Paradoxically, most traders,especially the ones with the “Get Rick Quick” mentality are all gung-ho about how much money they want to make, and have no considerations on how much they might lose. The stars in their eyes show all the potential profits, and never consider the potential losses if they are wrong in their trade. A lot of them spend time looking for so-called setups, or trading on tips, or asking others what to buy and when to buy, or looking for some red light/green light system that will tell them what to do, without them understanding anything about the markets. When these systems give them the light, they put a large portion of their equity into the trade, them complain if the trade does not work out, and they end up losing a large portion of their account.
Guess what folks. There is only one guarantee in trading: “As long as you trade, you are going to make trades the will lose money”. How one manages to keep trading is to ensure that the trades that fail do not wipe out the account. That means that a trader must have some discipline in how much to risk on each trade, and the discipline to get out when a trade loses money, instead of holding on, smoking hopium that the trade will eventually work out.
So how does one go about this? The first step is to decide the exact maximum amount of money that one is willing to lose on a trade, and get out unconditionally. Now, the market does not care how much you are comfortable losing, so the point here is to determine how much you are comfortable losing, then to place your stop at a logical place where if the stop is hit you will lose no more than that predetermined amount. In other words, it is not a matter of deciding how many ticks you are willing to lose, then placing your stop loss order at the corresponding price: it is a matter of only taking the trade if the logical place for your stop loss order will cause a loss of no more than you are willing to lose on a single trade.
The name of the game is: “Trade to trade well; control your losses.” Growing your equity is the result of trading with discipline. The profits do not quite take care of themselves; but, that is a mighty close way of putting it.
Calculating the Stop Loss placement
There are many complicated ways that some traders use to determine how large the amount that they will risk per trade. Such measures as the “Kelly Criterion”, various fancy Standard Deviation calculations, and other arcana. We use a much simpler method. After all, we are traders, not mathematicians. We just use the arithmetic to help us make rational decisions.
We use a very simple criterion for the maximum size of our acceptable potential loss: a fixed percentage of our equity. Let us look at an example. We shall assume the following are the values with which we are working.
- Account size: $10,000.00
- Percentage of account to risk per trade: 2%
Here is how we calculate the maximum acceptable loss if we get stopped out.
MaxTotalStopLoss = AccountSize x PercentToRisk = $10000 x 2 ÷ 100 = $200
This is our maximum acceptable loss (sans commission). Let us assume that you are trading an equity with a tick size of $5, for example /NQ. Then the maximum number of ticks that we are willing to lose on a trade is 200 ÷ 5 = 40 ticks. So if we are trading one contract, that would be the maximum number of ticks that the Stop Loss may be placed from the trade entry.
Does this mean that you must place our Stop Loss 40 ticks away, regardless the market structure, whenever we get an entry? No. This just represents the maximum distance away that you would place the stop. In other words, we would first look at where our stop should logically be placed, given how the market swings have developed, or how we determine the support area (assume that we are trying to enter a long trade). If that logical place for the Stop Loss order is further than 40 ticks away (for one contract), then it means that if the stop order were to be hit, the loss would be more than 40 ticks, so the trade should not be taken. On the other hand, if the logical place to put the Stop Loss order were to be (say) 25 ticks away, then we would place the Stop Loss there, as 25 ticks is less than 40 ticks, so if the Stop order were hit, we would have a smaller loss than we are willing to tolerate. That is a good thing.
Of course if we traded more than 1 contract, then we would have to still ensure that our total maximum loss for the trade would be 40 ticks. So for example, if trading 2 contracts, then the maximum allowable distance to place the Stop Loss would be 20 ticks (40 ticks ÷ 2).
Notice that we are simply showing how to calculate the maximum distance for the Stop Loss order placement. Whether one should be trading 2 contracts with a $10,000 account is an entirely different matter. If you must ask us, we think that that is definitely a bad amount of over-leverage, but that is really not our call to make.
Stopping the Bleeding
As traders (especially for Day Traders), we must have rules which we use to determine on any given day, that any more trading that day is throwing good money after bad; meaning that it is better to quit and wait for another day when the market is willing to cooperate with our methods. If the market is not cooperating with what we are doing, we take our ball and go home.
How do we do this? We use our trading journal. You have one, do you not?
- We go back over a large number of our recent trades.
- We record all our worst days.
- We examine them, with the following factors in mind and get some hard numbers.
- After how many consecutive losing trades, would we have been better off quitting, because in almost all instances of our worst days, the losses only got bigger? We record that number.
- On the winning days that turned into bad losing days, we determine the total number of losing trades on that day, after which we would have been off quitting, because in almost all instances of our worst days, the losses only got bigger? Note that this is not the same criterion as the first one above. This is regarding those days that were at some point a winning day because the first criterion of consecutive trades had not been met. Days which then turned into losing days. We record that number.
- For all days, we determine the amount of loss, regardless of how many profitable or losing trades occurred, where we have been better off quitting, because in almost all instances of our worst days, the losses only got bigger? We record that number.
These 3 numbers constitute our “Quit Trading Rules”. If any of them are hit, we must quit trading for that day, without fail. The trader should never hope that this day will be different, and so continue trading. Even if that day really turns out to be different, it will just encourage the trader to break the rules next time, and many more times after that. One will then discover, that that one different day has seduced one into giving the market many many more days to fleece one.
Are you following such a plan? Do you have a plan? Let us know in the comments. Good trading to you; may all your trades be winners.