if I were risking any more than that and if
I do not feel comfortable then it will affect my trading actions. For example,
I might hesitate and get in late, or if I see profit but I'm scared I might
take profit, but this might suffocate a really good trade. So, as we realise
getting a stop loss at a level were comfortable with is very important for your
psychology which overall will affect your trading decisions which will affect
your performance. Just like any sport to that matter.
I have often heard it being said that "a true
professional trader doesn't care if he wins or loses". Well, this is true
because he knows his method of trading will very probably bring in profit over
the long term. What is important is how many trades we win compared to how many
we lose and were only going to know this over time. So, therefore whether you
win or lose if you are a true professional it simply does not matter on one
day. It is when we are losing over many months that tells us we aren't doing
well and need to re-evaluate things.
BUT do not rely on stop loss
techniques alone to make your system profitable!
It’s a subject of much debate I'm sure on exactly
how you use a stop and I'm sure there is more books and websites out there
giving much scope on this topic but as far as I see a true long term profitable
trading system although I would say needs a stop loss and is very important. It
should not rely on a stop loss technique to be profitable as I am sure it won't
work long term as usually these types of system end up wiping out your entire
capital when things go wrong.
A good trading system must get the direction right
most of the time otherwise it is relying on the stop method which in my view is
not the path to long term profitable trading. Let us take Roulette as an
example. Now, I am a fan of online roulette, but I can tell you from experience
there is no system that can beat roulette no matter what you do. There are I
have heard over 7000 roulette systems out there. Of them, there will be
variations of those that rely on a betting method called Martingale. Let me
briefly explain:
Martingale basically aims to recoup a loss by
doubling the next bet. The allure is strong and quite rightly as so it appears
you cannot lose but oh yes you can. You see eventually a long losing streak
will wipe out the risk capital of the player. If you look at the roulette
player from short term, then it will appear they are doing well but if you look
at their playing over many months they are very likely to have lost their
entire risk capital at some point.
Example:
Balance £100
Bet £1 on Red it Loses Balance = £99
Bet £2 on Red it Wins Balance = £101
Bet £1 on Red it Wins Balance = £102
Bet £1 on Red it Loses Balance = £101
Bet £2 on Red it Loses Balance = £99
Bet £4 on Red it Loses Balance = £95
Bet £8 on Red it Loses Balance = £87
Bet £16 on Red it Loses Balance = £71
Bet £32 on Red it Loses Balance = £39
Bet £64 on Red it Loses Balance = £39
Can't place any more bets and there's no way you
can get back up to £103 so you have lost.
This is an example of relying on a flawed money management
strategy to win and not relying on a solid system. Because quite simply you
cannot get information or anything to give you an edge on a number. If we do
flat betting on Roulette, then the casino edge will slowly diminish our balance
also. Quite simply can only rely on luck to make a profit here.
If we take the stock market though it has elements
of predictability, it is not fixed odds betting, the chances of price moving in
or out of your favour changes all the time. Yes, it can be hard but a good system
can get it right otherwise there would be no long term profitable traders which
I can assure you there are.
Some of the most well-known stop loss
methods I know of:
Trailing stop
This is where the stop level moves along with the
price at a predefined level as set by the trader. For example, let us say the
price is 1.22432 and we want to sell so we place our stop at 1.22632. Now if the price moves lower to 1.22332 then our stop will also trail behind and move to
1.22532 without any input from the trader. Now if the price moves against us
the stop will remain at 1.22532 which in effect would protect us from a bigger
lose if we left it at 1.22632.
Although this method does have its pro's and cons.
Pro's = It minimizes losses
Con's = It doesn't allow your trade to breathe and
therefore diminishes some possible good moves.
But it all depends on the type of system you use. I
think it's not bad for if your system predicts breakouts.
Break-Even
When price moves in profit by a certain amount as
set by the trader the stop loss is moved from the stop loss level to the entry
price their bye protecting the trader from any losses.
For example, let’s say the price is 1.22432 and we
want to sell so we place our stop at 1.22632. If we think we should move to stop
to break even when we are in profit of 20 pips. When price reaches 1.22232 then
the stop is moved from 1.22632 to 1.22432 our entry-level.
I find this type of stop loss method good for swing
trading or when your system plans on holding the trade over a day for a good
trend.
Although this method does have its pro's and cons.
Pro's = It allows you to hold onto your trade for
as long as you think the price will move in your favour.
Con's = As markets do fluctuate it sometimes can
stop you out and so miss out on any profits.
It all depends on how the market behaves and it
think this method relies on the further judgement of the market’s behaviour.
50% Lock-In
This method involves firstly allowing the trade to
breathe and so is suited to holding the trade over a day or 2 and locking in
half of what is there. It's good because it allows our trade to breathe and is
in line with the golden rule of holding on to winners.
I would normally trade this as so:
I would enter a buy order at 8am say the EURUSD at
1.22432 with a 20 pip stop loss at 1.22232. I come back at 12pm to see the price is
now at 1.23032 which means I am in profit by 60 pips. So, I would move my stop
to a 50% level at 1.22732, so now I know I have profited no matter what but
still have a possibility of making more profit if the price was to move higher.
Stop Reversal
This is when we place an opposite order on a stop
loss level. This is an effective method for counteracting when you get the
trade wrong. It works thus, you would enter a buy order on the EURUSD at
1.22432 with a 20 pip stop loss at 1.22232 but you would also place an opposite a version of that sell order at this stop loss level of 1.22232.
My personal favourite is holding over
days while stopping the major peaks.
With my system, you might only be risking 20 pips
but every 3-4 trades place will see profits of over 100 pips because using my
favourite is the 50% lock in with a slight difference. Instead of locking in
the 50% level I instead look at the previous major price peaks and place my
stop at these levels. Price peaks give a better idea of true market direction
so what better way to hold onto that direction than using price peaks, as
although price fluctuates if it’s, for example, shorting then price shouldn't
rise above the previous peaks until there is a major direction change.
What is the profit factor ratio and your
ideal risk to reward ratio?
I’ve seen many trading systems and they all look
great on paper but there is one thing they never show and it's down to you to
find yourself. It is the Profit Factor Ratio or PFR. This is where you find the
ratio of your profits to your losses. If over many trades, it is still above 1
then your system is profitable. This one major point is what all trading
systems do not actually show you, but is what you need to be a truly
profitable trader.
There was 1 system I remember which I guess stuck
with me and is what led me to the goal of holding a trade over a few days for
maximum profits while risking only a small amount. Obviously, I can't give
names here, but the main promise was most trades make 100+ pips profit by
lunchtime. Now like all systems you read about they always show you the good
while glossing over the bad. What they do not show you is the reality of how
that system performs. You can only see the reality after you have bought the
system and experienced trading it yourself.
So, we must backtest and find the systems true
PFR.
From experience, my trades usually end up with a
risk-reward of 1 to 4 meaning for every £1 invested I expect a £4 return for if
that trade wins. This statement is irrelevant what really matters is the profit
factor ratio. Or simply your profits/losses. If it's above 1 then you are in
profit. It depends on how high above 1 as to how fast we can profit and how
much we profit can make. So, when trading I always inspect my system is working
and making sure the PFR is > 1.
For example, let us say I placed 1000 trades with a strike rate of 1 in 4, and each winning trade to make £20 while a losing trade
makes £5. We can expect 250 winners and 750 losers. Sounds bad at first, 750
losers Oh No! but watch:
250 winners at £20 a win = £5000
750 losers at £5 a loss = £3750
So,
Profit / Loss = PFR
5000 / 3750 = 1.33
Our PFR is 1.33 that is I would say a realistic
PFR. Trading at £1 a pip means we will profit £1250 over 1000 trades placed.
£1250 profit from a £100 investment is serious money-making potential. Of
course, this is a conservative PFR there are many systems out there with higher
PFR. I have read that most systems realistically reach just under 2.0. Mine is
1.33 I can live with that.
By Article By Stephen J Reynolds
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