Many traders spend the majority of their time perfecting their entry-picking skills without realizing that choosing an entry is just one aspect of a good method. Setting Stop-Loss and Profit Taking orders are equally, and sometimes even more important, than knowing how to enter a trade. The following 7 points will help you understand why a professional and thought out Stop-Loss and Profit Taking strategy can make a huge difference in your trading and how it can potentially improve your current approach.
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Choose your stop before your choose your Profit Taking
Most traders set their stops and targets in the complete opposite way of how it should be done.
First, you should define the stop loss level and identify a price level where your trade idea is proven wrong. Do not pick a stop loss level based on the profit potential and the reward to risk ratio you want to achieve.
After you know where your stop goes, look for a reasonable profit level. The price for your Profit Taking level has to be based on chart analysis and not based on how much money you want to make. This goes against all professional trading principles.
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You only can manage the downside of your trades
Traders often set their take profit orders too optimistic and so create an illusion of a positive expectancy. In reality, when you exit your trades ahead of your Profit Taking order, you reduce the expectancy and you can even turn a potentially good trade into a “bad” one by exiting too early.
When entering a trade, always focus on the downside first. The risk is the only thing that can be managed about a trade. Profits are always uncertain.
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The same stop with a fixed amount of points should be avoided
Fixed stop loss strategies are popular because they make the thought and decision-making process much easier. However, as we have mentioned in the last article, different markets have unique characteristics and volatility and momentum can vary significantly.
Using the same stop size on all of your trades, across different markets has to be avoided because it neglects the changing nature of financial markets.
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You can’t size your position without a stop
The (mis)beliefs around trading without a stop loss are widespread and they can be very dangerous for traders and their trading accounts. Using a stop loss is important for a variety of reasons – from protecting you against larger losses to avoiding the damage of emotional capital, to position sizing and risk management.
Without a stop loss, adequate and precise position sizing is impossible. The position size is always based on the distance of your stop loss order and the number of futures contracts you hold. Without knowing the stop distance, you have no control over you position size. And even using a “mental” stop loss is not good enough because executing your mental stop just a few moments too late will ruin your risk management.
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A large reward to risk ratio does not justify a bad trade
Often, traders enter a trade they know they shouldn’t take because it not completely fits their trading rules. Then, such traders arbitrarily set their stop loss closer and/or their Profit Taking further away to get a larger reward to risk ratio.
A bad trade does not suddenly become a good one by manipulating the reward to risk ratio. Professional trading is all about developing good habits and adhering to your trading rules and knowing when not to trade is a key attribute of professional trading.
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The pros and cons of a floating Profit Taking
A floating Profit Taking strategy describes an approach where the trader does not place a hard take profit order, but uses a trailing stop loss and just lets his trade run while trailing the stop behind current price.
A floating Profit Taking strategy can be good when it comes to catching large moves in a trending environment because it does not cap the trades’ profit potentials.
On the other hand, it can have negative impacts on a trader’s performance during range environments. Secondly, it does not allow you to define the reward to risk ratio and, thus, does not say anything about the potential expectancy of a trade. And finally, without a sophisticated trailing stop methodology, traders run the risk of gambling with their unrealized profits.
Having a fixed Profit Taking order, or a minimum take profit threshold can help deal with the disadvantages of the floating take profit method.
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Is your stop level an “amateur level”?
An amateur stop loss level is a level that is “too obvious”. Famous examples are placing the stop loss just below and above a very obvious support/resistance levels, choosing a round number, using the famous moving averages or using obvious candlestick patterns as stop levels.
Professionals are very good at spotting price levels where the majority of traders place their stops and it is then easy for them to squeeze amateurs and trap their stops.
It is advisable to at least get 2 or 3 barriers (support/resistance levels, other technical concepts or price action) between your entry and your stop loss AND add a bit of padding. Often, this means that your stop will be further away, but it also means that it is potentially harder to target by short-term stop squeezes.
There is a substantial risk of loss in futures trading. Past performance is not indicative of future results. The placement of contingent orders by you or broker, or trading advisor, such as a “stop-loss” or “stop-limit” order, will not necessarily limit your losses to the intended amounts, since market conditions may make it impossible to execute such orders.
