One thing that is certain in anyone’s trading journey is losses. It is how to manage risk make you a better trader. Even the best traders lose from time to time. What the best traders have in common however is that they are very professional losers. Knowing how to lose properly is a must in a long and prosperous trading career. This theme is also the back bone of trading success. The main focus for traders is how to reduce risk with three important tools and this article, 3 ways professional traders manage risk will show you how they do. The first is the proper use of protective stop orders, the second is proper position size and the last, but may be most important tool is to keep losses small.
Protective Stop Orders
Protective stop orders to the trader are as important as the oxygen tank to the Astronaut in outer space. Without them, and proper use of them, you’re in big trouble. Protective stop orders in trading are meant to help limit your potential loss. There is more than one type of protective stop order and it’s very important that you understand the difference between them.
Stop Market Orders: This is an order to buy or sell once price surpasses a particular point. Once price surpasses a pre-defined price, the order becomes a market order. This type of order can be used to enter or exit positions. Typically this order is used for protection. While execution of this order is typically guaranteed, the price at which the order is executed is not guaranteed. This is because the order being triggered is a market order. The benefit with this order is that if price surpasses your stop price the market order will take you out of the position. The negative is that if the market is moving fast you may see some slippage and not get filled at the price you desire. However, this certainly is the ideal order if your goal is to protect yourself. As a trader, I always use this order for protection.
Stop Limit Orders: This type of order combines the features of a stop order with the features of a limit order. Once a pre-defined stop price is reached, the stop limit order becomes a limit order to buy or sell at the limit price or better. The benefit of this order is that the trader has control over the price the order will execute at (it is “limited” to the stop price). The negative factor with this order is that it does not in any way guarantee protection which is what most traders/investors want in a stop order. For example, if you bought a stock for example at $41.00, and have a sell stop limit at $40.50, and price reached $40.50 but there are no buyers, price will keep declining and your loss will grow with no protection. In short, if you are looking for more guaranteed protection the stop market order is a much better choice. As a trader, I NEVER use this order for protection.
Where to place protective stop orders?
This is a shorting opportunity we identified in the Extended Learning Track (XLT) a little while back. On this day, the market opened and rallied right up to our pre-determined supply level. To protect the short position if we are wrong, we use a “buy stop market” order. The initial protective buy stop order placed just above the black line. The purple line is exactly where the buy stop market order should be placed. We place the stop at that price because it is just above where all the sellers are according to the chart. We know this is where all the sellers are because price could not go to that level, there was too much supply. This was our “initial” buy stop.
The next chart is a smaller time frame look at our S&P shorting opportunity. We go to the smaller time frame to identify where to place our “trail stop” if we want one. A trail stop is simply the act of moving a buy stop down with price during a short position or moving a sell stop up with price during a long position. The benefit of a trail stop is to capture the majority of an intended move in price so as to not “give back” profits. While there are a number of different types of trail stops, I will focus on one of the more objective ways we handle trail stops in the Extended Learning Track (XLT). As price is falling and we are in our short position, we want to bring our protective buy stop down as price falls to protect our profit. The circled candles on the chart represent strong declines in price. Once price declines from a price level, the origin of that decline is where supply is. Therefore, we can move our buy stop down to just above the new supply area. What we are doing is protecting our short position with these new areas of unfilled sell orders, supply. If the market is weak, price should not rally above these levels and continue to decline which is what we want for our short position. The circled candles drop as they do because supply is greater than demand at the origin of the decline. This, again, is one of the more objective ways we use real time supply and demand analysis to trail stop our positions.
Proper position sizing is another key component to managing risk properly. Here we have a pivot low support (demand) level and then a decline in price to that level for a low risk buying opportunity. If we buy at the top of the demand zone and place our protective sell stop below the zone, we can do some simple math to ensure we are not going to lose more money than we are comfortable losing by using proper position size. In this example, let’s assume we have an account with $100,000.00 in it and we decide that our maximum risk is going to be 1% of the account ($1000.00). If this trading opportunity requires a $0.40 stop and we do the math, we see that we can buy 2,500 shares. This means that if the trade does not work out we will only lose the amount of money we are comfortable losing, the $1,000.00. Having a position sizing grid like the one you see here when trading any asset class also helps your trading become more mechanical. The key is that you don’t want to be “thinking” much when the markets are moving. You simply want to follow a logical rule based plan which at its core is based on the laws of supply and demand.
Keeping Losses Small
The cornerstone of Online Trading Academy is risk management. Knowing how to minimize risk is the most important thing in trading. There are really only four possible outcomes to a trade or investment: A big win, a small win, a small loss or a big loss. As long as we ELIMINATE the big loss, we can live very comfortably with the other three. As humans we always want to be right; we hate being wrong. You can’t think this way in the world of trading and investing because the truth is, you will have losses. Embrace those losses as a part of your winning strategy and keep them small. I have losing trades sometimes but I really don’t care. On the emotion side of trading, I don’t feel any different about a winning trade or a losing trade. Perhaps the fact that I have been doing this so long is a factor but the reality is, I am simply executing a profitable plan over and over and over. Small losses are just part of a very profitable plan that does not allow for big losses. The 3 ways professional traders manage risk is central to every trader’s success.
Written by Sam Seiden, Online Academy Trading Instructor. As the Chief Education, Products, and Services Officer at Online Trading Academy, Sam shares his ideas on day trading, investing for beginners, online Forex trading and his personal passion—the futures markets. Sam brings over 15 years experience of equities, forex, options and futures trading which began when he was on the floor of the Chicago Mercantile Exchange where he facilitated institutional orderflow. He has traded equities, futures, interest rate markets, forex, options, and commodities for his personal interests for years and has educated thousands of traders and investors through seminars and daily advisory services both domestically and internationally. Sam has been involved in the markets since 1991 both on and off the floor of the Chicago Mercantile Exchange. He has served as the Director of Technical Research for two trading firms and regularly contributes articles to industry publications. Sam is known for his trading, technical research, and educational guidance.