Initial stop losses are a critical part of successful trading – Set them wrong and they may destroy your account!
Traders who do not set an initial stop loss are far more likely to hold onto losing trades and ultimately lose far more money on bad trades than they should. Depending on how close you set your initial stop losses though, there is a real risk that they may cause you problems that you might not anticipate.
Position Size Calculation with Initial Stop Loss:
Many traders use the initial stop to determine the position size of each trade using the following process:
- Determine the dollar risk per trade by using a small percentage of your total equity (e.g. 0.5%)
- Calculate the risk per share or contract using Entry Price – Initial Stop Loss
- Divide the risk per share by the dollar amount of risk per trade they want to take to determine the number of shares (or contracts) to buy.
This position sizing calculation is usually used in combination with a small constant percentage risk per trade to standardize risk across every trade. This is an excellent way to size your positions because it means each trade risks the same amount so no one trade can (in theory) wipe you out.
While this thinking is a good start, it is incomplete…potentially with disastrous consequences.
So what is missing?
The key assumption that underlies this position sizing approach is that you can actually get out at your initial stop loss level.
While most of the time this may be true, or at least close to true, there are occasions when you will get filled some distance from your stop loss due to a gap at the open or a fast market.
If this happens and your trade is exited well past your initial stop loss level, then this can cause big problems depending on how wide your stop loss is.
For example, lets say you are using a tight initial stop loss (maybe 1 ATR from the entry price), and the stock you are trading opens 6 ATR down because of a very bad announcement that was not expected by the market. This would mean you lose 6 times as much as you intended to on the trade. If you are risking 1% of your account on each trade, then all of a sudden you have just lost 6% of your account due to a single bad trade.
Now lets take an example where you use a wider initial stop loss (say 3 ATR from the entry price), and the same thing happens. The stock you are trading has a bad announcement and opens 6 ATR down. This would mean you lost twice as much as you expected, but this is now only 2% of your account. This is obviously a lot less than the 6% you lose in the previous example.
What is the lesson?
When you are designing your position sizing rules and initial stop losses, you must remember that you will not always get filled right at your stop loss point when a trade goes bad.
Also, the tighter your stops are, the greater the potential for you to lose much more than you had intended. This is because gaps and fast markets do happen. They may not even show up on your back test, but just remember, it is your responsibility to design your trading system to survive. This means thinking through scenarios like massive adverse gaps, unexpected bankruptcies, fraud etc. and ensure that your position sizing method will prevent you from blowing up your account if something like this happens.
In my experience, wider initial stops can certainly help reduce these risks. They also mean fewer trades, lower commission costs, higher reliability and less slippage compared to tighter initial stops.
As always, you should test everything for yourself, but don’t be fooled, the tighter the initial stop, the higher the chance of losing more than you expect on the trade.
Just in case you still don’t believe me…have a look at the image on this post. This was a one day gap move in the Swiss Franc currency verses the US Dollar. This sort of move is a good reason to consider wide stops, small risk per trade and low levels of leverage!!!