Futures and Forex Trading Strategy: Does using tight trading stops really limit risk?

Absolutely not!  In fact, the notion that “tightening up” a trading stop limits risk is one of the greatest trading myths that exists.

Let me explain.

Do you know any traders who consistently move from losing trade to losing trade?  Most likely their stop placement has a great deal to do with their consistent losses.  The number one result of placing ultra-tight stops is an increase in the percentage of losing trades.  If this was the entire problem, it would be bad enough.   Unfortunately, it is not.  The second result is less obvious but just as harmful:   Tight stops turn many trades that would have become big winners into small losers.

Combine a lower winning percentage with fewer big wins, and you have a recipe for almost guaranteed failure.

What is the right way to set trading stops?  It is critical that stop-loss levels be set beyond the “noise” of the market over the time horizon you are trading in.   The trader should set stop loss levels at points where the premise for the trade is no longer valid, or at a point where a trading edge no longer exists.   The position size of the trade should be set only after this level has been assessed.

Consider this:  If a positive edge still exists in a trade (As determined by whatever analytical method you are using) the next trade is economically speaking the exact same thing as the current position.  If a trading edge exists, you could have three losing day-long trades in a row, or you could hold one losing trade for three days -  If a similar edge existed at each decision point, these economic situations (minus transaction costs) are identical!    If risk exposure needs to be updated, then do so.  If the trading edge has entirely been called into question, then exit.  The bottom line:  far to many traders lose far too much money by “tactically timing trades” and getting stopped out – only to see that their big picture idea was accurate.  If this happens to you frequently, reduce position size and give your positions more breathing room.

Why do so many traders go wrong with their stop placement?   Two simple reasons:

Traders mistakenly believe that if they reduce the size of their maximum loss on a particular trade, they are reducing the risk of their overall trading program.  This is false.  The number one risk facing any trader is trading without a trading edge.  When a trader sets an arbitrarily close trading stop, they very well might be killing an otherwise successful trading approach.

Second, brokers love to promote tight stop strategies.  Why?   Tight stops limit the brokers risk, AND create more opportunities to generate commissions.  It is win/win from many brokerage firm’s perspective!

Bottom line:  Give your trades the room and time to work based upon your trading edge and strategy.  Anything less will be selling your results short!

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