If you have been trading for more than a few hours, I hope you have recognized the importance of using stop losses on all of your trades. There are several types of these stops which I will discuss briefly, but are you using stops in other parts of your trading activity? I hope so!
First of all, a stop loss is an order we use to help us minimize our losses in a trade. It is our line in the sand that says, “If price action goes here, my trade isn’t working out and I will lose x dollars.” We suggest using a stop that is 1/3 of our potential reward in the trade – a 3:1 reward to risk ratio. The most common type of stop loss is what is called a stop market. This type of order will exit your position using a market order when your stop price is hit. Some traders prefer to use a stop limit for their stop loss. This stop loss order will attempt to exit your position with a limit order when your stop price is hit. Yes, I wrote attempt. Depending on what price you use for that limit order, you may not get filled at all as the price action is (potentially) moving against you rapidly. In our Online Trading Academy classes, I ask students, “Do you want to be stingy or do you want to be OUT of a trade going the wrong way?” Personally, I want to be out, which is why I use stop market orders. Stop limit orders are very effective orders for entering positions, just not exiting them – all in my very humble opinion.
Another popular type of stop order that traders use is a trailing stop, sometimes called a mechanical trailing stop. This is where your trading software will move your stop order for you, following the price action as it moves in your preferred direction. The benefit of this order is that you don’t have to watch the charts to manage your trade, giving you more free time to do other things in your life. The negative of this order is that one quick move in your direction can move your stop to a technically bad location – you are taken out of the trade yet the trend is still intact, perhaps leaving many more pips on the table. Everything has its positives and negatives!
Now that we have briefly discussed stop orders on your trades, let’s discuss a few stops for your trading.
One type of stop I suggest to students is specifically geared to the daytraders. This stop rule states, “When you have taken three losses in a row, stop for the day.” Your number might be higher or lower, depending on how frequently and on how many different asset classes you trade. The reason should be pretty obvious – if you are taking numerous losses in a row, you need to stop the bleeding! Perhaps what you think you see in the market isn’t what is really going on in the market, you need to step away and clear your head. If you are a somewhat emotional person, imagine taking 3, 5, or 10 losses in a row! What will your emotional state be like? Probably a bit angry, frantic, upset, or even a combination of those emotions. When your mind is clouded with too much emotion, your future trading decisions will certainly suffer. Stop trading and come back the next day!
Another type of stop rule I suggest is, “If you have three losing days in a row, take two trading days off.” The reasons are the same as for the previous rule – it is time to step away and clear your head!
Those two rules are for when things are going the wrong way in your account. But what about when things are going well for you? Can things go too well? There is an old phrase in trading that states, “Your biggest losses come right after your biggest winners.” Many traders go through hot streaks and cold streaks (the cold streaks were mentioned above!) But when a trader gets on a hot streak, where he or she can seem to do no wrong, it is actually time to be cautious. Very often a trader’s ego will start to expand, where you think that you have this trading thing figured out. When you believe that you are smarter than the market, you will more than likely start to break some of your trading rules, for example moving your stop loss the wrong way as price approaches it, or adding to a losing position, then adding again, and again, and again… The actions will cause you to have huge losses, right after your biggest wins!
So what is the suggested rule? It goes something like, “When your trading account doubles, take three trading days off.” Or perhaps, “When your account doubles, after two losses take three trading days off.” You would actually be surprised how many money management firms have similar rules for their traders! If professional management firms have similar rules, don’t you think we should do the same?
There are other rules suggested in class, but you will have to be there to hear them!
Written by Rick Wright, Online Trading Academy Instructor. Rick Wright’s goal as an Online Trading Academy Instructor is to accelerate the student’s learning curve, whether they are interested in High Frequency Trading or Investing for Beginners. He teaches classes on Online Stock Trading, Forex Trading and Futures, among others. Rick studied economics and psychology at Iowa State University, and entered into the brokerage business in 1992. He earned the NASD Series 4,7,9,10,24,55,63, and 65 licenses. He helped grow an online brokerage business which was eventually sold off. Rick has also held positions as broker, branch manager, and several VP positions in the brokerage business. Rick began trading equities in 1997, and was introduced to the Forex market in 2002. Currently trading from home in Dallas, Rick is also a frequent contributor to various TV and business talk radio shows. In his articles, Rick will show you several examples of trading mistakes that he and others have made, which cost thousands of dollars in the past so you won’t make the same mistakes. You will learn how to recognize the differences between long and short term trends, where to enter trades, and where to exit based on previous price action.