Risk management is an essential but in most cases overlooked prerequisite to successful active trading. This article will discuss some simple strategies that can be used to protect your trading profits.
Planning Your Trades
Just like in war, planning ahead can often mean the biggest difference between winning and losing. Stop-loss (S/L) and take-profit (T/P) points represent two key ways in which traders can plan in advance when trading. Successful traders know what price they are willing to pay and at what price they are willing to sell, and they measure the resulting returns against the probability of the stock hitting their goals. If the adjusted return is high enough, then they execute the trade.
Conversely, unsuccessful traders often enter a trade without having any idea of the points at which they will sell at a profit or a loss. Like gamblers on a lucky or unlucky streak, emotions begin to take over and dictate their trades. Losses often provoke people to hold on and hope to make their money back, while profits often entice traders to imprudently hold on for even more gains.
Stop-Loss and Take-Profit Points
A stop-loss point is the price at which a trader will sell a stock and take a loss on the trade. Often this happens when a trade does not pan out the way a trader hoped. The points are designed to prevent the “it will come back” mentality and limit losses before they escalate. Just for example, if a stock breaks below a key support level, traders often sell as soon as possible.
A take-profit point is the value at which a trader will sell a stock and take a profit on the trade. Often this is when additional upside is limited given the risks. For example, if a stock is approaching a key resistance level after a large move upward, traders may want to sell before a period of consolidation takes place.
The best way to Effectively Set Stop-Loss Points
Setting stop-loss and take-profit points are often done using technical analysis, but fundamental analysis can also play a key role in timing.
Moving averages represent typically the most popular way to set these points, as they are easy to calculate and widely tracked by the market. Key moving averages include the five-, nine-, 20-, 50-, 100- and 200-day averages. These are best set by applying them to a stock’s chart and determining whether the stock price has reacted to them in the past as either a support or resistance level.
Another excellent way to place stop-loss or take-profit levels is on support or resistance trend lines. These can be drawn by connecting previous highs or lows that occurred on significant, above-average volume. Just like moving averages, the key is determining levels at which the price reacts to the trend lines, and of course, with high volume.
Calculating Expected Return
Setting stop-loss and take-profit points are also necessary to calculate expected return. The advantage of this calculation cannot be overstated, as it forces traders to think through their trades and rationalize them. As well, it gives them a systematic way to compare various trades and select only the most profitable ones.
The formula is:
[ (Probability of Gain) x (Take Profit % Gain) ] + [ (Probability of Loss) x (Stop Loss % Loss) ]
The result of this calculation is an expected return for the active trader, who will then measure it against other opportunities to determine which stocks to trade. The probability of gain or loss can be calculated by using historical breakouts and breakdowns from the support or resistance levels; or for experienced traders, by making an educated guess.
Traders should always know when they plan to enter or exit a trade before they execute. Make your battle plan ahead of time so you’ll already know you’ve won the war.