In many speeches, workshops and written articles I have made the point that long term profits come from managing short term risk.  You may well have heard me say this before, but it is so important that I want to address this yet again with a simple little example from yesterday’s trading.

This was brought to mind during a discussion with another trader who had been getting beaten up rather in the current market, which without a doubt is a difficult environment due to the collapse in volatility over recent weeks.  The trader concerned had fallen into the trap of giving trades way too much room before taking a loss and moving on.

In this case he was trading the S&P and using 3 point stop losses which, in my opinion, is miles too much risk at the present time.  It is easy to understand why – this was a habit left over from last year when giving a trade 3 points of room was about right.  That was a high volatility environment of course where successful trades regularly yielded 3, 6, 9 even 12 point profits.  Today profitable trades typically produce 1.5 to 3 point profits, so you cannot possibly throw 3 points away on losing trades and expect to be profitable overall.  The numbers simply do not add up.

So this leads us to the obvious question – how much room should you give a trade to work out?  Many traders like to use a fixed number of points, a fixed dollar amount or some sort of ATR (average true range) factor.  I don’t actually like any of those approaches and I hope the example above will help to illustrate why.  As with most of my work, my approach to stop placement is very simple – if the market reaches a price that would invalidate the original rationale for taking the trade, then I don’t want to be in it any longer.  It’s that simple!  So before entering any trade simply ask the question – where should the market NOT go?  That is then where your stop should be placed.

Protective stop goes where the market shouldn't

So here is a simple example, that coincidentally occurred right at the time yesterday when I was  suggesting to this other trader that his stops were too large.  This is a 1 minute chart of the S&P.

Firstly what is the rationale for this trade?

On the move up to point D, we know that the buyers have the upper hand.  The progressive higher highs being made at B, C and D demonstrate that they hold the balance of power.  However at E, buying is insufficient to drive the market up to new highs.

The buyers have temporarily run out of the money needed to push the market higher.  So the logical expectation is for the sellers now to take the lead and bring the market back down.  Hence for us this is an opportunity for a short sale at 875.00

So where does our protective stop go?  Well if our hypothesis is correct that the buyers are spent out and the sellers are now in control then the market should not get back up to the old high at E, so that is the perfect place for our stop at 875.75  Were the market to go back up there our hypothesis is clearly incorrect so we would want to be stopped out for a small loss of 0.75 points.

We don’t need to lose 3.00 points to know that we are wrong, when 0.75 points is sufficient to confirm that fact.

In this example you can see the market only came in another 1.50 points before stalling out, so this wasn’t much of a trade.  You could have banked 1.0 to 1.5 points and in this low volatility environment that would have been exactly the thing to do when a trade stalls.  At the very least you should have pulled your stop down to breakeven.  Although this environment only gives small moves, you would still have been in the trade for over 20 minutes before it got back to breakeven, so there is really no excuse for letting a winner turn into a loser.  Even if you managed the trade really badly, your worst case was still only a 0.75 point loss but at no point could risking 3.0 points ever be justified.

So in summary the amount of room a trade should be given is governed by (a) the rationale for the trade and (b) the prevailing volatility.  Together these two factors give you the right answer and it does vary from one trade to the next, hence my personal view that the “one size fits all” approach cannot be right.

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