Where to place your stop loss

As a father of three, I’ve developed a theory that children are like gasses. I’m not talking about the noxious smell in a teenager’s bedroom, but that children (whether you have one or ten of them) will expand to fill available space.

Whether it’s the floor space in their bedroom, or the amount of time I have ‘free’ on a weekend to drive them around. It’s always filled.

I’m starting to notice this phenomenon in more and more areas of my life, including my trading.

I’ve long banged on about the importance of giving our trades room to ‘breathe’ …

But how much breathing space do they really need? Are they just sucking all the oxygen out of our investments?

Are you making this ‘breathing space’ error?

I expect you’ll recognize the scenario …

I’ve placed a trade. Put my stop a nice, sensible distance away, so there’s space for some market ‘wobbles’ on the way to my profit target …

The price immediately starts moving the wrong way.

I watch as it runs about halfway to my stop loss. I’m tempted to cut and run, but I’ve been taught to give my trades room to breathe … and I may yet be proved right.

When I check back a little later, my stop has been hit, and I’ve taken a loss on my account.

It’s a situation that’s SO familiar to most traders, that I can’t help thinking there must be a better way.

Your best friend, and your worst enemy

All hypothetical trading tests show, with 100% certainty, that trading with stop losses makes us poorer.

The tighter your stop, the greater the negative effect it has on your profits, but even a wide stop will cost you money.

Of course, to trade without a stop loss altogether, you’d need unlimited funds. The ‘perfect’ trading strategy would look something like this …

• unlimited funds
• no stop level
• take profits as soon as the trade moves into profit

(It’s the polar opposite of cutting losses and letting profits run!)

But this isn’t a feasible trading plan, even for someone with deep pockets. However, it’s a truth that by trading with the widest stop you can afford, you can improve your chances of success.

BUT, there’s a fundamental problem with this

Wide stops may make us richer in the long term, but they can give hugely volatile returns, leaving us out of pocket for lengthy periods.

It’s a very uncomfortable way to trade, and makes keeping discipline really tough.

It’s easy if you’re doing hypothetical trading, on a spreadsheet that runs for two decades …

But us ordinary mortals need to look for something that will give us a steadier return. And this is where the stop loss is our friend.

Let’s get back to those all-too-familiar trades that seem to go wrong from the word go.

Those ones we insist on watching them for hours as they continue to lose us money.

Of course, occasionally, they do come back and go into profit – and these occasions are all the proof most of us need to know ‘that we were right all along’!

Well done, we held our nerve!

But what about all those losses when they never came back?

I’m making the radical (for me) suggestion here that we may be trading with stops that are too wide or simply leaving losses open for too long. If you think that might be the case, ask yourself these questions …

1. Why did you choose that stop level? Is it based on support/resistance levels? Or how far the market usually moves in that time period? If, for example, you believed the price was going to go up over the next 24 hours, are you prepared to let the price meander downwards for an entire day’s range before you accept you were wrong?

2. If the price has moved halfway to your stop, how do you feel about that initial trade? Would you still get into it at this price? If you’ve no longer got confidence in the particular signal that got you into that position, should you still be in the trade?

So, what are our options?

A simple solution would be to consider reducing our stop distances. This definitely isn’t something I’d rush in to. As I pointed out before, a tighter stop WILL cost you money in the (very) long term. But volatile returns are also expensive (check out these stats to see how much volatile returns cost us over smooth ones), as well as stressful.

Another option is to give our trades a time limit to move into profit. If they aren’t pulling their weight by that time, then we cut losses quickly.

I’m currently running tests on a couple of my medium-term trading methods, looking at much more radical cutting of losses. I’ll let you know how it goes …

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