An excellent post Steve that captures a number of key fundamentals to price action and speculative psychology very succinctly. Nice work.
Before anybody considers now placing their targets where their stops are and their stops where their targets are, they need to be able to have a reasonable shot at establishing the mean and extremity you refer to. The longer TFs which effectively drive this process have their own idea of future value as I’m sure you’re aware.
One of the most intelligent and informed posts for a while (apart from my own of course….)
Unfortunately it simply isn’t as simple as swapping your targets and stops around. It’s actually quite difficult to try and explain the point that I’m trying to get across. Can you see that with a stop the moment that it is triggered you are out of the market? Ask yourself what function a stop like that is actually performing? When we understand that a stop is performing a ‘service’ for us we can then move on to understand that this ‘service’ comes at a cost. It is this ‘cost’ that makes us consistently lose money. In simple terms, if we react to price is such a manner as to make us close our trade then we will more than likely be losing money.
Let me try the following as a semi practical demonstration....
Let us imagine we are trading GBP/USD. We will ignore trading costs to start with but will consider that a round trip cost is 2 pips.
Let us also assume that we are looking to scalp around 17 – 20 pips from a trade.
So, we see that GBP/USD has rallied to a round number at 1.9700. At this point we sell short at 1.9700. A trader prone to loss would now place a stop close by as he considers this ‘good practice’. Lets imagine that our generally losing trader places a 20 pip stop order to get him out of his short at 1.9720. At the same time he feels that his target for profit would be around 1.9680. He may or may not place a limit order to buy to close at this level. His feeling is that his ‘edge over the market’ is the fact that the market will normally reach points of resistance and support at round numbers and therefore by consistently making this kind of trade at these points in time he will, over the longer run, make money. At the moment this all sounds perfectly logical. (I will in due course try to prove otherwise.)
Imagine now that the market spikes higher still and reaches the stop at 1.9720. In an instant the trade is ‘stopped out’ and our friend is ‘flat’. Then what happens? Well obviously the market can still run higher or perhaps turn back lower. The chances are however that the market will run back lower and at some point will return to a level below the stop level set by our losing trader.
Try imagining now what would have happened if the trade would have gone into profit. Let’s suggest that over the course of 20 minutes the market fell those 20 pips. What would our trader do? The most likely thing is that he would have thought “Oh, this looks like it’s going lower” and held onto the position. Then, before you know it, the 20 point winner has diminished backwards into a 12 point winner... whoops... now it’s only an 8 point winner.... oh bugger lets close it for 8 while there’s still some profit left!
Do you see how both methods of ‘trade management’ are detrimental to profits? This is why our friend is a ‘generally losing trader’.
Psychologically our trader cannot win in the longer term because he is not capable of taking control of the trade management aspect of his trading. Instead he uses a ‘fixed stop loss’ because that ‘comforts’ him and causes him to believe that by doing this his potential losses from each trade are ‘under control’. Whilst this may be true to an extent our trader has failed to realise that, by allowing stops to get hit time and time again, he is consistently paying a premium to trade out of his positions at points of price extreme.
Of course the correct way to manage this type of trade is to use a mental stop which does not trigger an automatic exit from the market. Suppose in our example we set the following loose rules.
1 Mental stop of 20 pips.
2 Hard stop of 40 pips.
What we could do in terms of trade management is this. If our trade goes into loss then we will monitor it closely. If our mental stop is triggered we will move into ‘damage limitation mode’. This means that we have now accepted that our trade is a poor one and we are looking to get out. What we are waiting for is a better price than is currently available. It is possible that the market will move either way. If our mental stop of 20 pips gets hit and then the market retraces 12 pips then we can get out for a loss of 8 – see how remaining in the trade beyond our mental stop has saved us money? In most cases it will! Suppose, instead of retracing 12, the market moves on another 10 so our loss is now 30 – this can and does happen – it is still more than possible that the market will retrace 10 – 15 pips in the short term which still means a loss of less than 20 pips.
I hope that you can see that by taking responsibility for the trade management the losses can be far better controlled. This is because your exit from a trade is likely to be nearer to ‘true value’ than if you have a fixed stop set which is guaranteed to exit you from a trade at a price extreme.
Likewise by placing a limit close at a price extreme you are fair more likely to take advantage of poor losing traders when your trade closes at a point well away from ‘true value’
I hope this explains a bit more.
Steve.
