Trading Risk Management - Tight Stop Losses

Here's an extract from an email conversation I had recently with another trader, in which he discusses the use of tight stops:

"I adopted this approach in the beginning, but got stopped out of the market so many times I started to widen them. I've had on too many occasions the market pull back on my stops only to find that it went on to do what I thought it would. Meaning, I lost out again on a good trade. However, I do admit the financial risk is higher. But expecting the market to move fast every time in your desired direction is a lot to ask."

This is a common observation. There's nothing more frustrating than being stopped out and then watching the trade move on to your target without you.

There's actually no right or wrong answer with regards stop placement, only what makes you money and what doesn't. So if wider stops provide a greater edge for your trading, then that's absolutely the right thing for you to do.

For me though, wider stops just don't fit with my trading style, risk tolerance or psychology.

In any case, I thought it might be beneficial for some traders to hear a little about what tight stops mean to me.

It is my belief that regardless of whether a trader uses a tight stop or a wide stop, it should be in exactly the same place.

Having tight stops doesn't mean finding an entry and then placing a stop loss a small fixed distance away and just hoping it isn't hit. Regardless of whether a trader's intention is to operate with a tight or wide stop, the stop loss should be placed in a position which invalidates the setup.

If my stop is hit then it means that either something has changed in the market, or my setup was invalid. Either way, I shouldn't be in the trade.

So for me, the stop should be in the same place, regardless of how large my risk. That place is where I have proof that my setup no longer provides an edge in the market.

The low risk (tight stop) comes NOT from positioning the stop close to the entry, but rather from positioning the entry close to the stop.

For example, if my intention is to enter LONG on a retracement to an area of support, my stop loss will be below the swing low which forms at support. Then, I'll aim to enter as close to that support as possible. This is how I get tight stops.

In some ways this is opposite to most traders. They'll find an entry and then work out the stop loss position. I'll be different in that I know where the stop is, and then work out the entry. And if I can't get an entry that allows sufficiently small risk, I'll just pass on that trade.

Oh, and one other important point - lower risk comes also from incorporating a time stop. If the trade doesn't go my way within a reasonable amount of time, then I'm outa there. I recommend reviewing your trades and gaining an understanding of how quickly your setups should be moving into profitability. Then if that time period passes and you're still stuck in the vicinity of the entry, or in a drawdown, then maybe your setup has lost its edge. Maybe it's time to stand aside and look for the next opportunity in the markets.