A lot of new traders fall in to an insidious little trap. Because they hear from those who they consider better, more experienced, etc. that your stop defines your risk, they draw the conclusion that closer stops mean lower risk. Sadly, this just isn’t the case.
Are you thinking something like this right now?:
A closer stop means I lose less money if the market goes against me than a stop put further away. Smaller losses mean less risk.
If so, you are only looking at one side of the equation.
The risk you take on a trade combines not just how large a loss you might take, but also the probability of taking one. As I think we can all agree, markets very rarely move in straight lines. Then tend to wander around a bit as different forces push prices back and forth, especially as you move toward the short-term time frames.
Because of that movement, as you put your stop closer and closer to current price you increase the chances of that stop being hit. A higher likelihood of your stop getting taken out means an increased probability of taking a loss. Sure, the loss might be smaller than it would be if you put the stop further away, but you’re going to take the loss more often. At some point you reach a threshold whereby the tighter stops, because of their increased likelihood of getting hit, offset the smaller losses taken when compared to the wider stops.
As an example, let’s assume we have a market which has a 20% chance of moving 10 points and a 50% chance of moving 5 points during our trading time frame. If we do ten trades that would mean the wider stop gets hit twice, costing losses of 20 points. The tighter stop would get hit 5 times for a total of 25 points in losses.
But that’s only part of the equation. There are two other elements at work here. First, having close stops that are within the market’s normal trading range not only means more losses taken, it also means more of those awful trades where the market goes against you enough to take out your stop, then reverses and goes profitable. Having the tight stops, therefore, means you miss some potentially big winners.
That’s pretty hard to deal with. For some traders, though, losing at a high frequency is even harder. It can become significantly destabilizing to one’s trading confidence. Not good.
My own personal philosophy on the placement of stops is to put them at a point where if the market reaches them, the move I expected to unfold probably isn’t going to happen.
I never place my stops based on how much I’m willing to lose on a trade. I set my position size based on where my stop is going to be and what that implies in terms of position risk.
Does all of this sometimes mean that you take smaller positions to keep your per trade risk level? Absolutely! It’s been my experience that most traders trade too big, though, which usually means bad news at some point. Cutting back on your position size, therefore, shouldn’t be seen as a bad thing.
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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
** See John’s full bio.
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