Stop Loss as a Invested Capital Management Tool

Stop Loss as a Invested Capital Management Tool - kennynah May2010

Often we treat stop loss as a form of limiting our losses before those adverse trades kill off the trading account. There can be no further truth to this concept.

Now, an extension of this concept can be applied to money management, to ensure that we keep those trading profits close to our chests.

Let's use numerics to expound this idea.

Starting capital : S$10K
End of week/month/quarter : S$15K
Profits : S$5K

It's now the start of the trading week and you are deciding what stop loss you are willing to accept for each position you initiate. This is definitely the right approach.

However, I suggest that you take into consideration, how much of the profits you are not willing to lose, as a factor as well. Instead of simply having an arbitrary % cut loss.

In this example, let's say, I am willing to lose no more than 20% of the profits accumulated thus far. This means I'm willing to risk 20% x $5K (or $1K) for my new position. I then correlate that $1K to the amount of price adverse movement accordingly and put in my stop loss exit order. In the worst situation, I'll lose $1K and no more.

I would still have $4K of profits remaining and have 4 more attempts in making money from my later trades. This means, I can withstand a total of 5 continuous draw downs of $1K each, without dipping into my original investment capital. In any case, if I had a string of 5 losses, I think it wise to stop trading momentarily and take stock of the negative events.

Now compare this to setting a 10% cut loss of total capital; ie 10% of S$15K (or $1.5K per trade of cut loss). 5 such drawn downs = $7.5K. I would have damaged my original investment capital.

Agree that allowing $1.5K of stop loss will allow for more room for the underlying asset price to gyrate. It is all about understanding your underlying price movement that is key to making the decision on which is a preferred cut loss amount.

Nevertheless, playing to win and preventing giving back profits in anyway possible, is the name of the game. Otherwise, in the long run, you wont be able to accumulate more profits, if you keep chancing your original investment capital amount at risk.

Your thoughts?