Lessons from the Pros


How to Turn a Stop Loss of $150 into a $400 Loss

Most traders would want to read an article about how to turn $150 into $400. But then most traders lose money trading Futures. Why? This is because they focus on how much money they can make and not managing their risk first.

Professional traders always manage risk first by figuring out where they are wrong on a trade before they enter their orders. This means locating your entry price then looking for a logical technical level on a chart to place your protective stops. Now that you know what your risk is entry price minus your stop loss, you can easily calculate your potential target. Many traders like to find returns of at least three times their initial risk.

Now the novice trader sets his order platform up to enter the market at a particular price, places a protective stop and a price target of three times their risk. All set, right?

Well yes, if the markets always went to our target before it went to our stop loss. Unfortunately, the market does not work like this majority of the time. Many trades will go in the direction the trader elected by perhaps two times more than their initial risk only to come all the way back to their initial risk and stop them out for a loss first.

Let’s look at an example of this by referring back to the title of this article. A trader sets up their trade with an initial risk of $150. Placing a target of three times the risk would be $450 away from the entry price. Once the traders order is filled the market starts trading for a profit and gradually begins moving towards their price target. Yet, as the market approaches a profit of $390 the momentum of the price action begins to slow down and soon reverses direction back towards the trader’s entry price. The price now begins to spiral towards the traders original stop loss of negative $150. Soon the infamous sound of “Order Filled” is heard, and the trader has been stopped out.

The trader tries rationalizing what happened to help ease the frustration of a losing trade. Telling themselves it was only a $150 loss and was within their risk parameters of losing no more than 1% of their trading account size. But wait, at one time the trader had a net paper profit of $390 and then the trader allowed the price to come all the way back to their initial stop loss of $150. Let’s see, $390 + $150 = $540 !

In reality, the trader allowed the market to take back $540! What could the trader have done to reduce this loss?

Prior to entering the trade the traders trading plan should have outlined a rule regarding when to move their protective stop to breakeven from the original stop loss point. Personally I like to see the market move at least 1.5 times my risk in my favor and at that point I move my original protective stop to breakeven plus or minus one tick depending on if I am long or short. The extra tick will go towards covering my commission cost.

Once the stop has been moved to breakeven plus or minus a tick, you still need to find a way to protect your profits on the next price move towards your target. Leaving your stop at breakeven could still put you at risk of giving back a handsome profit and ending up with nothing to show for your effort. In the above example where the price had rallied to a profit of $390 if the price declines back to your breakeven price, you still are giving back too much profit.

To reduce the amount of profit you give back when a market fails to reach your target try using a manual trailing stop. Trailing stops are simply a method of trade management where you move your stop up under recent natural support levels in up trends and over recent natural resistance levels in downtrends.

Two types of trailing stops are available:

  • Automatic
  • Manual

Automatic trailing stops are applied by charting software at a predetermined price retracement off recent highs and lows. For example, if the trader wishes to trail the market with an automatic stop of 10 ticks then they would enter this number on their order platform under auto-trailing stop. If the price is in an uptrend the computer will always calculate the most recent swing high in the uptrend and subtract 10 ticks from the high price. If the current price trades down to this level then your stop will be activated and you will be stopped out. The problem with using an automatic trailing stop is they do not take the market structure into consideration. The trader is just using a random number to track the current price action.

Manual trailing stops are used with charts to locate natural support and resistance points on the chart to place stops in logical locations. If the price makes new swing lows in an uptrend a trader does not want to be long anyhow. If price makes a new swing high in a down trend a trader does not want to be short anymore.

Figure 1 will illustrate a manual trailing stop placement.

Fig 1

 Fig 1

Here we see a 60 minute chart of the March Sugar contract. Let’s walk through how we apply a manual trailing stop to this chart.

Initially we have a short position at (A). Our original protective stop is just above this high. Price then moves in our direction by 1.5 times our risk (AA). At this point we move our protective stop to breakeven minus 1 tick to reduce our risk if the market reverses direction. Price then trades down to (B) and begins a correction. We cannot move our trailing stop until price actually trades under the (B) low. Once price does trade under the (B) low we know the correction is over and we can move our trailing stop to 2 ticks over the natural resistance high candle of (C). Price then trades to (D) where once again a correction begins. Price trades up to (E), but we must wait until price trades below (D) to prove the correction is over. Once price is trading below (D) we can move our trailing stop to 2 ticks over the natural resistance high candle of (E). Price then trades to (F) and begins a correction to (G). Again we must wait until price trades below (F) before moving our trailing stop. Price soon trades under (F) and we move our trailing stop to 2 ticks over the natural resistance high candle of (G). As price rallies (H) our trailing stop is hit as price crosses our last natural resistance high and we are out of the market.

This style of a trailing stop allows the trader to lock in as much profit of a move as possible while giving the market room to move without stopping them out too soon. In some cases our initial target of 1:3 is reached and our trailing stop is not filled. But many times our trailing stop will be hit as the market corrects back against our position. It is up to us to protect whatever profits we can instead of allowing the market to come all the way back to where our initial stop would be sitting.

“Success is the sum of small efforts, repeated day in and day out.” Robert Collier

Wishing all of our readers and their families a very Happy Thanksgiving holiday.

Don Dawson

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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