Conservative Trading: Wide stop or close target?

The following is an extract written by Nick McDonald which featured in a book titled 'Stop Orders' by Tony Loton, published recently by Harriman House. See bottom of this page for a link to the book on Amazon.

I have met many self-proclaimed ‘conservative’ traders who think that the use of wide stops is what makes their trading conservative. They state that this approach means their stop is “less likely to be hit” and therefore it is a “sensible, more cautious approach”. They are correct on one thing, the stop is less likely to be hit. The stop, however, is just one factor in profitable trading and conservative does not always equal profitable. This is often conservative to the point of being detrimental to trading success!

A tight versus a wide stop can of course be quite different across a range of timeframes and products; however, let’s compare two scenarios on a share that’s trading at, say, 1500. Let’s call an aggressive, tight stop on this 30 points and a conservative, wide stop, 120 points. Also, let’s assume the widely agreed approach that you must have reward to risk in your favour: i.e. if you risk $1, you must stand to make at least $1 or more; a 1:1 reward to risk ratio or greater.

The Conservative Trader

Will risk 120 points and therefore must make 120 points to be sufficiently profitable to justify taking the trade and achieve the 1:1 ratio. This requires an 8% move in the underlying. It is a risk of $1 to make $1.

The Good Trader

Will also see that there is room for a 120 point move into profit but will only execute the trade if a precise moment
presents itself where he can have a well placed stop just 30 points away. Note: The Good Trader does not just have a tight stop for the sake of it, he or she waits only for the correct trades that actually justify it. There will be multiple technical factors protecting the stop loss from been hit in the form of support and resistance levels. There are minimal to no technical factors stopping the target from been hit. To be sufficiently profitable, the good trader only needs to move 30 points into profit to justify the trade, a 2% move in the underlying. If the trade does go on to move 120 points as predicted, the good trader is up 4 times what the Conservative Trader is up. It is a risk of $1 to make between $1 and $4. Which is more conservative? Trying to predict an 8% move or a 2% move? The Good Trader profits in either scenario.

The success of my trading has been built on the exact opposite philosophy to wide stops – tight targets are actually what is conservative but only in the situation where the tight stop too is justified. The Good Trader waits patiently for these opportunities. I would much sooner have a conservative target that makes me money than a conservative stop that loses it! A trader should not assess whether a stop is likely to be hit soon, rather, what is more likely to be hit first: stop loss or target? A precision entry with a defined trading strategy, a technically protected stop loss and a target with no technical support or resistance stopping it from been hit is the approach that I recommend all traders work to adopt.

Merry Christmas to all and a Happy New Year from the team at TWP!

Nick McDonald
Founder & Head Trader
Trade With Precision

 

Links to Stop Orders book on Amazon:

Amazon.com: http://www.amazon.com/gp/product/1906659281?ie=UTF8&tag=lotontech-web-20&linkCode=as2&camp=1789&creative=9325&creativeASIN=1906659281

Amazon.co.uk: http://www.amazon.co.uk/dp/1906659281?tag=lotontech-web-21&camp=1406&creative=6394&linkCode=as1&creativeASIN=1906659281&adid=13HEW4T8XRYVFM8K48W3

 

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