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Exits: The Key To Your Trading – Part 3
  • : January 23, 2021
  • : B. Krishnakumar
 
Exits: The Key To Your Trading – Part 3
 
We have been discussing about exits in the past few weeks. Let us continue with this subject and delve slightly deeper into the concept of stop loss. Initial stop loss is one of the crucial aspects that plays a big role in influencing your risk, drawdown and expectancy or profitability of the system.

If you have not done it already, I strongly recommend you read and understand the concept of “expectancy”. Understanding this concept will provide clarity to your approach to trading and help you focus on the more important aspects in the journey to become a successful trader.

Stop Loss Placement:

Stop loss is one of the vital aspects of your trading and spend a lot of time in deciding your initial stop loss. Here are some factors that must be considered while placing the initial stop loss.

 
  • It should be at a logical level.
  • It should accommodate underlying volatility in the instrument.
  • Should not be too far away nor should it be too tight.
  • If you consciously keep the stop loss slightly closer to the price action, then have a clearly defined re-entry rule to participate in the trend.
  • Have a clearly defined trailing stop loss mechanism We will discuss more about stop loss placement this week.

Stop loss at Logical Level:

Your initial stop loss should be placed at a logical level and not at some random level. Ideally, your initial stop loss should be placed at a level which will effectively invalidate your entry logic.

What I mean by this is, if you are long, then your stop loss should be at a level which will invalidate the bullish view in the time frame you are trading. Also, try to accommodate the underlying volatility while placing your stop loss.

This cushion for volatility is essential as this will ensure you do not get stopped during normal volatility.

There could be occasions where your initial logical stop loss (as discussed above) may be slightly wide from your entry price, making the trade unaffordable. You can deal with this situation in one of the two ways detailed below.

 
  1. If your initial stop loss is wide, adjust your position size so that the overall risk at the portfolio level is within the predefined limits.
  2. If you either do not want to adjust your position size or if it is practically not possible to adjust your position size, then you can cap the initial stop loss at some percentage of your capital and take the trade

The problem with the second approach is that you can get stopped out and the price can still go in the direction of your trade. To deal with this scenario, you must have a logical re-entry rule so that you can control the initial risk as well as participate in the trend, without having to adjust your position size.

Now, the logical question could be which of the two approaches is correct. Both have their pros and cons. As I have been emphasizing on several occasions in the weekly webinars and discussions, there is a trade- off in every decision.

There is no right way or wrong way. Understand the pros & cons and choose an approach that suits you and stick to it.

What are the different methods or approaches to stop loss placement?

I request you to share your approach or thoughts so that it gives me more insights and probably interesting approaches to the concept.

I will try to list out common approaches or methods of stop loss placement next week. Looking forward to your response.