This special stop loss will halt losing runs in their tracks

Most traders are well-trained enough to use a stop loss when they trade. It’s what we’re taught in trading kindergarten – always place a stop loss to protect ourselves.

But there’s another type of stop that will not only protect our capital, but will also increase our profitability … yet very few traders use this kind of stop …

It’s not difficult to apply. And if you’re not using one, it’s simple to add to any trading strategy …

The bad news about normal stop losses is that they generally cost us money.

Don’t get me wrong – I’m not saying we shouldn’t use them. But if we had deep enough pockets to wait for markets to turn around, we’d be better off without them. In tests, the tighter the stop, the worse it is for our profits. But, as most of us have limited funds, we can’t afford to sit on huge drawdowns, waiting for our trades to come good.

If it didn’t wipe out our trading accounts, it would certainly have a negative effect on the health of our hearts.

So, we use stop losses to keep us out of trouble.

See them as a necessary evil – like paying out money on an insurance policy.

But that’s not the kind of stop loss that I want to talk about today.

Instead, I’d like to talk about a stop level that boosts our profitability.

It keeps us safer, and it makes us more money – that’s the kind of insurance policy I like!

The kind of stop loss I want to look at is setting a maximum loss, or drawdown.

‘Drawdown’ is a thing that traders don’t like to dwell on. Drawdowns make us sweat under the collar … they make us doubt our trading strategies … and they often lead us to make knee-jerk poor trading decisions …

A lot of the reasons behind these ‘bad’ behaviours are that we just don’t plan for our drawdowns.

Instead, we stick our fingers in our ears and pretend they won’t happen to us.

Here I’ll lay out how to set a simple stop limit that can stop drawdowns in their tracks, so you’ll know exactly what to do when that panic of ‘yet another’ losing trade sets in …

How to set a drawdown limit

All traders have different pain thresholds and approaches to risk, so all will take a slightly different approach here … but the premise is still the same … we’re going to halt losses before they get severe.

Here’s an example of how I’ve used drawdown limits in my own trading …

If I have a system that makes either 2% profit or 2% loss per trade, and I find myself 6% down, I’ll stop trading.

The result is that the maximum I can lose in a day is 6% (roughly – it can sometimes be more if I’ve a number of trades on at the same time). While my maximum gain in a day is unlimited.

I’ve naturally swung the odds in my favour.

And the only effort it’s required is to trade less.

I ran a split test of this on my trading a couple of years ago, and over the space of six months, by applying the drawdown limit, I boosted profits from 57% to 98%.

A daily 6% limit isn’t suitable for all traders, or for all trading strategies. You may find that a weekly or monthly drawdown limit is more suitable … of a combination of limits: X% limit on a day; X% limit on a week; X% limit on a month.

So, what do we do when our limit is hit?

This part can be surprisingly tough …

What traders naturally do when hit with a drawdown is one of the following …

… stake bigger to win their money back
… adjust their trading strategy so that the most recent trades would have won
… stop trading altogether
… look for someone to blame

Here’s what we need to do … STOP trading (or, even better, revert to demo trading, so you can still monitor results).

When we’re in drawdown, we’re generally eager to make that money back, so we’re reluctant to walk away from the table. But that’s exactly what we need to do.

I’ve often found that there are just bad days in the markets. If you’ve taken a number of losses already, chances are that markets just aren’t fitting in with the theory behind your trading strategy, so you’re safest sitting out.

If you come back the next day … or next week … you’ll have a better chance of making that money back, rather than throwing good after bad.

By building this discipline into your trading routine, you can halt painful drawdowns, where you’re left with a mountain to climb just to get back to your last high-water mark.

A drawdown of 50% requires a profit of 100% just to get back to where you’d started at – so it’s important to put these kinds of measures into place.

Putting it into action

Many traders struggle with the idea of a drawdown limit – it can feel counter-intuitive to stop trading, just at the point where you most need to make money.

Plus, we’re told to ‘hold our nerve’ … to ‘not jump ship after a few losers’ …

… and it’s true that if we give up on a trading strategy every time it gets a run of losses, and jump back in every time there’s been a run of winners, we’ll increase our chances of missing every winning run, and catching every losing run.

But that’s not what we’re doing with a drawdown limit.

We’re not waiting until after a pullback has happened to get back in. Instead, we’re just limiting losses in bad times.

Plus, there are psychological benefits …

All strategies have drawdowns, but if you’re not prepared for them, you’re likely to get demoralized, wiped out completely and give up on trading.

But if know where the sandbags are … and when to bring them out … you’ll be able to weather the storm.

If you’re not convinced, then I suggest that you take a look through some of your trading records to see how adding a drawdown limit would have affected them.

I think you’ll be pleasantly surprised.

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