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The amount of money a trader should risk in a trade is determined by various factors. The important concept to understand is that the stop placement location is independent of the amount of money the trader wants to risk. A protective stop should be placed at important technically derived price points. In general this seems to work best at important price levels that were generally respected in prior market activity. Should the penetrated price that would represent a failure of the pattern used to enter into the market represent a monetary loss that exceeds what you are willing or able to accept, then you must pass on the trade. In other words, if your methodology recognizes a certain market pattern indicating that you should get long, and you determine that the nearest significant price that would represent failure of that pattern exceeds the amount of money that your rules permit, then you must not make the trade. |
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Another thing to remember is that the market you are looking at will move a certain amount each day. If the amount that you are risking is less than the amount the market typically moves in one day, you are virtually guaranteed to be stopped outunless you have an instant winner. In other words, if you are trading U.S. Treasury bonds using daily data, and you are willing to risk only $200 in a market that typically moves $1000 every day, then you're almost guaranteed to be stopped out with a loss. If the amount of money that you are able to risk as determined by your risk parameters is only $200, you should find an acceptable market that moves $200 or less in one day. |
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The market can become very volatile instantly. If your protective stop is on the wrong side of the market when the volatility suddenly increases, you will quite naturally be stopped out. Generally this might not be so bad, since it typically means that the trade was not the right one. Your protective stop should not be your exit strategy, unless your exit methodology is to use a trailing stop. |
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Protective stops are used to limit the amount of loss experienced by the trader in case there is a huge move against the trade. A stop loss order does not guarantee that you will get filled at that price (your fill could be even more adverse to your position than you would want). It does mean that you will get out (provided the huge move isn't a limit move). It is not meant to replace your exit strategy, as discussed in the previous chapter. The protective stop is intended only to get you out of your position. Placing protective stops can be more of an art than a science. I like to place my stop at a price level that indicates a sudden and decisive change in the continuity of thought. The question I ask is: ''At with price area would the force that I am aligned with be in total disarray, beating a hasty retreat?" Once I can determine this price area, I place my protective stop just beyond it. Another factor to keep in mind |
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