Learning to accept the risk.
Placing stop losses is very crucial to trading. I have never come across a successful directional or short term trader, who traded without any stops. It is a very important risk management tool. There are traders who hold positions for months, or even years and they do trade without physical stops in the market, however, after speaking with them, they have confessed that they still follow the market and do have a mental stop.
By placing a stop loss, psychologically you are admitting that you believe that this could be a losing trade. It is very hard for someone to accept that, but once you accept the fact that not all trades are going to be winners and that even seasoned professionals take losses all the time, it becomes easier to accept and place a stop.
I should, however, emphasise that there should always be a strategy behind placing the stop. There are different reasons that people use and let me share some of them with you.
The mistake: No margin for volatility.
One of the common reasons why people place a stop is that they wish to make “Y” amount of profit for an “X” amount of risk. So, they place the stop loss “X” distance away from the entry point. I think it is one of the most flawed ways to place a stop. Quite often, this “X” distance is within the general volatility of that instrument, and hence the probability of that stop loss being triggered is greater than the probability of the trade being a winner. Also, an inexperienced trader would think, “had I not placed that stop, I could have had a winning trade”. Wrong, if he had not placed a stop, he could have lost all his money in case of an abnormal move.
The correct thing would be to analyse the instrument being traded, look the average volatility range, and then consider the probabilities of taking profits or making a loss and adjusting the trade size accordingly.
In the FX and CFD markets, most brokers offer good leverage, so this is where you take advantage of the leverage offered and then place the target profits and stop losses in a place that would feel comfortable with your risk appetite.
The mistake: Adjusting on the fly.
Another common mistake I have seen is that people tend to change their stop loss or even their target profits in the middle of a trade. Technically, this is sound, especially in a trending market. The mistake that the traders often make is that they do not wait for a confirmation of the trend and do not lock in the profits before implementing such a strategy. If there is any small correction in the market, often, even if the stop has been moved to guarantee a profit, the profit taken will be less than the real profit, had the goal posts not been shifted. This is also often the mistake made by traders who use trailing stops.
One of the ways to do this is to split the trade, or if your risk management allows, take 2 or more trades at the same level with the same initial stop, but with a scaled reward (takee profit). Once the first reward has been triggered and you see a trend developing or a confirmation of a trend, then adjust your stop on the balance of the trade or the second trade to at least the first reward point and then trail from there.
Most FX and CFD brokers offer a trading platforms which have these capabilities, if they don’t, then it may be time to look for one that does.
The mistake: Choosing wrong duration of positions.
I have recently noticed that there are a lot of traders, who are either following or using some strategies that have been put out in terms of using technical analysis. This is a good thing, as long as the strategy and style of trading suits you and your needs. It makes no sense to follow a trading strategy for short term intraday trading, when your personality and time available for trading support long term trading style. The common pitfall that I have noticed in terms of stop placement using the technical analysis, is that traders often place their stops directly at, or very close to support or resistance lines, for example.
What they often do not do is look at trend lines or significant numbers. If the support or resistance level is close to one of these, you need to adjust your stop accordingly and then manage your risk to reward ratios and trade size accordingly.
There is no fool proof method for placing trades. There is also no guaranteed method for profit on all markets. However, by sharing some of the common mistakes that people have made, I am hoping to explain a bit more about the importance of placing stops and how not make the same mistakes over and over again.
If you liked this article, you may want to read some of my other posts that tackle the psychological aspects of trading, or pass this article on to someone who you think would benefit from reading it.