Manage stop loss and reduce losses
In today’s post we will discuss about ‘how to manage stop loss’ in trading. Stop loss management is critical for the success or failure of any strategy. This is why well defined strategies have emphasis on stop loss, take profit and risk to reward ratio. The topic of stop loss is inherently a subtopic of money management. Nevertheless stop loss management is so important for traders because without getting it right, there will be no light at the end of the tunnel.
We will structure this post in an faq model. Below you will find listed some common mistakes done by traders with regard to stop loss management or placement in the first place, followed by solutions to the problem.
1. Using a fixed stop loss across every trade
This must be The common misconception among traders. Assuming that using a fixed number of pips as stop loss for each and every trade is a good strategy. This just doesn’t work. Because every trade is unique. So should be the placement of stop loss. Its a good idea to look into indicators like the ATR (Average True Range) and have a good understanding of the average pip range of price action. You must also consider the currency pair traded, recent volatility of the pair, surrounding news events and the time frame in context. The point is that each and every trade should be treated on its own merit. For example having a 20 pip stop loss on every trade just does not work.
2. Stop loss too narrow
Placing or trailing stop loss too narrow to the price is a silly mistake on every dimension. Let’s analyze this problem in terms of probability. If a trader places stop loss very close to the price often within the common price range of short term price action, what would be the most probable outcome? The solution on the other hand is NOT to compromise risk to reward ratio either. The solution is to understand the recent price action and the context of the trade. The key is to think about negation of the signal – at which price point the entry signal is invalidated? For example suppose you are trading a bounce off of a support level, the stop loss should be below the the support range or previous low (if there has been a test of the level already.)Let’s analyze it in terms of market behavior. The price never travels in a straight line. Instead price has a structure of a zig zag pattern. Even if price goes to reach your target levels, in between there would be plenty of pull backs and mini reversals. It only makes sense to account for such pull backs and place your stop loss accordingly.
3. Stop Loss too wide
This is the other extreme of stop loss placement, contrary to the previous point. There is only a fine line between trading and gambling. In terms probability, yes it makes sense that having stop loss ‘beyond’ the reach of price would produce high probability of wins. But it also creates room for large drawdown. Yes you have to account for your risk tolerance as well. If you have not already read this post – ‘What is your risk tolerance‘ Even if the risk is within your comprehension, what’s the point if you can’t sustain the same level of risk after a few losing trades?In the beginning of the trading career, every trader focuses on the win ratio and end up widening their stop losses. Beware, this kind of approach will kill your account very slowly.On the other hand, stop loss, win ratio and drawdown are correlated. Think of it as a triangle. Your job is to find the sweet spot right at the middle of the triangle for every trade.
4. Incorrect use of trailing stop
This is not a problem in itself. But incorrect use of trailing stop can be. For example if your trades are with a healthy risk to reward at the entry, use of trailing stop will deteriorate the risk to reward ratio of the trades. Although you would feel safe after moving the stoploss to lock in some profit, on the long term it may seem that it would have been better off without trailing. Of course its highly dependable on the strategy. A rule of thumb would be to maintain at least the initial stop loss distance throughout the trade. Whats the point of having a 30, 40 pip stop loss initially, only to move it within 5, 10 pips as soon as the trade goes into positive territory? The same probability theory applies to trailing stops too.
5. Constantly interfering with the trade and stop loss
This is another mistake that most traders do. This is often caused by itchy fingers and impatience. I used to do this a lot in my early days, until I analyzed my statements and found that I was actually hurting the profits. Stop loss is a measure of faith and confidence given to that particular trade set up or signal. So if you are willing to widen or narrow down the stoploss randomly on an active trade, it means that you have not put enough thought into the placement of stop-loss to begin with. The only way to overcome this problem is to think of each trade as a journey on a one way road. There is no turning back. This sort of thinking will actually make you analyze your set ups more cautiously, before entry. Entering the markets is easy, its just a click. That is exactly why you have to be very cautious and selective about your entries. Ultimately, the objective is to let the trades run on its own and let the markets do its own thing. If moving stop loss is part of your strategy, by all means go for it. As long as you trade by a set of rules and guidelines, it should not hurt your profits. But the point here is to avoid impulsive tampering with the trade outside of your strategy.
All in all it comes down to discipline. If you have a methodical approach to trading there is very little mistake that you can make with regards to placement and management of stop loss. One guideline that will save you from many pit falls is that remember to put logic behind every action you take in trading, whether it be managing stop loss or a basic thing as drawing a trendline on the chart.
I believe this post addresses the most common and critical problems with regards to managing stop loss in trading. If you like it, consider sharing them with your friends and colleagues as well. If you have any suggestions or additions regarding stop loss in trading, please share them with us in the comments section below. We would love to hear from you.