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Stop loss - Risk or Money management?

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Saw a post by @Caseynotesfrom Sept 6 on podcasts about stop placement where a professional was discussing the % room allowed for stops as against long term returns.  Quite interesting, although I wasn't sure of the basis for the % calc but anyway it made me think about the stop placement question and what stops are really used for.  I flirted with this topic in discussion with @TrendFollower but we never really got into it.  We tend to be very focused on getting into a trade, understandably so, but not so much on exiting (whether cutting losses or maximising profits, which was the basic premise of the podcast - if you haven't seen it worth check it out).

So simple questions really:

  1. Do people view stops loss placement as risk management or money management (or is there any different)?
  2. How do people select stop placement (great to see an historic example or even better a current one)?

I'll start by attempting to answer my own question from my personal perspective (long term swing trader using short term charting - 1 hour - to trigger trade entry)

  1. I think they are different.  I think about risk management as assessing the risk that the trade you take is wrong (i.e. the probability of success vs failure) and assessing the potential returns across the various opportunities you have identified vs the potential cost to access them, but I guess it is hard to eliminate the quantification of the loss that would be suffered as a result of being wrong from the assessment/appetite for taking a risk.  Money management is about ensuring you don't risk too much on a single trade (or at a single period of time) thus preserving your capital to live to fight another day and wait patiently for the better set ups.  The latter is clearly about stop loss to me.
  2. My trading methodology is about minimising both the risk of being wrong and the potential cost if I am.  Therefore I wait until I see markets turning according to my road map projections at key support/resistance levels and place close stops below/above these level plus a bit to account for ST volatility.  In a high volatile period (e.g. NFP data releases) I need wider margin of error.  In a quieter time I can use closer stops.  Alex Elder said, "enter a trade when the market is quiet".  I think this is what he meant.  I do have an overall backstop rule to not risk more than 3% of my account balance on a single trade nor 10% total at any time (this assumes stops work and does not account for flash moves - i.e. I am not using guaranteed stops).

Using a recent example (see chart below). I entered the EURUSD Long when the 4 hourly Triangle was swiftly broken with stops below the recent lows.  My logic was that a reversal below this point (and creating a new lower low vs the 15 Aug low) negated my set up thus requiring a reassessment of the market direction.  I then entered a Long again when the market came back down to retest the Fib 62% and placed my stops below the Fib 78% (also the retest of the original breakout point).  If this level was broken my set up would be challenged and I was unwilling to take 2 positions below this point (my first position still being as per the original entry.  Once the market rallied up through the Daily Triangle I took another Long (actually a bit higher than shown on the chart  round the 11,440 point) with stops below the green line support level (circa 11,400 or a bit lower).  When I woke up and saw that my overnight trade was triggered I move my first two trades stops to break even to reduce my total account exposure.  This also frees me up to engage in a pyramiding strategy on a potential fast and long EURUSD rally.  My final trade so far (as signaled to @TrendFollower this morning) was a Long on the breakout of resistance at about 11,480.  My stop level on this one was below the second green line support level (and crucially below the Daily Triangle line but since then I have moved it to join my third trade stop level at about 11,388.

Love to get people's thought on Risk vs Money management and stop placement and also in flight management (i.e. do you move stops use trailing stops etc?)

EURUSD-1-hour_071118.thumb.png.f00e62a2a794138f83e6b8043d05b39d.png

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@Mercury,  for me the definition of Risk management is simple, it is the risk you take when entering a trade and that is the stop loss, the size of your stop times your position size is the risk. Money management is where I clump everything else, amount of account risked on each trade, amount of account at risk in all active trades and the amount being risked to hold a trade open. 

For exits, I may use a target if price is refusing at a significant level or otherwise I will either just trail a long at the most recent higher low or I might use a stepwise ATR, both are very similar in any case.

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@Mercury,

I think it is extremely important to understand what exactly 'money management' is. It is basically all to do with the amount of capital you allocate to a specific trade. In other words the actual size of your position that you trade. One could also add the amount of leverage one uses as part of money management. I personally think stop losses would also be part of money management as it has an impact on the amount of profit / loss one is going to make. Good / sound money management will assist one in making as much profit as possible and at the same time make the amount of losses as low as possible. One could argue that money management is there to reduce / minimise risk. So this in effect could be viewed as 'risk management'. 

The one thing you forgot to mention was 'trading risk'. Now, I love playing Poker. Poker can be a simple and fun game on a basic level. However on a more higher level it is all about odds and probability. Trading risk is all about the probability of losing a trade and the capital being used to trade.

My answer to your question 1. is another question - Does it really matter? Stop losses are an important part of trading and risk management / money management. 

My answer to question 2. is that I tend to use a trailing stop which I use to trail my stop loss below the previous swing low until the price goes through it. I am also an advocate of moving averages. For short term trades I sometimes will use a stop loss when the price goes below the 20 DMA. For medium term trends - 100 DMA and for longer term trends - 200 DMA. I also sometimes use base stop losses when the faster moving average goes below the slower moving average and I would then exit my long trade. If the faster moving average goes above the slower moving average then I would exit my short trade. 

When there is a strong trend demonstrated by the price action then from my experience the price tends to move away from the moving averages. When the trend gets weaker it tends to move nearer to the moving averages. I find that the moving averages can act more as support and resistance.

It would be interesting to see how others set their stop losses and what their trading style is. 

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Interesting responses guys thanks.  Let me ask a related question:

If you had 2 trade ideas where you were going to risk £100 on both but on one you stood to make £100 and on the other you stood to make £1000 which would you take?  That's easy with the info available so I will answer that one, obviously the larger gain.

Now what if I told you that the probability of the £1000 gain coming off was 5% (95% chance you lose your stake not it just doesn't quite make as much as £1000) and the probability of the £100 gain coming off was 95%, which would you take?

 

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I would say that if you take 20 trades you can expect to win 1/20 (5% change) times £1000 and loose 19 times £100. So you will probably loose £1900 and win £1000. So this will give you a loss of £900. If you win 19 times a £100 and only loose £100 once you'll end up making £1800. I'll go for the £100 gain with a probability of 95%.

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Correct of course @FGJB, thanks for playing along.  This is of course a simplistic illustration that seeks to show risk management is, in my opinion (and in my methodology), not just about the stake you risk but also about the chances of success (NP if others just use the stake - no skin off my nose) .  This realisation led me to conclude that it is far more profitable to seek to identify high "likelihood" of success trading ideas and to wait patiently for them to take shape rather than take ideas that "promise" big returns but are more risky.  I use the term likelihood because I do not employ actual statistical analysis to assess probability, rather I use technical analysis married to fundamentals and trend identification on long term charts.

That does not mean I do not trade the other kind (my current bias for Long EURUSD is an example) it just means that I have to be a lot more careful doing it (closer stops, faster scratching if the market moves against my set ups and positions).  However I know I would be more successful at building my account balance in the long term if I did just wait for the more likely ones...

To be clear, using the current EURUSD trade idea as an example, my overarching assessment rules on high likelihood of success comes from identifying the prevailing long term trend (that should resonate @TrendFollower) and having macro fundamentals supporting.  The fact that my Long EURUSD clearly goes counter to the prevailing trend and my fundamental view that the Euro is set for oblivion and USD is set for a strong rally makes it higher risk.  I counter this by having close stops and only entering a Long trade when all my criteria are met.  I also take far fewer and lower outlay positions on such retrace trades.  This is all about both risk and money management and both are important but to me Risk assessment and management is absolutely central to my methodology (and not just in trading either...).  I would not be flirting with EURUSD Longs if there were other better options in the market right now but I can't see any just yet.

I would be better off if I waited patiently for EURUSD to retrace and take the Shorts, but hey what is life without a little (little) risk?

Happy trading!

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