Set a Protective Stop on Every Trade

04/08/2010 12:01 am EST

Focus: STRATEGIES

After having identified your entry on a new trade, the next step should always be to identify the price level for your protective stop.

The difference between your entry and your protective stop level is your risk and represents what you are willing to lose on the trade. There is really only one guarantee in trading, and that is if you trade, you will have losing trades. How you manage those losses will have as much to do with your success or failure as a trader as any other factor. Too many new traders use what they call a “mental stop.” They have a price level in mind where they would consider getting out if the market moves against them, but do not enter it into the trading platform. 

Typically, when the market does move to that price, instead of exiting, they wait and see how the market will react. If the loss becomes larger, they then decide that they will exit when the market moves back to their original mental stop level. As the market continues to move against them, intentions about getting out turn to hope about the market coming back before they get a margin call. Many times, it is that margin call that determines their exit, not their own analysis. 

Sound familiar? I hope not, but this happens more than it needs to in the world of trading. You can avoid this by simply placing a protective stop in the market with your entry, which means you have identified and limited your loss to an amount that you have determined to be acceptable. For instance, as the chart below shows, you could sell on a move down through the previous low and place your protective buy stop above the high before the low.

chart
Click to Enlarge

A losing trade does not mean that the trader does not know how to trade, and it is not something one can avoid by not using protective stops. We should instead limit those losses with the use of a protective stop. This way we can make sure we have protected our account balance with enough funds to take advantage of the next trading opportunity. We should judge our success by the results of a series of trades, not just one trade. Without identifying our risk and using a protective stop, we risk not having the funds to be around long enough to take advantage of a series of trading opportunities. By using a protective stop in every trade, we can help to keep this from happening.

By Thomas Long of DailyFX.com

DailyFX provides forex news on the economic reports and political events that influence the currency market.

Related Articles on STRATEGIES