How big should your stop loss be?
A lot of retail trader’s email into our team asking about how they should approach their stop loss and risk.
The most common question is ‘How big should my stop loss be’. So I thought I’d write this very short post to cover this topic.
The short answer is that the size of your stop loss isn’t nearly as relevant as the amount of money you are risking. However, it can be a major factor in your demise if your stops are extremely small.
What is too small?
To determine whether or not a stop is too small we need to think about how it will impact our overall trading performance.
Imagine that you are trading with a 5 pip stop loss. A lot of retail traders think that this is brilliant because they can crank up the leverage so that every pip of profit they make can make relatively huge gains on their account.
What they fail to realise is that by cramming so much leverage into such a tiny stop they actually increase their odds of losing trades. Regardless of how good you think you are, the one thing that has been proven time and again to erode trading accounts is the associated fees and spreads.
If you pay a spread of 1 pip and use a 5 pip stop, then you are instantly 20% of the way to hitting your stop the second you get in! This means that the market needs to move less against you to hit your stop.
Even increasing the stop size to 10 pips still exposes you to this risk. It doesn’t matter if you use lots of leverage or no leverage. The fact is that using small stops will result in your stop loss order getting triggered more often than if you used a bigger one. And that is not simply down to market fluctuations, but because of the magnified impact of those spreads and commissions that all retail traders must pay.
As a general rule your stop size will have less of an impact if it is around 20 times larger than your spread. This gives you a margin of safety in which to operate in.
The use of leverage
I myself have grown my investment business by using large stop losses that are much greater than 20 times my spread. This gives my positions room to breathe. The downside is that it means I can’t use much leverage.
I prefer this mode of operation because it is relatively risk free, and if something bad did happen my positions are so small that I have plenty of time to react and exit the trade.
Do not confuse this with me not condoning or liking the use of leverage. Leverage can be a beautiful thing and when I was trading in London I worked with some absolute beasts that would use leverage in a very calculated manner to reap huge returns!
But the key here is that they always deployed leverage at very specific times during very specific events. They would never simply ‘always’ trade 100:1 leverage no matter what.
Sometimes they would use no leverage at all. But when the opportunity came and the time was right, they were not afraid to go all in and take the risk.
This suits some people’s personalities (I myself am more conservative by nature!) and allows them to trade in a way that fits them. But the point is that there are no set rules on whether you should use leverage or not.
If you want to, then I would urge you to think carefully and only unleash it at those times when the trade is of the highest probability. And in general trading conditions use it sparingly.
So to summarize this post, using tiny stops is counter-productive and the size should simply be based on the spreads you are paying, to keep it really simple. You could also factor in the average daily range. For example, I usually trade with stops of between 50% and 75% the average daily range as a secondary guide.
But the point is that you should move away from fixed amounts like ’10 pips’ or ’30 pips’ and base the stop size on all the variables associated with each specific trade.
Professional traders operate from gut instinct, which they gain through experience. Which, in turn, they obtain from regular trading activity, using the tools and resources that every other professional trader uses.
Leverage can be a fantastic resource, but again, avoid using a ‘one size fits all’ approach and look for opportunities to take advantage of it while protecting your risk at all times!
The final say must go to practice. As a retail trader your biggest asset will be the practice you get being in the markets and taking trades and most importantly, looking for ways to learn from what you experience.
This process will be far more beneficial to your trading than any mechanical, rule based stop loss strategy!
The post How big should your stop loss be? Reducing risks in FX trading appeared first on Jarratt Davis.