Job #1
Risk management for a trader is Job #1. Looking back to to this article "How many shares to buy?" we remember that the two main components of proper risk management are position sizing and stop orders. So what is a stop order and how is it used?
For this discussion a "Stop" will simply be a price point signaling that the trade has failed or changed. We will look more at automated stop orders in a future article.
Choose the stop before the trade is entered
Each and every position entered should have a stop order at a meaningful price, determined before entering the trade.
Once a stop is determined and a trade is started there are three potential outcomes. Price moves in your favor, price moves against you, or price continues sideways.
If price moves against you and triggers the protective stop the trade is closed for a loss equivalent to 1R.
-SPECIAL NOTE- Just because a stop is entered at a given price there is no guarantee that the closing transaction will be executed at that price. It is possible that price "gaps" down lower (or higher in a short position) than the stop level and a loss of great than 1R is realized.
Protect your profits
If price moves in favor of the trade then the next part of the game plan comes into play; protecting profits by moving stops.
Trailing stops
As price moves up and down it's important to let the action demonstrate meaningful levels, or "pivots" and use those as new stops.
Imagine the typical "saw-tooth" action of price moving back and forth within the overall trend. Some of these reversals will represent meaningful pivot points. As long as the trend is to continue the price shouldn't exceed a previous pivot. Those pivots provide sensible places to place stops.
Rules to make it more robust
This process can be strengthened by adding a couple complimentary rules. Don't raise the stop unless 3 conditions are met on the desired timeframe.
There is a meaningful pivot in price action
There is a new higher high achieved (time frame appropriate)
The moving averages have caught up to the price
Using these rules will put the trader on the path to better protection of profits and maximization of returns.