Trade Management: The Art of Placing Stops and Taking Profits

Trade management is somewhat of an art form. Skillful trade management is the hallmark of a great trader. However, even if you spent half your life trying to understand where to place stops and when to take profits, I can guarantee you will never be satisfied. This is because the market is changing character all the time and a fixed set of rules which worked really well in one week, will often bring poor results in others. Trade management is somewhat of an art form. Skillful trade management is the hallmark of a great trader. However, even if you spent half your life trying to understand where to place stops and when to take profits, I can guarantee you will never be satisfied. This is because the market is changing character all the time and a fixed set of rules which worked really well in one week, will often bring poor results in others. I am certainly not quite satisfied with my current approach to stops and taking profits, but I have penned down some of my thoughts in this posting.

Placing the Initial Stop
My first rule around stops is: I always use stops and I never enter a trade without also putting my stops in at the same time.

I never use dollar stops, percentage stops or stops based purely on some volatility calculation (such as average true ranges or standard deviations). To the rest of the trading world, these are meaningless and bear no relationship to where conditional orders are likely to be clustered. You really need to be basing your stops on some feature of the price chart, such as a support/resistance line or a swing high/low. If there isn’t a convenient feature on the chart because the market is trending nicely, you might want to count back 2 or 3 significant bars in the trend and place the stop above the high or the low. This way your stop sizes are adjusting naturally with the volatility of the market and they are more likely to be related to clusters of conditional orders.

Finding these points on the chart is not always easy as the daily chart can be a bit coarse to work with. In placing stops, I sometimes find it is worth looking at charts at lower time frames (e.g. 4 hour or 1 hour charts) to find better positioning for stop.

As a rule of thumb I try not to plan my trades around excessively tight stops. Excessively tight stops lead to more exposure and lower your win/loss ratios as you will be frequently stopped out unnecessarily by market noise. It is also very difficult to overcome the poor win/loss ratio by having a high payoff ratio. The other benefit of wider stops is it increases your margin for error around market direction in the short term. You may, for example, have picked the market direction correctly in the next week or two, but shorter term twists and turns in the market may through you out sooner than you had expected.

However, on the flip side of this, excessively wide stops are an equally bad idea. Because I use fixed fractional position sizing, if you use an excessively wide stops, your positions become extremely small and the profit potential for such trades is minimal. A tighter stop will allow you to use larger position sizes whilst still staying within your rules for fixed fractional position sizes.

Therefore to accommodate both sides of this equation, I try to find logical stop points roughly somewhere between 2 to 4 times the daily average true range (ATR) from my entry point. For markets with a nice clean well defined trend or well defined pattern based set up, you will probably want to find a feature on the chart for your stop closer to 2 ATR. For more volatile markets or a not so perfect pattern set up, you will probably want to find a feature on the chart for your stop closer to 4 ATR.

You can achieve tighter stops (and hence more leverage for your position if you are using fixed fractional position sizing) if you have have enough statistical data on the maximum adverse excursion (MAE) of your entries. Successful entries tend to have a lower MAE compared to unsuccessful trades and you might find you can tighten your stops as far as 1.5 times the ATR for certain types of trades.

Finally, be careful placing your stop too close a chart feature, such as a support/resistance line or a swing high/low as overshooting of price action around these points can stop you out. It is best to place your stop a just above or below the preferred point. I generally look at the maximum spread of the pair to get an idea of how far apart to place the stop from the chart feature as the maximum spread is usually a good sign of how far the market will move in conditions of low liquidity.

Profit Targets and Trailing Stops
This is not an easy topic. So many times I have taken profits too soon based on a predetermined profit target only to miss out on a bigger move and then I switch my strategy and hold open my positions open and trail my stops only to exit the trade with less profit then you could have gotten from the price spike. This can be psychologically draining as you feel like you are continually leaving money on the table.

My solution to this situation is to take profits on half the position when there are a reasonable amount of pips to pick up and then move the stop up to break even. This way I will have banked some profits – even if the market does turn. I then start manually trailing the stop up to logical stop points (based on the rules above) on the rest of the position. The other thing this does is lowers my maximum risk exposure, so now I can look to add positions to my portfolio in other markets.

Taking profits on half your position in the longer term is not mathematically optimal for maximising the size of your account. However, it takes a certain psychology to be able to handle the higher rate of failure. Therefore, I would not attempt this until you have your head sorted.

If your psychology and trading skills are up to it, a more sophisticated strategy again is not to trail stops beyond your break even point and just aim for a profit target. This can yeild an even higher profit in the longer term compared to trailing stops, but it takes a significant amount of skill to be able to pick effective profit targets. Without a serious amount of back and forward testing in a certain market to get some decent statistics for informing your profit targets, I would never attempt this.

Parabolic Price Movements
If the market spikes and gives you a major windfall, make sure you take profit on half of your position and tighten your trailing stops up on the remainder of the position. This will keep your toe in the water in-case it spikes again or will at least let you have some nice profits if the spike fails to follow through.

Time Based Stops
Generally, I will rarely hold a position open longer than a couple of weeks. This is not a firm and fixed rule. If the trade is performing well, why get out of it? However, if I have a non-performing trade open for a while and I find a better opportunity somewhere else, I will not hesitate to scratch the trade.

Pyramiding
I am not a big fan of pyramiding. I would rather find another trade somewhere else and diversify my portfolio before I would add to an existing trade. However, if there are no other good quality trades and you have got a nice entry signal on an already open position, then sure, go ahead and pyramid.

Scratching Trades
I will scratch an existing poorly performing trade if I find a better opportunity. I will also scratch a trade before it hits its stop if I catch wind of some major news that would throw me out of the trade.Scratching trades too frequently can really damage your performance – so be careful.

Macrotactics is a blog devoted to recording a part time trader's journey into the world of trading currencies. In my day job I work as a manager in an Information Technology company. I live in sunny Queensland, Australia with my wife, a cat and a baby on the way. I have been banging my head on this trading thing for at least 3 years now and the deeper I dig into the topic of trading, the more I realise there is to learn. Trading for me has become... More