Any time I see someone comment on a blog or in a forum, or hear someone say, that they use tight stops and/or recommend doing so I get nervous. Of course “tight” is a relative and nebulous term, but the implication to me is very close to their trade entry price. That’s what puts me on edge.
You might be wondering why. It’s for a good reason, I assure you. 🙂
Unfortunately, many traders (especially new ones) equate tight stops to low risk. That would seem to make sense, right? If my stop is close to my entry point I stand to lose less money if the market goes against me. That sounds like a good thing.
Here’s the rub. The closer you put your stop to where the current market price is, the more likely that stop is to get hit. Put it too close and you are almost guaranteed to get stopped out due to normal market volatility.
Your risk is a combination of the expectancy of the trade and how large it is. When you move your stop closer to the market you lower the expectancy of your trade. If you do it repeatedly, you basically assure yourself of not seeing the type of performance you expect to see from your trading system/method.
Of course it’s all a trade-off. You need to identify the stop level which is at the point where normal volatility during your proposed holding period isn’t likely to trigger your stop, but not so far away that you lose unnecessary points on a position that’s clearly going against you. That’s why it’s important that you keep that term “volatility” in mind. It’s the key to all this. Fixed stops will almost never be the best solution because volatility changes over time. As such the placement of your stops relative to where you enter a trade will necessarily vary.
So when you hear someone talk about tight stops or see them talked about on a forum be aware of all this. In some cases the speaker/writer won’t really be putting their stops too close – they just use the term. In other cases they do. Try to find out which one is true.