Lessons from the Pros
Subscribe to the Weekly Newsletter published by Online Trading Academy. Receive the full newsletter with charts!One thing that is certain in anyone's trading career is losses. Even the best traders lose from time to time. What the best traders have in common, however, is that they are very professional losers. Knowing how to lose properly is a must in a long and prosperous trading career. This theme is also the backbone of the Online Trading Academy success. From the classroom to the Extended Learning Track (XLT) program, a main focus for us is showing traders how to reduce risk with three important tools. The first is the proper use of protective stop orders, the second is proper position size and the last, but maybe most important tool, is to keep losses small.
Protective Stop Orders
Protective stop orders to the trader are as important as the oxygen tank to the astronaut in outer space. Without them and proper use of them, you're in big trouble. Protective stop orders in trading are meant to help limit your potential loss. There is more than one type of protective stop order and it's very important that you understand the difference between them.
Stop Market Orders: This is an order to buy or sell once price surpasses a particular point. Once price surpasses a pre-defined price, the order becomes a market order. This type of order can be used to enter or exit positions. Typically, this order is used for protection. While execution of this order is typically guaranteed, the price at which the order is executed is not guaranteed. This is because the order being triggered is a market order. The benefit with this order is that if price surpasses your stop price, the market order will take you out of the position. The negative is that if the market is moving fast, you may see some slippage and not get filled at the price you desire. This certainly is the ideal order however if your goal is to protect yourself. As a trader, I always use this order for protection.
Stop Limit Orders: This type of order combines the features of a stop order with the features of a limit order. Once a pre-defined stop price is reached, the stop limit order becomes a limit order to buy or sell at the limit price or better. The benefit of this order is that the trader has control over the price the order will execute at (it is "limited" to the stop price). The negative factor with this order is that it does not in anyway guarantee protection which is what most traders/investors want in a stop order. For example, if you bought a stock at $41.00 and have a sell stop limit at $40.50 and price reached $40.50 but there are no buyers, price will keep declining and your loss will grow with no protection. In short, if you are looking for more guaranteed protection, the stop market order is a much better choice. As a trader, I NEVER use this order for protection.
Where to place protective stop orders?
This is a shorting opportunity we identified in the Extended Learning Track (XLT) in the S&P. On this day, the market opened and rallied right up to our pre-determined supply (resistance) level where some XLT members sold short. To protect the short position if we are wrong, we use a "buy stop market" order. The initial protective buy stop order was placed just above the black resistance (supply) line. The purple line is exactly where the buy stop market order should be placed. We place the stop at that price because it is just above where all the sellers are according to the chart. We know this is where all the sellers are because price could not go to that level, there was too much supply. This was our "initial" buy stop.
The next chart is a smaller time frame look at our S&P short trade. We go to the smaller time frame to identify where to place our "trail stop". A trail stop is simply the act of moving a buy stop down with price during a short position or moving a sell stop up with price during a long position. The benefit of a trail stop is to capture the majority of an intended move in price so as to not "give back" profits. While there are a number of different types of trail stops, I will focus on one of the more objective ways we handle trail stops in the Extended Learning Track (XLT). As price is falling and we are in our short position, we want to bring our protective buy stop down as price falls to protect our profit. The circled candles on the chart represent strong declines in price. Once price declines from a price level, the origin of that decline becomes new resistance (supply). Therefore, we can move our buy stop down to just above the new resistance area. What we are doing is protecting our short position with these new resistance levels. If the market is weak, price should not rally above these resistance levels and continue to decline which is what we want for our short position. The circled candles drop as they do because supply is greater than demand at the origin of the decline. This again is one of the more objective ways we use real time supply and demand analysis to trail stop our positions.
Position Sizing
Proper position sizing is another key component to managing risk properly. Here we have a pivot low support (demand) level and then a decline in price to that level for a low risk buying opportunity. If we buy at the top of the support zone and place our protective sell stop below the support zone, we can do some simple math to ensure we are not going to lose more money than we are comfortable losing by using proper position size. In this example, let's assume we have an account with $100,000.00 in it and we decide that our maximum risk is going to be 1% of the account ($1000.00). If this trading opportunity requires a $0.40 stop and we do the math, we see that we can buy 2,500 shares. This means that if the trade does not work out, we will only lose the amount of money we are comfortable losing, the $1,000.00. Having a position sizing grid like the one you see here when trading any asset class also helps your trading become more mechanical. The key is that you don't want to be "thinking" much when the markets are moving. You simply want to follow a logical rule-based plan based at its core on the laws of supply and demand.
Keeping Losses Small
The cornerstone of Online Trading Academy is risk management. Knowing how to minimize risk is the most important thing in trading.
There are really only four possible outcomes to a trade or investment: A big win, a small win, a small loss, or a big loss. As long as we ELIMINATE the big loss, we can live very comfortably with the other three. Let me share an email from one of my XLT members with you. He is somewhat new to trading and the education path at Online Trading Academy. As you can see below, in the last two months, he only had profitable trades about 30% of the time. The other 70% of the trades were losing trades. However, by keeping the losses small and holding on to the profitable trades to the pre-planned targets, his account is up around 50% in the first two months of this year. While we will certainly work with him in the XLT program to increase his winning percentage, his results are fine with the winning percentage he has now. The key for him is following the risk management rules we focus on.
Sent: Friday, March 20, 2009 6:57 AM
To: Sam Seiden
Subject: Re: Futures XLT
Sam,
I wanted to share some stats with you. This is since the beginning of the year. Roth IRA Performance Position Sizing
| Stat | Value |
| Ticks | 952 |
| Profit | $13,185.73 |
| Wins | 7 |
| Losses | 17 |
| Avg. Win | $2,528.29 |
| Avg. Loss | ($265.43) |
| Biggest Winner | $4,369.30 |
| Biggest Loser | ($925.50) |
| Win % | 29.17% |
| P / L Ratio | 9.53 |
| Max % Risk | 2% |
| Max $ Risk | $827.35 |
| Start Capital: | $28,182.00 |
| End Capital: | $41,367.73 |
| Net Gain %: | 46.79% |
Perhaps the fact that I have been doing this so long is a factor but the reality is, I am simply executing a profitable plan over and over and over. Las Vegas has huge losses every day but they don't care. In fact, they are perfectly comfortable with them like our XLT member because they know the losses are small compared to the winners and this is all just part of a very profitable plan that does not allow for big losses.
