The Stop Loss is Supreme

Trying to predict the market is a fundamental tendency, which most traders or investors do. Trying to predict the market.

Caution is always the name of the game. The stop loss is supreme. As everyone knows, the market does not move in a straight line. It moves in waves. If you do find a financial instrument moving in a straight line, either up or down, you can be sure that is manipulated.

Using Stop Losses

Unless you are totally committed to watching the market while it is open, you should always set stop losses every time you trade, and these can be written down or placed with your broker. Later in this module we’ll discuss the types of orders that you can use, and this includes stop losses and trailing stops. Some traders are very nervous of placing open stop loss orders ‘in the market’ because of a phenomenon called ‘stoploss hunting’, which is where a big investor such as a finance house may create price movements that force your position to be closed automatically before the price continues in the direction you had forecast. This can happen with certain securities, where you can see the pending orders on a Level II screen.

If appropriate, the advantages of stoploss orders which don’t require you to be watching each security all the time will normally outweigh the chance of market manipulation. The need to have stoplosses in the market depends on the style of trading that you want to do, as in some strategies the intraday fluctuations are ignored, and the decision whether to close the position to cut losses is based on the end of day closing price. As long as you are checking your positions every night, in this case an automatic stoploss isn’t needed.

Risk v. Reward

When you first hear that even good traders may only take winning positions half the time, you may wonder how they are successful. The secret is in the risk versus reward ratio of the trades they take. This simply means that when they have a winning position, they stand to profit a lot more than the amount they would have lost with a losing position. By taking bigger profits than the losses you suffer, you will make money.

When you first consider a trade you must use technical analysis to determine how much profit you think it will make. You then take the other stance, and figure out what price it will have to fall to for you to know it’s not working out, and liquidate your position – what is your planned stoploss level? Many traders will aim for at least a 3 to 1 reward to risk ratio. So you look for a profit level three times as high as the possible level of loss. If you don’t stand to gain that much, then it’s probably not worth trading and taking the risk. Your primary goal should always be preservation of your account, and if you then take favorable trades your money will grow.

A Simple Ratio For Spread Betting

An important part of financial spread betting is managing the inevitable individual trading losses that will occur. Money management discipline has been pounded home in every trading book and seminar by every guru or market wizard. The mantra goes: manage your losses and the wins will take care of themselves.

But we don’t learn at the most cellular level from books or seminars. We learn from real world experience. All the trading books in the world will not mean a thing until we have felt the pain of losing valuable trading capital. Only when it hurts can we truly appreciate what good money management is all about.

From my own experience, when I have been knee deep in losing positions the last thing I am capable of is making rational decisions based on book knowledge. Individual trading losses play havoc with the emotions of traders and all too often speculators lose their focus.

Spread betting uses leverage and leverage creates tensions. If we are winning we think we are a market genius while if we are losing we tend to get upset, angry or even depressed. Such is the nature of trading. Rare is the person who can stay emotionally balanced in the face of either mounting losses or winnings.

What we need is something that will tie us to the mast so that we can weather those emotional ups and downs with objectivity. We need to plan ahead so that when we are about to experience a losing trade we already have a strategy in place to deal with it.

The first line of defence is the much talked about and celebrated protective stop loss order. No trader should begin trading without them.

However I know I am not the only trader in the world who has violated my own stop loss discipline the moment my trade started gunning for that magic number.

I am only human and losses hurt like hell. We are programmed by society to not be losers. Losing is bad. Losing money is really bad. It is therefore  no surprise the lengths we go to in order to avoid them.

Stop losses are a good tool in a traders arsenal but I personally need more. I need to examine in black and white what an idiot (or market genius) I have been after the event.

Enter the R-Multiple. What is it? My explanation is best served with an example.

Suppose I have entered a trade and I have allowed myself a permissible loss of £50 on that trade.

That is my 1R.

If I close the position out with a profit of £100 then my R-Multiple is 2R. I have doubled my return on capital.

If I close the position out with a profit of £150 then my R-Multiple is 3R. I have made three times the capital I was willing to lose.

And if I have a loss of £100 then I have a negative R-Multiple of 2R.

In the last example only one of two things can have happened a) I disobeyed my stop loss discipline  or b) the market gapped seriously lower and the first price I could get before my stop loss order kicked in was £100 below my entry point. This is uncommon and though it does happen in all likelihood would rarely result in such a poor R-Multiple.

Some people use nominal amounts in analysing their trading results and that’s fine with them but it does not give a true reflection of how well a trade went.

Every savvy investor knows its return on capital that counts and not the capital amount itself. The R-Multiple is merely a measurement of return on capital employed.

Monitoring my R-Multiple has given me an awareness of my trading ability and performance that I never had as a novice. It is a vital money management tool that I believe has saved me from the blow up graveyard, and as such cannot be ignored by financial spread betters.

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