“I believe a key to successful trading is learning how to become comfortable with taking a loss…”

Traders are always interested to learn how I set my stops, especially with trades that last less than 1 hour. Well, let me tell you losing Traders often bring a measure of perfectionism to their work. I too am guilty of this as it’s in my nature to want to achieve the best result.

Some Traders will equate a good trading day with a profitable one. This, however, can be a problem. In actual fact, a good trading day is one in which you have followed your well-researched Trade Plan with focus and discipline (i.e. You planned your trade and you traded your plan). So, with this in mind, good trading days, over time, will generate profit. Remember, of course, that uncertainty in the markets does mean even the best-laid plans can go awry.

Therefore, in the short term at least, you can’t control your profitability. But you can control whether or not you have good trading days, which will generate profit over the long haul. Providing you have adequately researched and backtested your strategy.

They say broken clocks are right twice daily. Even unresearched strategies can occasionally yield profit. Those might seem like good trading days, but in reality, they reinforce the very qualities associated with failure.

The perfectionistic Trader equates taking a loss with experiencing negative feelings of frustration. A more realistic Trader on the other hand, realises there is a degree of uncertainty built into the market and that losses are simply a cost of doing business. The aim is to limit these losses as effectively as possible.

STOP LOSS

There are three basic stop loss strategies. Price based, time based and indicator based. All of these can be back tested in advance to help make the process of taking a loss more automated and thus less emotional.

Price Based

Most Traders are familiar with price-based stops despite not all adhering to them! I utilise price based stops as part of my Trade Plan when time and indicator based fail to take me out of a trade.

I like to view each trade as a hypothesis. For example, if I take a long on the DOW Jones using smaller timeframes like the 1 minute, 5 minute & 15 minute, it is because I have identified a potential low level of support. Perhaps I have noticed the S&P and NASDAQ have also found significant support. So I may look to place my stop below this support.

By saying the prior low is an important level, I am asking the question as to whether this is just a pullback in an upswing. Therefore, if the price returns to test that low, my hypothesis is not supported and I need to protect my remaining capital.

A key to making such price-based stops work is setting your entries near the low (or high) so that losses will not be excessive. With short-term trades, this means I am examining smaller timeframe charts along with my various other confluences. Remember, if the patterns you are trading only historically succeed 50% of the time, you must keep the size of the losers much smaller than the average winners for your system to be profitable.

Time-Based

The second stop loss approach makes use of time. It is designed to maximise any volume at the start of the London session. The stop itself is generally there as a rule of thumb to ensure any sudden volatility in the wrong direction does not result in a large loss. If the desired profit has not been achieved during the opening period – which may last anywhere from 5 minutes to 1 hour – I would consider returning to trade the US Open. Then I would look to repeat this process by attempting to capitalise on any short term volume.

The logic for such a time based stop allows me to enter trades where momentum is increasing in the direction of my trade. If I have been successful, the position should become profitable fairly quickly. If the market stays flat or choppy, it most likely suggests I did not read price action correctly. Thus allowing me to close my position early even if price has not hit my stop.

NOTE
One of the few rigid laws in trading is that risk and reward per trade are proportional to the holding period. This means the amount of time you hold a trade will vary depending on your personality, amount of risk and risk tolerance (i.e. pain threshold).

Therefore, when formulating your Trade Plan to include Risk Management and Strategy, I encourage you to also factor Holding Period into account.

Indicator Based
The third stop loss methodology is indicator based. I spend much of my time back testing indicators because the relationship with price action regularly shifts. For example, I have three main strategies which I use. They all encompass some form of indicator. And depending the time of year, or a key global news event, may see these indicators work really well or not so well at all. My goal, therefore, is to identify what is currently working well and to keep doing it, until it degrades. Then tweak accordingly.

Indicators can help to identify when price action reaches an extreme level. Such information can be useful when setting stops. One of my strategies involves Divergence. This powerful but simple indicator highlights potential reversal levels thereby allowing me to enter at the beginning of a move or exit towards the end.

Stops Are A Psychological Tool.
Armed with such intel, may help provide an edge to your trading. Not only this, but stops can be used as a psychological tool. Once a stop is set, it can be mentally reassuring. They say a good loss is a planned one. The only true market failures are the ones that are unintended.

It is an irony that successful Traders plan for ‘failure’ whereas unsuccessful ones fail to plan.