Defence, Stop Loss and Position Sizing

Keeping the emotions out!

Say you have $20 k in your account. And you have a perfect trade strategy or a trading mentor whom you follow. All is going well and you seem to be on the roll. You have had 2 good trades already trading 1 lot and your account is now $22,000. You feel confident. Increase your trading size to 4 lots, waiting to end the week with another 20 pt win and plans to withdraw some cash out for the before the weekend. And now, all of a sudden, the 4 lot trade is going against you on a 15 pt stop. When the trade is down 10 pt, you add 2 more lots as "defence". Market bounces a little, briefly giving you break even on the combined position but you still wait for your profit objective. You feel the trade is finally working out. And then, boom, the next leg down starts and you get stopped out - provided you controlled the urge to move stop further away or remove altogether for that second chance to break even. You end the day with 4 * 15 and 2 * 10 pt loss ($4000 to be precise) and your account is now looking negative for the week! You are frustrated. If the trade which went against you was your own plan, you kick yourself, scream at your spouse or break few crockery. In extreme cases you punch the screen and cause a further $300 damage. If the trade was your trading mentors call, you go out and call him all sorts of names and bash him wherever you can. Basically you throw your toys out of your pram! Sounds Familiar?

Well many inexperienced traders suffer from this. There are several things at play here which determine the success or failure in trading - and it matters at each trade level as a single trade  can wipe you out if you are not careful and disciplined. 

A) Stop Loss Distance : 

The most frequent mistakes trades make is in calculating their stop loss distance. They want to risk $1000 on a trade. They want to trade 4 lots on each trade. So the stop is $1000/50/4 = 5 pt. Now that is rubbish! Markets are volatile and 5 pt is simply a "noise" in the market. You are more likely to end up seeing yourself stopped out and then the trade making off in your direction. 

A trade, however well planned, is still a play on the probability of success. A trade plan is not a guarantee of success nor being on a roll (having few successful streaks) makes the next trade more or less likely to succeed. Therefore each trade should be planned as individual trade with its own risk parameters.

A trader should always keep two stop loss points. 

One - the HARD STOP which has to be in the order book or with your broker. So if your computer breaks down or you are out on a walk and market moves against you, this is the level at which you will DEFINITELY want to get out.

Second - the soft or MENTAL STOP, a level once breached, you start wondering about the success of your trade. May be the market is not acting the way your trade plan asked for. May be something has changed in the analysis or fundamentals of the market. May be you should not worry about reaching your profit objective as per the original plan and instead worry about getting out break even or with minimal loss. 

The HARD STOP should be at least at point where a normal trading day is not expected to trade if your trade plan is right about market direction. In case of day trading, 0.5 - 1 * Average True Range can be a good start. If you are using 50% retracement type trade, the hard stop can be below the bottom of the move whose pullback you are planning to trade. Your mental or soft stop can be at a level of key support or say 61.8% retracement point. For swing trading the hard stop is much wider below key support level. Trader should pay utmost attention to hard stop level as a right stop level can dramatically change the performance of trader. The very tight stop, and chances of getting stopped out increases. A very wide stop and you cannot take sufficient size (see calculating trade size) and therefore reduces your overall profit potential.

B) Trade Size:

The size you trade depends upon your account size (or the capital you are willing to risk per trade) and the HARD STOP level for a given trade. The first question you need to ask yourself is "how much capital I am willing to lose on a single trade?". Usually deploying 2% - 6% of your account per trade is reasonable since the loss suffered by a single failed trade is not sufficient to cause significant damage to your account. As the account size increases you can trade bigger quantities. Remember to decrease the trade size when you are suffering losses. Ideally if your account falls by 25% you should reduce the trade size by 50%.

With a 4% risk level and 15 pt hard stop on S&P 500 futures, the ideal trade size for $20k comes as 20000 * 4% / 50 / 15 ~= 1 lot. That is what you should trade!

C) Defence:

They say - never add to a losing position. Or averaging has killed many traders. And I 100% agree. However, being experienced traders, you know that markets do not move in one direction and there are pullbacks and counter trend moves. Here the so called "defence" comes into play. Assuming that your HARD STOP was at a sensible place where markets were not "expected" to trade on a normal day and your mental stop was a close support level where markets are usually expected to bounce, you can use area around mental stop level to add to your position to defend. Please be clear that when you are defending you are basically giving up your original trade plan to reach your profit objectives and now you are looking out for a break even or small loss exit. You also have to be quick now as the counter trend pullbacks are usually short lived and the next leg down can do further damage to your increased position. 

The size of defence can be same of half the size of your original trade. Remember you are increasing the risk on the trade by defending and keep that risk into consideration while calculating your original position size in the first place.

Also you need to decide if you need to defend or not. Not every trade needs defending!

It is very important to follow a discipline about stop loss level, position sizing and defence to improve your chances of success in trading. You of course need a winning trade plan to start with but remember that you can still mess up if you do not apply further discipline to trading. That is precisely the reason why many traders still fail following the same/similar trade plan which other fellow successful traders are following.