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Getting Started in Trading, Part 3
By Toni Hansen | Published  03/19/2005 | Currency , Futures , Stocks | Unrated
Getting Started in Trading, Part 3

The key to limiting your losses as you make the switch to trading live is understanding stops. We will get into how and where to place stops later on. For now though, let's look at them theoretically. Stops are designed to limit your trading losses. They are the maximum amount you are willing to lose before you admit that you are wrong. There are a number of ways people will place stops. For some, they are willing to only let a stock or index go against them a certain amount, such as a 50 cent negative move in a stock, before they will bail. Others take the same amount of shares no matter what and will be willing to let the position go again them by so much, such as $100. Some traders will never let a winning position turn into a losing one, even if the amount of the gain is very minimal. It is my opinion that all three of these have some serious disadvantages. The main one is that they do not tend to take into account volatility and the fact that every stock or index trades differently.

The ideal way to place a stop in my opinion is technically based. If I am long, meaning that I have bought shares or contracts, then my stop is always under a support zone. It is never an arbitrary amount. If I am short, my stop is over resistance. For everything I do in a trade, I must have a valid reason that I can explain to a fellow trader and not look like a complete fool doing so. Granted, there are times when I will exit a position ahead of a stop and ahead of a target, but this is because the pattern upon which I based my trade is no longer valid. For instance, if the pace in the setup has changed to my disadvantage and is now favoring a break in the opposite direction. This requires a great deal of experience and skill, however, and is a common downfall to the newer or unsuccessful trader, where exiting early is more often than not merely second-guessing the initial premise as opposed to an actual change in the odds on a position.

By using technically based stops, it is easy to manage your risk. You should create a risk control cheat sheet that you have next to you at all times giving you the amount of shares you can trade based on a given stop amount. To help make this easier for you, I have created a template. Click here to open the template in a new browser window.

At no time should your risk amount exceed 2% of your entire portfolio, although once you are trading up to full size I would recommend using only 1/4% - 1/2 % risk per trade. It is typical for swing and position traders to take slightly more risk on a trade than daytraders. This is partially due to the ability of swing and position traders to manage their stops more gradually, without having to make a split second decision. It is also because stop amounts are generally much higher on swing and position trades, so in order to be able to make a worthwhile profit, you tend to need to take more shares than you might be allowed using smaller risk parameters. Similarly, those with smaller trading accounts will typically have wider risk parameters than those with larger accounts. Again, because they need to risk more in order to make an amount that is significant. The difference is that those with larger accounts and smaller risk parameters will have greater staying power. They will be able to make it through the rough spots in the market better, with smaller, less significant drawdowns. It is something to consider when funding your account.

The following is an example of a swing trading account using the maximum risk parameters. Click here to view the swing trading example in a new browser window.

Use this as the basis for your own risk control cheat sheet and be sure to update your own cheat sheet every time you up your trading size.

P.S. I'd love to receive feedback from you. Please leave a comment or discuss the article by clicking on "Make a comment on this article" below.

Toni Hansen is President and Co-founder of the Bastiat Group, Inc., and runs the popular Trading From Main Street. She can be reached at Toni@tradingfrommainstreet.com.