Selling on a stop: The iron triangle

The main purpose of using a stop is to protect yourself from an adverse move by limiting the loss on a trade to a predetermined amount. The secondary purpose is to protect paper profits. With loss control being the key purpose of stops, it is no wonder that setting stops is tightly linked with money management.

The process of risk control works in three steps:

1. Set a stop on the basis of chart analysis and calculate the dollar risk per share by measuring the distance from the planned entry price to the stop level.
2. Use your money management rules to calculate the maximum amount you may risk on a trade in your account and decide how much you will risk.
3. Divide the number of dollars in line 2 by the number of dollars in line 1 to find out how many shares you may trade. I call this sequence the Iron Triangle of risk control. One side is your risk per share, another your total permitted risk per trade. The third side, derived from the first two, gives you the maximum trade size.

Stop placement is tightly linked with trade sizing. Once you decide what to trade, you need to decide how big a position you will put on. Most people make this decision on the basis of some vague gut feel. They trade bigger after a few successful trades or smaller after getting slapped around by the market. Many approach the sizing decision from the wrong angle. Some trade the same number of shares every time, others invest the same percentage of their account in every trade. These common approaches make little logical sense.

Size, as the joke goes, does not matter. What matters is risk.

As a trader, you do not really trade IBM or EBAY or soybeans—you trade money and you deal in risk. This is why you must set your position size on the basis of risk. It is risk, rather than any external factors like number of shares or the cost of a position, that matters.

Compare buying 1,000 shares of a $20 stock and placing your stop at $17 to buying 2,000 shares of a $40 stock and placing your stop at $39. Even though the size and the cost of the second position is greater, the amount of risk is lower.

Let us review the three steps outlined above, followed by a few trading examples:

1. Calculate dollar risk per share. Suppose you decide to buy a stock that is trading at $18. Now suppose that your chart analysis indicates that if this stock falls below $17 it will cancel the bullish scenario. You decide to place a protective stop at $16.89. Your risk per share then will be $1.11. It could become even higher in the case of slippage, but $1.11 is a reasonable estimate.

2. Calculate dollar risk per trade. Suppose you have $50,000 in your trading account and follow the 2% money management rule, as explained in Chapter 1. This means that your maximum risk per trade is $1,000. That is actually quite a lot of risk for a modest account. Many traders decide to risk less than 1%.

3. Divide your risk per trade by risk per share. This is how you find the maximum number of shares you may trade. If your maximum permitted risk per trade is $1,000 and the risk per share in the planned trade is $1.11, your maximum number of shares is below 900. Remember, the $1,000 maximum allowed risk per trade must cover commissions and slippage. Also, there is no law that says you must go up to the maximum permitted risk on every trade. You are not allowed to risk more, but you are perfectly welcome to risk less.

What if you have big expectations for that $18 stock? You may want to give it some extra room and place a stop as far away as $15.89, but then your risk per share would be $2.11. Since the maximum permitted risk for the trade would remain the same, your maximum purchase would drop to 470 shares.

On the other hand, if you sit in front of the screen, watching that stock like a hawk, you may put a stop at $17.54, and risk only 46 cents per share. Your maximum permitted risk will remain $1,000, but now you will be able to trade a 2,170-share block.

Decisions about stops are tightly linked to decisions regarding profit targets. You must weigh the amount of risk you are willing to take against the potential reward you are trying to reap. As a rule of thumb, I am attracted to trades with reward-to-risk ratio of 3:1 or better. I would be very reluctant to enter a trade whose reward-to-risk ratio is 2:1 or lower.

Using stops is an essential practice. Before we discuss the wide variety of stops available to you, let us clarify two extremely important distinctions. We must choose whether to use market or limit orders for our stops. We also need to look into the rarely discussed choice between soft and hard stops.

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