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What’s a stop for?
Risk control obviously. Blah. Blah. Blah.
We all know that stop is the only thing that stands between you and financial ruin and yet we ALL ignore that advice once, twice, a million times over the course of our trading.
Because most of us don’t understand stops and see them only as a source of pain.
A stop is there only for one purpose only.
To. Make. You. Money.
That’s right. You heard me. A stop is there to make you money. If you are not making money -- you are doing it wrong.
The stop’s only function is to answer the following question -- how much room do I need for my trade to hit profit at a bigger expectancy than my stop? To review the idea of winning edge read my column from last week, but meanwhile, understand that you WILL LOSE. YOU WILL ALWAYS LOSE. The key to winning is to make that loss either much less frequent or just less than you profit.
It is in my view much easier to make the stop be less frequent rather than absolutely less money than your target. But that depends entirely on your personality. If you are the type of person who can hold for a 200 pip gain -- then sure you can have 50 pip stops and still win. Still, in all my testing experience it is much easier to find a positive setup with 1-4 risk-reward profile (risk 200 make 50) rather 4-1 profiles (risk 50 make 200). 4-1 profiles usually payout 18-20% of the time which makes them a loser (4-1 has a breakeven of 20%) 1-4 profiles can be accurate 85-87% of the time making them profitable.
But that is neither here nor there. The point is not to start a religious war about risk-reward ratios but to find a sweet spot for YOU.
In my day trading, I have found 1-2 risk-reward is just the sweet spot I need. I worked out my stop after I figured out what I can accept as a take profit. As you all know I have zero impulse control so I can only take 2 points in ES 20 in YM and 10 max in NQ before I start getting the joneses. So the question I had to answer was -- what was the reasonable stop on such a set up that gave me a winning edge? The answer was twice my risk putting my breakeven at 67%. Since I’ve been hitting 75%-80% of my trades I am very comfortably ahead.
Now here is the amazing thing that happens once you understand the purpose of the stop. You never again lift it. You not only accept it but you actually expect it as it all becomes part of your trading plan, just like food spoilage is part of a restaurant’s business plan.
Of course, you do your best to minimize it, but honestly, most of the time you don’t even think about it because you are focused on what really matters most -- the next good set up. This is the way it should be and I can’t tell you how much less stressful this becomes on a day to day basis.
You stop agonizing over every market beat and instead ask the only question that matters -- is my plan working in the current environment?
So, taking my last three columns together, here is what I think works in the market.
1. Don’t contort yourself to the market. Know your comfort level. Find your sweet spot profit and start from there.
2. Understand expectancy and the winning edge. Be realistic. (5% above breakeven is AWESOME!)
3. View your stop as a key part of a profitable trading plan and work on entries -- cause trading is timing and that’s all there is.
Happy Trading Guys!