Hello fellow Slopers - I am a first-time guest poster on SOH. My name is Ryan
Mallory of SharePlanner.com. As for my style of trading, I am a swing-trader who
prefers to keep his charts as simple as possible, with my analysis
coming primarily from price and volume.
As many of you already know, one of the biggest factors in successful trading
is how well you manage the trade – that is the stop-losses you place, the amount
of capital that you put to work, where you take profits, and how you protect the
profits that you already have. You could, no doubt, write many books on each of
these subjects, but for now, I'm going to focus on a small, but critical aspect
of risk-management and my inspiration comes from the movie "The Patriot", which
happens to be one of my favorite movies of all time.
In the clip below, Benjamin Martin (the
father) asks his two young boys, "What Did I tell ya 'fellas about shooting?"
and they replied, "Aim Small, Miss Small". Every time I hear those words I tell
myself how true they ring across so many spectrums of life. As an avid hunter, if you
just aim the gun at the direction of the game you are targeting, you are bound
to miss. However, if you pick out a tiny, specific area of the animal, whether
its the upper-right side of the chest, or some other smaller area, you have a
much better chance of hitting your target. In fact, the smaller the target area,
the lesser amount of margin for error you have in missing.
So how does this apply to trading, you must be asking? The stop-loss that we set
in relation to our entry price is a reflection of our "Trading-Aim"
When I trade, I look for setups that are as close as possible to a desirable
stop-loss. By desirable, that means I'm not just picking a spot that is 1 or 2%
from my entry price for the sake of it being so, instead, if I am long, I am
going to look to place a stop-loss somewhere underneath a critical support
level, and if I am short, then I am going to place a stop just above an area of
resistance. So the place that I choose for my stop-loss is that of a strategic
area and a point to where I know, that if it hits the stop, I know that my
thesis is no longer valid and therefore, I must exit the trade.
I try to stay away from positions that require me to put a stop-loss at 10%
or more from my designated entry price. Mainly because the capital I can
allocate to that position would not be meaningful enough, and as a result the
potential gains wouldn't really be all that favorable for me. I want my
stop-loss to be no more than around 3-5%, from my entry price, while preferring
something around 1-2%. Now some might say that I'm not giving myself enough
"wiggle-room" and that it will lead to a lot of positions being prematurely
stopped-out, but I would argue that if I aimed for stops in the range of 10% or
more, that my win/loss ratio would probably be about the same as the stop-losses
I currently use now of 1-2%. The difference being with small stops, is that I
can put more capital to work, and thus realize bigger gains.
There is also an opportunity-cost in using wide
stops relative to the entry price, in that, you commit your capital for an
extended period of time beyond what is necessary, and can vacillate within a 10%
range from your entry price and stop-loss without ever making a significant move
in any direction. But with tight-stop-losses, if I am wrong on the trade, my
capital isn't likely to be tied up for near as long, and whether I'm right or
wrong on the trade, I am going to know it much quicker.
Finally, it is worth mentioning too, that when you "Aim-Small" you give
yourself the opportunity to "Hit-Big". If my system of trading dictates that I
only risk 1% of my total portfolio value on any one trade (not meaning the total
position value is 1% of your portfolio value, but the total amount risked
between the entry price and the stop-loss is 1% of your portfolio - the total
size of the position will be much bigger that 1%) , and I initiate a trade in
which a stop-loss is 2% from the entry price initially, and ultimately that
stock makes of move of 12% in my favor, then I just realized a 6:1 return in
terms of Risk-to-Reward! which thereby means that one trade just increased my
portfolio's value by 6% – and that is just one trade.
Now there is a drawback to this type of trading, in
that the risk of holding a stock overnight, opens you up to an increased risk
greater than the one represented by the stop-loss set originally for the trade.
Perhaps overnight, there was a downgrade against your long-position, and now the
stock is trading down 5% pre-market, well now, you are much further in the red
than you anticipated ever being, and had you used a wider stop, you'd actually
be in the trade still. The best way to prepare for this is by putting some
buffer in the capital that you are willing to risk in a trade. If you only want
to risk 2% on a given trade, than maybe consider risking only 1% of your
portfolio value so that you can prepare for any sudden surprises. Other ideas is
to avoid earnings announcements and other "known" events that could cause a
sudden and dramatic price drop in the value of your position, especially if it
occurs while the market is closed.
Despite the risk I just outlined in the previous paragraph, it is important
to remember that we cannot completely eliminate all of the risk, both known and
unknown from our trades. Risk is inherant, but we can manage it to such a
degree, that it affects us the least possible amount on our trades due to being
disciplined with our management of the trade. While there are plenty of
successful traders out there who use wide stop-losses compared to what I am
advocating on behalf of, I nonetheless, believe that using tight stop-losses
takes advantage of maximizing the potential of each trade, while preventing you
from wallowing in a losing trade for an excessive amount of time simply because
your stop is too wide. It will also allow you to take advantage of more
opportunities out there, since the time you spend in losing trades will be
minimal to the time you spend in winning trades, and your profits will be
maximized in the process.
And to wrap it up with one more piece of
advice from Benjamin Martin:
"Lord, make me fast and accurate!"