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Tight Stops Make Me Nervous

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.

By John

Author of The Essentials of Trading

9 replies on “Tight Stops Make Me Nervous”

tight stops area greeat idea:

1- If you would have been stopped out even with a wider stop. So, if you would be stopped out with a 25 point stop, clearly it makes sense to have a 10 point stop.

2- if you are not too concerned with having a lot of losing trades

3- You are good with your entries

john – To your points:

1) If you knew you were going to be stopped out, why would you even take the trade?

2) If tight stops are lowering your win rate (more losing trades) to the point where they are adversely impacting your expectancy, that’s bad.

3) Good entries help solve a lot of trading problems. 🙂

this article misses out on a very important point.

It’s not about your stops, it’s about what risk you take on a single trade and basing your stops on that.

Ex: if you want to risk 5% on a trade, then take that 5% and divide by your stop loss. So now it doesn’t matter if you set your stop loss at 10 points or 100. you always lose 5%.

geez

syed – I wouldn’t say that the article misses that point. It just doesn’t speak to it as the focus is elsewhere. I have most definitely addressed the risk/stop discussion in other posts.

I would definitely not say “basing your stops” on your risk is the way to go, though. I think in that you misspoke, as what you said in the next line hits the mark.

amazing article. this line of thought has helped me a lot…. i always believed that tight stops were good, till you’ve managed to convince me that its not.

in your other article you mention that they not only increase the number of losers but also decrease the number of potential winners, if you place the stop withing normal ‘wiggle room’, which would necessarily happen with a tight stop loss. when i read that, it was like a light bulb going on over my head. *grin*

thanks.

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