Wednesday, July 25, 2012

What's in a stop?

A stop is designed to protect your capital when a position moves against you. An initial stop potentially limits your loss to a maximum of 1R (assuming there is no slippage or gap through your intended stop level). 

Adhering to an initial stop and exiting a position is an admission that your trade has not worked. From a trend following perspective, adhering to a trailing stop and exiting a position means that the trend has exhausted itself, and the stop has been set at a level consistent with the rules of a system.

I only ever get taken out of a position when my stop has been hit. I do not manually exit a position, as that overrides one of the very basic rules of trend following. You must never work to price targets and potentially restrict profits (NOTE: I do use the Uniform Risk Exit as described in my e-book, however that is used very sparingly and only when certain conditions arise, and even then, is not a complete closing of a position).

Failure to adhere to a stop may, once in a while, mean that you remain in a position which then reverses back in your intended direction. You may even end up making a profit. However, it is always preferable to adhere to your stops. Why? Failure to adhere to a stop may lead to any of the following:
  • An erosion of hard earned profits on a position;
  • A small loss becoming a bigger loss, that may cause significant damage to your equity;
  • Some people keep on holding meaning a short term trade becomes a long term investment, tieing up your capital.
I have been picked up several times on bulletin boards for being 'wrong' by exiting a position. My answer to that is:
  • One mans pull back many be another man's trend reversal - and both look the same when they start;
  • I control what I control - i.e. I control and restrict how much I can lose on one trade.

Some people think that losses only become 'real' when the position is actually closed. That is NOT how any successful trader sees it - a paper loss is a very real loss.
Remember that the name of the game is to control your losses, and to protect your capital. If you lose your capital, you cannot trade. Always concentrate on defence before offence. Profits will take care of themselves.

On a positive note, if you are using a system with positive expectancy, taking a loss means you are one trade nearer to a big winner.

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