Learn The Benefits Of Trading Stop
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.
Even though we all dread it, trades won't always go exactly as we'd hoped for, and this is where a trading stop comes into play. Essentially, an initial stop is a predefined exit point that allows you to get out of a trade when it's not going as planned. Remember, you could unknowingly enter into a trade right at the end of a trend so therefore, you need to have a predetermined point at which you'll exit. In simple terms, a trading stop is simply deciding to bail out once the price slips below a certain mark.
When a particular trade starts heading south, we almost can't help ourselves from wanting to hold on for too long, hence the importance of being able to make decisions which are counter intuitive.
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.
A question which is commonly asked by traders when they first hear about the concept of an initial stop is, how wide should a stop be set at. The truth is, because it depends primarily on the time frame being traded, there is simply no one single answer.
As I've mentioned already, the exact amount of room you choose to allow for movement depends on the time frame of your trade. For example, if you trade short term, setting your initial stop close to the price is recommended. On the other hand, if you trade long term, it's recommended that you set your initial stop wider, thus allowing for more movement. However, you also need to realize that once your time frame has been determined, it's important that you ignore normal market fluctuations within that time frame. There is always a certain amount of volatility in trading and you don't want to close in on a position, simply because of normal fluctuations that are to be expected.
A trading stop which is set just below the trade entry price is known as a tight stop and the problem with this is, if it's set too tight, it could cause you to loose your position within a trade, before that trade has even had a chance to recover. On the other hand, a looser trading stop won't trigger an exit as quickly, but it could of course result in a bigger loss. The advantage however is, by setting your trading stop looser; you allow a trade more time to recover if it's recently taken a dip.
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.
Essentially, this is perhaps the main reason why I advise clients to go for a trading system over a slightly longer time frame. The stops on short term systems just tend to be too tight in the vast majority of cases.
Tags: trading, trading entry, trading stop