Stake Sizing and Capital Protection

The areas which seem to give beginners and even at times the old hands most difficulty are stake sizing and capital protection.

The following is a link to a very good guide. The 3% Rule.

Entering a trade is the easiest part of trading.
Entering a trade at the right time with an appropiate stake level and a clear exit plan is a little harder.
Exiting a trade when the stop has been hit is the test of a trader and quickly sorts out the wannabe’s and the traders.

Setting and using a Stop loss

A stop loss is probably the single most important part of successful trading. Planning the exit for a failed trade and then executing the plan is a test of your trading character. It is far better to take a series of small losses and for these to have a very limited effect on your trading capital than to take one large loss which could have a significant effect on your capital.

A situation many traders find themselves in at some time is illustrated here. You have taken a view and waited for your entry and you are now in the trade. The market now goes against you and hits or passes through your stop loss. Now, unless you put in a stop when you opened the trade, you have a decision to make. Do you take the stop and close the position? Do you give it a little more time? Do you add to the position as the price is now significantly better? My own experience as a beginner was probably typical, I would give it a little more and then add to the position. Sometimes this would work and often it would not.

The problem with not taking stops or not even having a stop planned is that the one failed trade will often turn into a serious loss. The difficulty we have with taking a stop loss is that we are striving for success in all we do. We are conditioned and trained from school upwards to get it right. A failed trade is a failure whichever way we look at it and we don’t want to fail. When trading it can help to think in terms of sports. The aim is to win the game. Whilst it would be nice to get a goal, hit a home run, hit a six or get a treble twenty every time we kick the ball, swing the bat or throw the dart we know before we start that this is very unlikely. What we are trying to do is win the game and that includes all the missed opportunities, missed kicks etc. They are part of the game.

Let’s look at a typical poor discipline trade and the possible outcomes. For the purpose of this exercise the instrument traded and the value of the instrument are not important.

Example

Buy Dow Cash at 16,900 for £1 per point when actual at 16,900 with a planned 50 point stop loss.
Actual now falls to 16,850 and SB quote is 16845-16846. Don’t take the stop as price poor.
Actual continues to fall and add with a buy at 16,830.
Actual continues to fall and gets to 16,780 with a quote of 16,779/16,781. We are now sitting on a 121 point loss on the first trade and a 51 point loss on the second trade.
Actual continues to fall and we now either have to get out with far bigger loss than originally planned or let it run and hope it recovers to a point where the loss is acceptable or add again so that if it does recover we can get out a little earlier.

The ugly part of this is that we have quickly ended up the wrong side of the market with a stake which is at least twice the size we would usually use and the loss is heading for more than three times the planned loss.

We are now in the traders nightmare zone. We don’t want to stop or get out because it must/will turn around now or very shortly (we hope). If it is going to turn around then we should not stop and we should be adding, shouldn’t we?

There are now two outcomes we will consider. The first is that you take a loss either by closing the position yourself or the position expires and you realize a loss which is far bigger than any you had originally planned. The second is that the wished for turnaround actually happens and you manage to get out with a reduced loss or possibly at breakeven. It is unlikely that you will actually make a profit as you will usually be so pleased to have got out at breakeven that letting it run and making money from it is not likely. The other thing you will notice from these breakeven trades is that the price you eventually get out at is usually still outside your original stop loss zone. You could have taken the original stop and not had the increased exposure of the additional trades and been no worse off for the original trade.

From my own experience the most likely outcome is that the position will expire at a loss and that this loss will be significantly higher than any planned loss.

If we had taken the planned loss (even if the price was poor) we would have been able to absorb this in the day’s trading. Being a goal or two down is not the end of the game that we are trying to win. Putting everything into the attack when the other side has the ball just gives them goals. First you have to stop them, then you have to get the ball and only then can you attack and try to score.

The other thing we have done in this example is spent a good part of our trading day and mental effort trying to manage a poor trade. This time and effort would have been far better spent trading the market which we could have done had we got out of the first trade.

Occasionally you will take a stop loss and the market will turn and go the way you originally anticipated and traded. This happens, it is part of trading. Move on and trade what it is doing now.

You can probably take your stop ten times in a row and still be better off than if you had ignored it once and added to the position and it had continued against you.

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