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stop-loss is that of a strategic area and a point to where I know, that if it hits the stop, I know that my thesis is no longer valid and therefore, I must exit the trade.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!”