Stop Placement and Scaling

As a general rule, before any trades are placed, entries, profit targets and stop losses should be clearly defined prior to execution. A “stop loss” is the point at which a trader is willing to accept defeat and exit the trade at a loss. The profit target is the level at which the trader will exit the trade with the understanding that gains are unlikely to run much further.

Let’s look at the broad outlines first: The maximum amount risked in any given trade should not exceed 2% of your total account size. Above this level, traders become over-leveraged and risk losing the entire trading account. The first rule to remember is that trading is not a “get rich quick” scheme. You will lose a significant number of trades no matter how intelligent or well-prepared you are because nobody can predict what will happen to the markets in the future. If a trader is over-leveraged, that trader will not last long in this business.

The only way to combat this is to risk conservative amounts of capital in each plan. Then, over time, your winnings should out-pace your losses and overall success should be realized. The next factor to keep in mind is your win-to-loss ratio, which should be 2:1. What this means is that after your trade is planned (stop loss and profit target identified), the amount of loss that is being risked is half (or less) than the amount gained once the profit target is reached. With this method, a trader could actually fail in half of the trades placed and still come out with gains overall.

A final point here is that once stop losses are placed, they should never be moved unless there is an exceptional reason. One of the biggest mistakes traders make is moving the parameters when a stop loss is close to being hit. This is another situation where emotion and subjectivity take control away from the original trading plan. Once a trade is planned, researched and executed, the original idea must be honored faithfully.   Emotion and subjectivity are the most formidable opponents for anyone looking to trade successfully and these things need to be avoided as much as possible.

The next technique we will look at is “scaling.” This, essentially, is breaking up your trade size into smaller parts and slowly adding to your trade if the market starts to work against you. Let’s keep in mind, this does not mean that your trade size should ever exceed the 2% figure. But if 2% is equal to 100$, for example, then it is better to break up that money into 3 or 5 equal parts and slowly build the position if the market moves in unanticipated ways. The reason for this, again, is that nobody can predict the future. It is impossible to identify the perfect entry point and we should always assume that, to at least some degree, the market will move against the trade. This method helps to both limit losses and improve the average entry point, as you will continually be adding to the position at more favorable levels.   If the market does move in your direction from the very beginning, all the better. In this case, it is true that your position size and total gains will be smaller but so will the amount risked. Moreover, in these cases, you will never be worrying about a position that is moving against you.

Last, we will look at a final word about stop-loss placement. One of the lessons traders need to learn quickly is that markets can never reward all of its participants. In fact, markets tend to move in ways that hurt the most people. This is why the placement of stop-losses is an art that needs to be paid careful attention. Let’s look at the following example:

 

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Based on this chart, how would you structure a trade? Support for this asset clearly comes in at 1.5300. This is our buy area (the trade entry). Resistance comes in solidly at 1.6000. This is the profit target for long positions (or, conversely the entry area for short positions). If this trade works in our favor, the trade would gain roughly 700 points. From this, we should remember that our stop loss should be no greater than 350 points (our 2:1 trade ratio). So, if we originally enter at 1.5300, we can continue to scale in until 1.5000. 1/3 of our buy order could be placed at 1.5300, 1/3 at 1.5200, 1/3 at 1.5100 and then our stop could be placed below 1.5000. This gives our trade some breathing room if support at 1.5300 breaks. Many stop losses would likely be placed under 1.5300, so we can avoid being in the majority and falling victim to false breaks if we place our stop safely away from the consolidation of market participants.

On a side note, simply buying into support or selling into resistance is generally not enough for technical traders to enter into trade. The above example was presented mainly to illustrate proper stop-loss placement. Ideally, prices falling into support should be confirmed by indicators which are signaling the asset has entered into “overbought” territory. (The reverse is true for short positions.) These factors, taken in unison, give the trade a higher probability of success.