Stop Losses, Take Profit and Adding to Positions

A very tricky area that tends to bother traders – well, it is all in the headline!

For some reason related to human nature / the human mind, we tend to “get” the idea of finding good entries: what they look like, etc.

Obviously, a “good entry” is when it looks probable that the trade is going to move in one direction away from the current price, and not in the other direction. So, this is a simple concept, and I think entries are the part of trading that most of us get comfortable with first.

The problem is that picking good entries is barely half the battle of becoming a profitable trader, and getting the other stuff right is much harder for most of us. This is at least partly because in these areas, it is hard to think clearly, and our mind plays tricks on us.

An example of what I am talking about it adding to a winning position. Traders that do this usually impose rules on this operation, for example, making sure that some profit has already been locked in before adding to a position. Yet is this necessary? Mathematically, every position stands on its own. Aren’t these rules usually more about our own psychological comfort? There is not necessarily anything wrong about protecting your own psychological comfort to some extent when you are trading, but you should be clear with yourself that this is what you are doing. Another example is moving a stop loss to break even. Usually, this should not be done until a position is in a very healthy floating profit, to make sure that a spike in volatility doesn’t take you out of a position prematurely. However, most of us probably do this sometimes just for our own comfort, and end up taking an additional loss!

So as these are areas where it is easy for traders to become their own worst enemy and sabotage themselves, let’s get a few things straight.

1. Stop losses should always be used, unless you are an excellent trader who trades with minuscule position sizes, and you can spend days doubling up and doubling up to “rescue” your losing trades. It is hardly worth it.

2. Stop losses should either be based on volatility or technical factors. They can never be levels where you are “right” or “wrong”, they are there to limit your maximum loss (hopefully) from any losing trade.

3. Stop losses should never be widened, but can be tightened as time from the trade entry elapses.

4. You should only add to profitable positions, and you should never increase the risk on the overall trade. For example, if you open a trade with a stop loss of 40 pips and it goes 40 pips in profit, you could move the stop loss to break even and use a 40 pip stop loss for the second trade, assuming they were the same position sizes.

5. It usually makes sense mathematically make the added part of the position smaller than the initial part. This is because the first entry was more “right” than any subsequent entry. Think about it….

6. Exits are very difficult. You can expect them to be the hardest challenge you face as a trader. The reason for this is because you almost never successfully execute a “perfect” exit, which would be getting out to the maximum pip before the stop loss is hit. This is ironic, as for some psychological reason we don’t really care about whether our entries are “perfect” in the same way!

7. Trying too hard to get exits right can ruin profitability. Accept that making some level of profit trading is not that hard. If you don’t believe me, try testing or using “time-based” exits in your trading. This can be a profitable method. You must ask yourself whether your discretionary exits are good enough to beat time-based exits!

8. In all but scalping, the best exit strategy is usually lies in letting the price tell you when to get out, instead of aiming for targets. If you don’t enter on targets, why exit on them?

9. Jesse Livermore outlined a great exit strategy (for a long trade): “Sell after a reaction if there is no rally.” I.e. wait for the first lower high.

10. You can also use time in exits in another way. Imagine you are in a profitable trade that has been rising steadily for 6 hours. The price then goes sideways for the next 7 hours. This is probably going to be a good time to take at least some profit or possibly even exit completely, because the sideways state has come to dominate the market, so you are in a 50/50 situation.

Hopefully these are some things worth thinking about that you can use to get yourself mentally “straight” for trading.

Good luck!

Adam Lemon

Adam Lemon began his role at DailyForex in 2013 when he was brought in as an in-house Chief Analyst. Adam trades Forex, stocks and other instruments in his own account. Adam believes that it is very possible for retail traders/investors to secure a positive return over time provided they limit their risks, follow trends, and persevere through short-term losing streaks – provided only reputable brokerages are used. He has previously worked within financial markets over a 12-year period, including 6 years with Merrill Lynch.