Much has been written about trading rules. A quick search of the internet will expose any number of rules that traders can follow. Many contain good advice. However, too often these rules are explained in isolation and by the use of simplistic examples which can lead to problems. Let’s look at a couple of the more common rules and unpick them a little bit.
1.) “Always trade with a stop loss!” This rule works as follows. Imagine a trader opens a trade at $1.00 per share and sets a 10% stop loss. That means if the stock trades below .90c the trade will close. If the position was 1000 shares, then $100 has been lost. If the trader had $10,000 capital, he/she has lost 1% of their capital, which is said to be the maximum risk a trader should take per trade. This is the standard model that is found so often on various websites. It is, of course, technically correct.
The problem with the model is that it is oversimplified. The main flaw is that the model does not consider the stock price volatility profile. If a trader is going to use a 10% stop loss, that trader should be aware of the typical percentage swings the stock under consideration exhibits.
If the stock regularly swings more than 10%, then the stop loss is likely to regularly and prematurely trigger a 1% capital loss. This means the stop loss amount should be tuned to the volatility of the stock more than it is tuned to the amount of capital at risk, or better – both! Remember, the stock price action is utterly disconnected from your personal risk profile calculations. A stop loss is critical to protect capital, but an incorrectly set stop loss will cause repeated losses that could be avoided.
The assumption that must be included when deciding on a stop loss amount or percentage is that the trader’s stock selection process is efficient enough to locate opportunities with a high probability of the price rising soon, if not immediately, after the trade is opened. That is, the trader knows that their stock and entry point decision making comes from paper trading results that prove the strategy being used is profitable. Once the strategy has passed being paper traded, then it is ready for the real world of trading.
This is where the next trading rule comes under the microscope.
2.) “Only trade with money you can afford to lose”. It sounds logical at first, but the premise is that the trader is accepting that their stock selection process is going to lose money. Sure, all traders have losing trades. That is a fact of trading life. However, if a trading strategy has been thoroughly back tested and paper trader prior to going live, the risk of losing a trader’s entire capital amount should be minimal. No rational trader should persist with a strategy that just keeps losing until all their capital is gone. As a rule of thumb, a trader should be looking to win around 60% of the time or better, and in addition, obtain a profit to loss ratio of 3 to 1 or better. If these ratios are achieved a trader’s capital must increase. Then, it is better to say a trader should trade with money they are willing to risk a small portion of, rather than accepting that the entire trading capital is at risk.
Further, the broad trading strategy is important to consider. If an investor wants to buy and hold a blue-chip stock which pays a healthy dividend, the last thing that investor wants is to be exited from the stock every few weeks or months because there is a market dip. A buy and hold investor is not a trader though. Still, the principle holds. The trader’s strategy must be considered as a working mechanism with adjustable parts. Stop loss levels should be tested and tested to ensure the level being used is a good fit to the overall strategy and its performance over time.
3.) “Never trade against the trend!” The contrarian trader looks to buy while the market is falling and sell while it is rising. If a market is falling heavily, trading opportunities will arise as the market reaches historic lows. When the rebound occurs, a trader may look to buy stocks at a discount in anticipation of the market rising again. However, at this time volatility will be high. Stock prices are likely to be whip sawing around and a 10% stop loss will have obvious problems associated with it – premature exiting. What does the trader do in this case? He or she can wait for the market to settle, or they can assess the stocks recent price range and set a stop loss according to the recent swing magnitude. Of course, this is not to say enormous risks should be taken. However, a sensible widening of the 10% stop loss with smaller position sizes to minimise risk, may prove to be more profitable than adhering to textbook example levels such as 10%. Wea re not advocating trading against the trend, but it is sensible to pick a stock that is rebounding from a recent price reduction provided it has returned to an uptrend.
Ultimately, the message is that no trade should be left open and without protection by some form of disaster stop. The message is that a trader needs to be flexible and adaptable enough to understand the need to not apply a one size fits all approach to trade risk management. Adjusting entry and exit rules to fit the personality of a stock is part of the art of trading. A stocks personality can be assessed in a few minutes by reviewing several years of chart activity with a bias on the recent few months. Looking a the size of the chart candles or bars and the magnitude of the peaks and troughs will quickly reveal just how much a stock swings over time. The smaller the candles and the smaller the swings the less volatile the stock is. If the stock is in a reliable uptrend, it might be considered a trade opportunity. At the very least the stock should stay in one direction for a reasonable length of time. If it continually changes direction and has little price appreciation over time, the chances of a medium-term trade profit diminish.
