Never Risk More Than You Expect To Gain
To set an appropriate stop-loss, a person needs to know his average gain. For example, with an average of 5% gain, will anyone be willing to risk 10%? In that case, to break even, he will require to be correct on almost 70% of his trades. However, if he gains 10% to break even a risk of only 5%, he can avert trouble despite being correct in one out of three trades.
Mark strongly disagrees with the idea of setting a wide stop-loss just to provide room for volatile price action. Very often during a tough market environment, high volatility is experienced. During such times, the profits and ratio of profitable trades are smaller than usual. Hence the losses must also be cut short as compensation.
A common indicator used to set a stop-loss level is the Average True Range or ATR. It was introduced by Welles Wilder for commodities but is also used for stocks and indexes.
A high volatility stock will have a higher ATR or wider stop, and stock with low volatility will have a lower ATR or closer stop.
The stock market is all about speculation because there is no certainty in it. Thus, speculation is based on certain assumptions. When a trader buys a stock, he hopes that others will soon recognize the value in the stock and buys the shares, creating demand that moves the price higher.
Take an example of a 50/50 trader, if he cuts losses at 10%, with the assumption that his winners will rise 20% on average, but his upside turns out to be only 8%. In this situation, he surely loses money because he has a negative expectancy.
Expectancy is the percentage of winning trades multiplied by the average gain, divided by the percentage of losing trades multiplied by the average loss. To be a winner, one has to maintain a positive expectancy.
PWT (percentage of winning trades)*AG (average gain) / PLT (percentage of losing trades)*AL (average loss) = Expectancy
Defining the upside potential can be achieved in two ways. First, by using Theoretical Base Assumptions (TBA). Secondly, by Result Based Assumption (RBA). Using RBA to determine risk requires a lot of discipline.
It is not necessary to set a stop-loss at one price for the entire position. Staggered stops can also be used to mitigate losses. The key to using staggered stops is maintaining the line without getting knocked out of the entire position.
The author himself follows several guidelines to decide when to raise his stop above the original position. He never allows a stock that rises to a multiple of his stop-loss and is above his average gain, to go into the loss. When the price of a stock he owns rises by three times his risk and his gain is higher than his average, he always moves his stop up to the breakeven at least.
A trader’s actual results encircle not only his strategy, but also the faults, abnormalities, and emotions that frequently override a part of even the best laid-out plans.
Mark’s invariable goal is to minimize risk and maximize potential gains. He applies a trade management technique called the Add and Reduce.
Calculating risks smartly is the main element for constant superior performance. Experts play percentage ball which makes them more consistent than beginners in the long run.
When one relies on the probabilities to win, he is sure to succeed. The more times he turns over his edge, the more profit he will make, and the more possible, the proportions will distribute correctly over time.
Professionals understand that stock trading is not directed by absolutes, but on probabilities. They choose the course of action with the highest probable rate for success.
Investors tend to be emotionally attached to their stock holdings. When their stock takes a plunge, it knocks their ego, which in turn, leads to excuses and justifications for not selling. Most investors fail to sell and cut their loss short because they fear that the stock might go back up after they sell. It’s propelled by the fear of guilt, which results from pure ego! Ironically, the same fear controls them when they have a profit. They feel pressured to sell too quickly
Because they fear that the stock may go down and wipe out their gain. To be successful at trading, pretence must take a backseat and emotions must be removed. Fear, hope and pride have no place in a trading plan.