The Importance of Stops

01/14/2014 7:00 am EST

Focus: FOREX

If you take care of the losses, the profits will take care of themselves and that is why stops are so important, writes Tyler Yell of DailyFX.com.

“Participating in the markets without a plan is like ordering from a menu that has no prices, then letting the waiter fill out and sign your charge card receipt. It's like playing roulette without knowing in advance how much you had bet, and only after the wheel stopped, letting the croupier tell you how much you had lost or won.”

Jim Paul, What I Learned Losing $1 Million

Have you ever lost a lot of money on one trade or maybe a series of very bad trades? What's worse when you look back on those trades is that as the loss deepened, the analysis often lost scope, which is what you've likely focused so much of your trading system development upon. If your analysis only matters when you enter a trade but not on your exit, then it's likely best to step away from your analysis and focus on your exits.

The opening quote reminds me of something I saw in New York a few years back. While eating breakfast at Norma's, I saw a $1,000 Frittata, which prompted the internal question, “what if someone ordered this without knowing that this was a $1,000 breakfast?” As a trader, I couldn't help but think that many traders fall into that same trap of approaching a trade without having a clue as to how expensive it may be to their p/l and career.

The key focus of this article is that without stops, you're potentially stepping into a financial and emotional trap that you're likely unable to handle. When the market moves deeply against your trade and you see your losses stacking up, it's often easier to hope things turn around as your account equity drops. The rest of this article will unpack that statement for you and help you see why stops are more critical than any other part of trading and play perfectly in hand to the truth of trading.

Why Many Traders Only Pay Lip-Service to Stops
Many traders could possibly have a larger total profit if they were paid for every time they heard “cut your losses short, and let your profits run” instead of just banking the profitable trades they've closed. In the heat of the moment, this statement is about as effective for traders as “eat less and workout more,” is for dieters. It makes sense but as emotional beings we need more to hang onto for the wisdom to stick.

Unfortunately, many traders often think they have accepted the risk on the trade when they place a stop, but as soon as they move the stop against their trade, allowing them to lose more, they've revealed that they're dictated by emotions more than a plan. A trading plan with a stop would keep you from staying in a trade that is draining your account equity and should be a focal point of your trading.

When asked what mistake many novice traders make all too often, hedge funder Bruce Kovner said that, “they trade three to five times too big. They are taking 5% to 10% risks on a trade when they should be taking 1% to 2% risks…. My experience with novice traders is that the emotional burden of trading is substantial; on any given day, I could lose millions of dollars. If you personalize these losses, you can't trade.” (Emphasis mine). This quote has many nuggets of wisdom but the takeaway should be that if you can't walk away or cut a bad trade with a stop, you'll personalize losses and will continue to suffer in your trading. Therefore, when you personalize your losses, you're likely only paying lip service to stops.

NEXT PAGE: The Trick to Money Management

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What Pros Focus on When Choosing Entries & Exits
There are many effective ways to place stops but just like you shouldn't worry about where the perfect entry is, you also shouldn't worry about the perfect stop placement. A common joke in the world of trading is that the perfect stop is one pip away from the corrective high or low against your trade. Of course, if that happens, you're more likely luckier than good but, nonetheless you should understand what a stop is for and what trader's with a good track record focus on.

A Stop Should Protect Your Capital & Trigger When Price Nullifies Your Trade Idea

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Click to Enlarge

Professional traders will likely focus on the technical points where there trade idea is nullified. This means that if you're trading based on a 20-day moving average or something a little more complex like Ichimoku, you should exit when the indicator that issues a buy trade now issues a sell trade. Beyond the technical trigger to exit your trade, you should make sure that your trade size is calculated in such a way that when your stop is triggered, you've only lost a forgettable amount of your account balance so that you can easily move on to the next trade.

Without a doubt, pros look for an edge when placing a trade but they're not overly concerned with the “perfect entry” like many traders who are new to the market do. Instead, many fund managers or large banks will look for a decent edge when the fundamentals and charts combine and then they follow up that trade with a firm protective stop so that they can let the market tell them they're wrong as opposed to deciding for themselves when they're wrong.

The Trick to Money Management
The trick to money management is doing it. The sad truth of trading is that traders will pay $1,000s for a new trading system guaranteed to pin-point entries but will not pay $15 for a book on placing stops and how to define when their stop is no longer correct as per their analysis so that they should be out of the trade and wait for the picture to be clear. One trader did a great service to me in my earlier years by telling me that every trading desk on Wall Street has a risk management department but none has a Profit Forecasting Department. In other words, if you take care of the losses, the profits will take care of themselves and that is why stops are so important.

By Tyler Yell, Trading Instructor, DailyFX.com

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