Guest post by Shane Daly, who is a Forex Analyst and Trading Coach at NetPicks, leading day trading systems developer since 1996. For more educational articles, webinars, videos, interviews and more, visit http://netpicks.com/trading-tips.
One thing that traders have control over once in a trade is where to get out. At any time, you can quickly hit “close position” and all your risk will be taken out of the market and if the trade was in your favour, you bank your profits. A very simple concept.
What isn’t very simple for many people is stop placement. This is not just about finding a technical level or X amount behind your entry but the effect that stop is going to have on your overall profitability. Many traders optimize their systems in an attempt to find the perfect entry point while having a tight but reasonable stop. For those traders that based position sizing on %, this makes sense.
Example:
Account size: $1000 account.
Risk: 2% of account ($20.00)
Stop required: 20 pips
Per pip amount: $1.00
The trader in the above example is going to risk 2% of account size and needs a 20 pip risk. This trader is prepared to lose MAX $20.00 which will allow a position size equalling $1.00 per pip (generally one mini contract). As you can see, the stop placement using a % model has a direct influence on position sizing. A smaller stop equals a greater risk/reward.
Trader A. 100 pips profit using a 50 pip stop = 2:1 reward to risk
Trader B. 100 pips profit using a 20 pip stop = 4:1 reward to risk
Trader C. 100 pips profit using a 10 pip stop=10:1 reward to risk
All things being the same including risk % which trader will experience the greater return? Obviously Trader C who gets a staggering 10:1 reward to risk ratio. The main drawback this trader will face is that when using such a tight stop, you don’t allow for the waves in the market. This trader, although a great r/r ratio, may still have to contend with numerous stop outs of their positions which will certainly drive down their win rate and also their stamina to remain the trading field.
Trader A will make lower profits on the trade but will have a greater win rate for the simple fact that their stop may be right out of the way of the typical swing in the market. This trader is probably going for more of a swing move. A day trader, who looks to take advantage of smaller blips in the market on an intraday basis, probably would not want to utilize such a large stop. Unless they are trading a fair sized account, they can’t expect windfall profits using a position approach based on % of stop.
You can see that r/r has a direct impact on the money you can make. If you want to utilize a big stop, you should be looking for a bigger move. How big? Depends on how high you want your reward to risk.
If you are a fan of using bigger stops, make sure you consider your reward to risk. If you want to use a 100 pip stop make sure you are looking for, at least, 300 pips of profit so you can make some money on this trade. As well, with this size of stop and you are tradking in the direction of overall sentiment, you have a greater chance of staying alive in this trade which will increase you win/loss ratio AND help fight that “need to win” urge we all suffer through.
Here is how this trade plays out using the same account information as above.
.20 per pip (2 micro contracts)
Max loss equals $20
Win equals $60
There are some key points to remember. Don’t overtrade looking for these big moves especially on a weekly basis. The time this post is being written, last week saw the GBPUSD only have a high to low range of about 240 pips. The volatility of the market is a key issue when looking to grab these larger moves. You can’t mechanically just place these types of trades looking for these moves with the same stops. You do have to have some idea of sentiment of the market and current and pending volatility.
If you are a day trader thinking of utilizing a large stop for tiny profits, think again. If you are using a 100 pip stop and looking for 20 pip profits, you are setting yourself up for a wipe out when the inevitable happens and that 100 pip stop gets hit. Notorious for these large stop/small profits are the expert advisors that pry on the lack of trading education of people looking for a quick fix.
My favourite play when looking for larger moves is to gear down to a smaller time frame to look for a better entry. With a lower entry while looking for a long plan I get the benefit of the bigger move potential and also the smaller position size. This takes a bit of study and the confidence of my market analysis. It does give me the best of both worlds by having a larger stop outside of the normal ebb and flow of the market (tightened up on the lower timeframes) and the potential to have a nice move unfold and being along for the ride without a premature stop out.
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