Tight stops VS Large stops
Today, we’re going to talk about pros and cons of using tight stops versus using large stops. A couple of things upfront, number one, when using a stop, a stop should always be driven. The stop placement should always be driven by your strategy or by your technique. If you are picking stops simply because you say, “I don’t want to risk any more than this,” in my opinion, I think that’s a big mistake. In my humble opinion, a person should always utilize the rules of their strategy and then decide their investment, what they’re willing to risk or what they’re willing to lose. Some people will say, “I only want to risk 30 ticks in the futures market or 30 pips in the Forex market or 5% move inside of the stock market.” I firmly believe that’s a mistake because you are limiting your opportunities because you’ll be at the mercy of your average true range. If average true ranges increase, your strategy, your fixed rule will just be completely destroying your research and destroying your approach. We’re going to talk about large stops versus small stops.
Remember, it’s all strategy based.
Imagine the market’s making higher highs and higher lows and your intuition, your analysis, your research says, “You know what? I think this market’s going to go up.” You say, “I’m going to buy the market right there.” If you place a small stop and a stop is an automatic exit for loss, which basically means if the market crosses below this red line or that price point, you will admit defeat and you will say, “I was wrong.” The market is probably going to reverse, right?
Some people trade with smaller stops to control risk. Usually your scalpers and day traders, they’re the individuals who will trade with tight stops. I’m a big believer that if you trade with smaller stops, you’re going to lose more trades. You place 10 trades and you will probably lose half your trades if not more than half your trades with tight stops, simply because stuff like this happens all the time, all the time. If you’re an active trader, you know that. The question you’ve got to ask yourself is, are you using tight stops because you’re trying to limit the amount of money you’re willing to lose? If that’s your driving focus, I think you may want to reassess your strategy.
Tight Stops & Small Stops
If you’re saying, “Hey, I have a strategy. My strategy says I can have a tight stop or stop this very close to my entry, and I already know when I place 10 trades, I’m going to lose six of them. I’m only going to win four of them, but when I do win, I’m going to win three times what I lose. Therefore, after 10 trades, I’m going to make more than I lose.” If that’s the case, then you’re in great shape. Oftentimes, what ends up happening is when you trade with tight stops, psychologically, when you lose three trades, four traits, five trades in a row, you can self-sabotage yourself because you say, “Well, it first went my way. Then it stopped me out.” Normally, what ends up happening, well, we are going to have to fight with is when you say, “I’m going to buy the market with a tight stop.” Place your stop right underneath it. If you just lost three, four, five trades in a row, think about this. You just lost three, four or five trades in a row. Market goes your way, and then these nightmares appear, right? Oh man. You know, the last time the market went down, stopped me out. If I would have closed out early, I could have won my last four trades instead of losing my last four trades. What do you do? To realize the game, you close out and then look what happens. You close out here, but then the market does this. When you’re supposed to win big, you actually limited your success.
You need to be aware that if you’re going to trade with a smaller stop, it needs to be strategy driven. You need to understand your formula. You got to obey your risk versus rewards. If you’re supposed to win big, you got to let yourself win big. You can’t limit your success. Otherwise, trading with smaller stops, in my opinion, won’t work.
Large Stops & Bigger Stops
Now, let’s talk about trading with the bigger stop. Well, normally if you trade with a larger stop that’s further away, you’re going to naturally win more trades or have more opportunities to win more trades or to close out with profits. If you place your stop far enough away outside of the structure, the only way you can lose is if the structure breaks, and it takes a lot to break structure. If momentum is going up and the market’s going up long-term, sometimes the market will go up for eight years in a row. Look at your S&P 500. Look at your NASDAQ 100. Look at your Russell 2000. They’ve all been going up, essentially. If you had your stop super far away and you just been focusing on buying, structure hasn’t been broken.
Sure, there’s been some sharp, downward pushes, but structure still pushes up. You normally have the ability to win more trades, but you will have more drawdown. Drawdown means the market usually will go against you before it goes for you. Normally what ends up happening with some of the larger stop is stuff like this happens. They bought the market. It comes up, goes against them, but eventually, the market turns around and goes for them if the trading in the direction of the trend. What you’re going to have to ask yourself is, are you willing to lower your investment size to make the stop risk small enough to fit your risk management techniques?
What I mean by that is, let’s just say you are used to risking or you are used to having a tight stop, and you go, “I’m going to give this a shot. I’m going to have a bigger stop.” You can’t really trade with the same investment size here. Let’s just say you’re risking $500 in this trade, right? Well, if you keep the same investment size and you move a larger stop, that larger stop needs to still equal $500 if that’s your risk tolerance. That means you’re going to have to pick and choose your right investment sizes.
What’s the big difference between small stops, tight stops, versus large stops?
Larger stops require a larger physical risk, but you can keep the dollar amount equal and balanced through risk management techniques. Here’s the E-mini Russell 2000. Basically, as long as you had your stock below structure, any by trade would have won until just recently. If the market goes back up, you’re still going to win, right? If you are scalping along the way, you’re probably losing half your trades, winning half the trade, but through good risk management, you’re in good shape. That’s the big difference.
Once again, to summarize it, if you trade with a tighter stop, normally you lose more trades than you win, or you’re 50/50. For that strategy to really realistically work, you’re going to have your reward larger than your risk and you’re going to be psychologically tough because when your reward is supposed to run, you can’t exit out early. You have to be mentally strong. If you are using larger stops, you’re going to be winning more trades according to the probability. You just have to make sure that you’re trading with good risk management so you’re not over leveraging, over risking to where the time that you do lose, it doesn’t wipe out your account.