It’s easy to think about all the money you’ll make if your trades go well, but much harder to focus on all the money you could lose if things don’t turn out so well. A savvy trader knows that how you avoid losing your cash is a far more important concern than how you go about getting more. The primary tool in the arsenal of any serious trader is the stop loss order.
Stop loss orders serve two main functions. One is to get you out of Dodge before your balance is zeroed when your trade decisions go wrong, but the other is to keep you in a trade long enough to ride out the inevitable roller coaster whipsaws that will often plague even a good trade before it finally becomes profitable. It’s very important to remember the need to meet both of these goals when setting your stop losses. Here’s an important adage I try to keep in mind:
A stop loss is like a call to 911. It’s not designed to prevent you from pain or injury, but to keep you from dying.
Too many traders are prone to be over-optimistic and to assume that a good trading signal means the market will just take off in their chosen direction. They set their stops just a bit behind their entry points and enjoy the warm, comfortable feeling of knowing that they won’t lose very much if the market moves against them. Then they see their stops hit (for a small loss) just before the market turns around and steams off in the direction they were originally looking for. They see the profit they should have had slipping away while they are left with their ‘warm, comfortable’ loss. This will tend to happen often enough that these traders almost never make money.
The mistake they make is in not realizing that a stop loss saves your life, not prevents pain. If you decide to enter a trade, you must accept that you may need to suffer some pain, either in the short run before your trade develops, or in the end when your trade craps out on you. Pain and losing are an unavoidable part of market speculation, and you must learn to accept them and to deal with them in a realistic fashion.
The best strategy is to make your stop losses conform to what you see on the charts. You need to find a stop loss level that makes sense from the standpoint of the technicals that got you interested in the trade in the first place. Triggering a stop loss is an event that should occur when the market movement nullifies your previous sentiment. It should be a screaming red flag that says “You were wrong, and the reason you entered the trade is no longer valid!”
Consider as simple support level trade. If you saw price bounce off of a long-standing support level and begin moving up, you may have decided that is was a good time to buy. This could be a fine trade, but if the price moves down below that previous support level the importance of that support is significantly weakened, and the likelihood is now that the support is broken and the market will now head downward. Clearly that’s the time to call it quits and take your loss. In this example you would recognize that a breaking of the support level you were depending on would remove the technical justification for your long trade, and you would place your stop loss a few pips below that support level – far enough to avoid short term market spikes.
If that stop loss position looks to be too far away, don’t give in to the temptation to raise it… just adjust your trade size downward to reduce the overall loss risk. I cover trade sizing more in another post.
