Risk Exposure, Money Management and Stops

Now that we know the trading basics, we need to address the key issue of Risk Exposure. Simply what Risk Exposure is, i.e. what is the amount of your margin/deposit that you are prepared to risk. The spread betting providers give you various tools that allow you to limit your losses and lock in your gains (profits). The main ones are listed below along with their use.

 

Leverage: A Double-Edged Sword

I am devoting a short chapter on the question of stops, since it is crucial to whether you are successful or not in your trading. It is one of the most important factors! I want to make one thing as clear as I can:

Learning to control risk is equally, if not more, important than learning how to make profits. There is no system, methodology, tip, strategy, or anything which can 100% guarantee that a market will go in one direction or the other, despite your best efforts at convincing yourself otherwise! Market Forecasting is about probabilities. That means that we must acknowledge that we will be wrong some of the time. Just so long that we ensure our winners outstrip our losers, we will be net winners. That is our goal.

Knowing when to exit a trade is a key to making a fortune is this business. If you don’t know when to take profits, you can end up losing everything you make and more. Even more important than taking profits is understanding how to control your losses. I will teach you some powerful techniques to do this.

Our trading guide will teach you how to limit your risk to a level that is within your own comfort zone and detail several techniques available to you.

Risk Management and Technical Analysis in Markets

Regular Stop Losses

To help us maximise our winners and minimise our losers, we use stops. It’s as simple as that. If you are stopped out of a promising trade, you always have the option of getting back in (although emotionally, that is difficult for many traders). Let’s have a look at how we use them:

These operate in a similar way to guaranteed stops except they are not guaranteed. Usually, the spread betting company would be able to close a bet at the pre-arranged stop-loss level, but occasionally it might not be possible.

  • This could happen if there was a big shift in the underlying market outside the trading hours of the bookmaker;
  • Or if during normal trading hours the underlying market suddenly “gapped” to a much higher or lower level.

The disadvantage with stop-loss levels over guaranteed stops is that there remains an outside chance that you might lose more than your stop-loss level implied. The real advantage with stop-loss levels over guaranteed stops is that they are free – they do not involve paying some two or three-point penalty on the spread.

Effective use of stop losses is a very important part of being an effective and profitable trader. Later in this guide we will discuss where to place stops to provide you with the greatest chance of success when trading financial markets.

Stop Loss Mechanics

A stop loss does exactly what it says. It’s a price point where you want to signal a close on the trade. For instance let’s say that we have opened a LONG trade on the FTSE100 (March) @ 4000 at £10 per point. Now we don’t want to risk too much and we know that the FTSE isn’t highly volatile, so we place the Stop Loss at 3950. Which would mean we would be Risking a maximum of £500.

Before you start panicking and shouting at the monitor saying you don’t have that kind of money. I am just using the £10 trade as an example. It can be anything from 1p to £500 per point, depending on your financial position.

What happens now with the Stop Loss is should the price fall to 3950 you would be what is called ‘Stopped Out’ and the trade is closed for you. You are not given any warning, it is up to you to watch the market and decide to leave the Stop Loss in place or reduce your exposure amount e.g.: increasing the number from 3950.

Very few people actually use ‘Stop Losses’ properly. Here is how some people use ‘Stop Losses’ and wonder why they keep getting ‘Stopped Out’ all the time. They place their trade and put a stop just a few points below their opening price. The trade amount they opened is quite high and therefore risks a considerable amount of their margin on deposit with the spread betting company. Therefore to reduce their Risk Exposure, they have a limited Stop Loss. This is a common and tragic mistake, regardless of the market that is being traded.

Markets fluctuate all the time. They don’t stay static and go up or down. Even none volatile Indices such as the FTSE fluctuate. What happens when you place a Stop Loss too close to your initial opening price is that you will get “Stopped Out” very quickly, and lose money as a result. This is what is known as ‘Death by 1000 Stops’ as what usually happens is the trade is reopened and the same shallow Stop Loss placed again, to which in a few hours the trader has lost by being “Stopped Out”.

The sensible method is to first look at the chart for the previous week and check to see how much it fluctuates – my rule of thumb if I am unsure is to look at a Daily chart broken down into 15 minute intervals for a day, followed by a broader hourly chart covering 1 week. We’re not looking at the massive trends just the general movement of the stock. By analyzing the chart we can then see where our stops should be placed, relative to the trade we opened, we will go into this more in depth later. The other thing is if your trade is a high trade e.g.: £10 and you can’t afford to go beyond 50 point Stop Loss, then simply reduce your trade. It’s much better to have a more flexible Stop Loss and a lower trade, than a high trade and a small Stop Loss.

Remember, there are several things to do if you are unsure as to how volatile the market is you’re trading. First look at a 15 minute chart that covers first of all a day, then an hourly chart that covers the week. This way you can spot the basic validity and where to place your Stop Loss. Most charting packages and online charts allow you to draw lines that allow you to gauge where the highs and lows of basic validity are.

Since first writing these modules the Financial Services Authority in the United Kingdom have advised that many spread betting providers automatically place a stop loss when you open a trade. This has some advantages, in that should you forget to put in a stop, you are automatically protected. However, with these types of accounts, sometime there is little flexibility in moving the stop loss.

For example on some UK trades the point movement isn’t as wide as it is with some US trades. However, to lock in profit with UK trades on an account where the stop is automatically added, you have to wait until the stock has moved a considerable amount before you can move your stop in and lock in profit.

It is worth shopping around the spread betting companies that are available, as there are many of them now. More so than when I first started writing these modules a couple of years ago. Maybe it’s because there is never such a thing as a poor bookmaker. This does make things better for everyone, in that as the market has really started to mature, more and more products have become available for us to trade and the more there are means the more chance we have to profit. Plus with the added competition of all the other bookmakers around, we get lower spreads. So, look around before opening an account. Ideally you don’t want an account that has very little flexibility in moving the stops and has large spreads.

For instance, beware of some of the lower end spread betting companies that allow you to trade pennies rather than pounds to begin with, these are the ones that are focusing on the beginner – so be careful, they have very large spreads. Remember the spread costs you money.

Locking In Profit – with a Stop Loss!

Sadly this is a technique that few traders use. Not exactly sure why, but there may be a misconception that once a Stop Loss is made it can’t be changed. Which is nonsense and one of the key areas of locking in profit in a trade. What does locking in profit mean? Let’s say we have the same trade as before, but instead the market goes in our favour past our original opening price and because it was a LONG trade we are now in a profit position.

All we do is either call the spread betting company or even better go to the website and change the Stop Loss so that the stop is actually higher (because we went long) then our opening price. This therefore guarantees the profit we have locked into that point.

Opened at 4000 Long on the FTSE100 @ £10 Trade. We set the first SL at 3950. Our risk is £500. The FTSE100 goes up to 4100 in a couple of days. We have been wise and have gradually throughout this time increased the SL from 3950 to 4050, locking in a £500 profit.

You can use the same principle for going SHORT also. You just have to think in reverse. You set your stop HIGHER than your opening price and lock in your profit (when it’s there) by going lower than your opening trade price.

Locking in profit is paramount to your money management when Financial Spread Betting. Always look for chances to lock in profit, it is one of your keys to success in Financial Spread Betting.

We have covered the Stop Loss, but one of the things you must be aware using a Stop Loss is the following:

The markets move incredibly quickly and if there is a rush on any share, or indices or whatever it is, sometimes a panic is started. This panic good or bad can send your trade soaring upward or plummeting downwards. Using a stop loss will protect you to some degree when the market is flighty. Let’s say we have traded the FTSE100 and for some obscure reason the market crashes badly – a rare thing for an Indices to crash, but not that uncommon should you say be trading in highly volatile trades in Tech Stocks etc, that can plummet or soar very quickly indeed. For this example though, we will be using the FTSE100 as that is our ‘de facto’ trade for this course.

So we opened a trade on the FTSE100 at 4000 going LONG @ £10 per point. Something terrible happens which results in the FTSE crashing and within minutes it starts to plummet.

Of course we were sensible and when we opened the trade on the FTSE we also put in place a stop loss order at 3950. Now the stop loss will kick in as soon as it can, but and this is something you should take note of, you are not guaranteed that your trade will be closed at 3950. Normally they are traded close to that amount give or take a few points, simply because the market has moved and it takes a few minutes for the system to acknowledge the stop loss – believe me a few minutes is as quick as we could ever hope. However, if like in our example the trade is falling like a stone by tens of points a second, by the time our stop loss has been actioned (at 3950) but confirmed (39??) the trade could have dropped much, much further. Resulting in an even greater loss of what we had first expected. Which would be our expected loss of £500 plus whatever amount the trade had fallen between the few minutes it takes to acknowledge the closing order.

I am not saying this to freak you out, or to worry you in any way. I have never had any bad surprises like the above. Of course I have had a stop loss actioned and lost a few extra pounds than I had hoped, but nothing to warrant panic of any kind.

I have given you the above example so that you know what can or could happen if there was a massive swing in the trade. Don’t get too preoccupied with the above though as most trades will close very near your stop loss, and if you stick to the more secure trades (any FTSE/Dow Stock or Indices) you won’t have to worry too much. If on the other hand, you decide to venture into the more volatile and potentially higher reward areas of Financial Spread Betting (Tech Stocks etc.) then I would strongly suggest you use the following order on all your ‘high risk’ trades.

But always be mindful of moving in the stop too close to the current market value of that trade. This can get you stopped out very quickly indeed. Look at the 15 minute data of that stock over 1 day, the chart you should use for this should be not be a third party software programme – no! You should use the spread betting company’s own chart for this. It shows you the data they are using. Look using Candlesticks (more about those later), and you will see where the stock is bursting up or down. You should aim to be outside of these limits over that day on your stop loss to protect yourself from being stopped out. It’s best to use this technique when moving your stop and will limit the amount of times that you do get stopped out.

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