The Hidden Value of Stop Losses

Stop losses not only protect your trades, they have other benefits in helping you optimise your risk/reward profile.

• To be successful with spread betting you have to understand the risk/reward ratio and always bear it in mind when making your trading decisions
• If you don't consider the potential risk, spread trading is a very dangerous game and Spread Bet traders who ignore risk often end up trading the wrong sized position, be it too large or too small

The solution to trading the right monetary amount is both simple and elegant but impossible without some sort of risk analysis. This is the hidden value of stop losses.

How To Set Up A Spread Bet Trade Correctly

Why do some spread betters always trade the same monetary amount?

Today they buy £5 a point of Vodafone, tomorrow £5 of Tesco. The risk/reward profile on those two stocks is markedly different. Or perhaps they never know how much to trade? But if you know where your stop loss is, you can easily determine exactly what position is appropriate.

First you must determine how much of your trading capital you are willing to risk on each position you purchase. Professional spread bet traders tend to risk anything between 1%-5% of their trading funds, or £100-£500 on a £10k account.

• You are forecasting the FTSE 100 to rise over the next 1-3 days. The Index is priced at 4100
• Using a technical stop loss a level of 4065 is identified via the charts, so the stop loss is placed at 4060
• Assign a risk level of £200 which is 2% of a £10,000 trading account
• £200/40 points = £5 a point to buy
• FTSE 100 moves higher as expected and a 150 profit is taken
• 50 x £5 a point = £750 profit
• If the trade had not worked then the loss would have been around £200 plus any slippage

Same Example - Different Stop Loss Level

• Again forecasting the FTSE 100 to rise over the next 1-3 days. Index priced at 4,100
• Assign a risk level of £200 for the trade which is 2% of a £10,000 account
• Using a technical stop loss a level of 4080 is identified on the chart, so the stop loss is placed at 4075
• £200/25 points = £8 a point to buy
• FTSE 100 moves higher as expected and a 150 profit is taken
• 150 x £8 a point = £1,200 profit
• If the trade had not worked the loss would have been around £200 plus any slippage

It is very important to realise what is going on here. In BOTH trades the risk of around £200 has been kept constant. But the profit potential has varied due to the different size allocation of the trade. This has only been possible because we were able to define the risk via a stop loss before the trade was taken.

• Professional traders are the masters of this kind of allocation and it is the main reason why the size of their trading positions varies tremendously
• You will also find that in times of high market volatility your positions get naturally smaller (because of wider stop losses) and vice-versa when the market goes quiet
• This is clearly good news because a sound spread better always tries to adapt to different markets and different potential

Conclusions

The goal of the stop-loss is to define a predetermined sell level in advance using logic and reason. Your views regarding current news or market events must not cloud your decision. A good stop loss provides a perfect vehicle to cut losses fast, harvest profits when appropriate, and let winning trades run as long as possible. While other spread betters are pulling their hair out wondering what to do, stop losses allow the luxury of not worrying. If they are hit, sell. If not, stay in.

One of the most important aspects of stops is that it's more important to have one in place rather than be concerned about the exact position. If you don't know where to place a stop then just use a very basic percentage stop or a monetary one. And again, don't make your stop loss policy complicated, keep it simple and logical.

Finally you should start to approach every trade from the angle of risk and not reward. The first question you should be asking yourself is 'how much am I prepared to lose' should this trade move against you. Then and only then will you be approaching trading and investing the same way as the spread betting professionals.