This is a fundamental skill necessary for trading. First of all the most important thing to grasp is that you should never ever trade without a stop. Even if you are looking to exit manually at a stop point you should at least have a stop in place somewhere beyond just in the case that something goes wrong. You don’t want to be floating a potential huge loss on account of just not having a stop in place.
The formula that I use is “what is the lowest possible risk that gives me the greatest opportunity to win.” Often what new traders will do is first determine stop placement on account of money management. You should not first dictate stop placement based on money management. Money management is a secondary concern. It is a concern, just a secondary one. We don’t want to choose our stop points based on arbitrary pip amounts. Every trade is different and may require a different stop distance depending on point of entry, etc. The first thing to consider when looking to place your stop is location based on real trading principles. That is why I use the above given formula. I first think through what is the lowest possible risk in a location that gives me the best opportunity to win.
Where are these “best opportunities to win” located? Since the market can only move in one of two directions and since the basic overall structure of the market is to work in zones of support and resistance then these “best opportunity to win” locations are going to be those prices where the probability of the market continuing against your position increases exponentially. Part of the process is then looking for critical price points where if the price continues you are going to want to liquidate your position to protect your capital. The good thing is that these points also provide you with the possible opportunity of exiting your losing position and looking for a new entry to recover loss. This is not to be done on a whim under emotional duress, but with proper understanding of market movement and an ability to think of the new position as a separate trade. You are in essence liquidating one position to protect capital, and taking a brand new position apart from the previous based on legitimate market price levels that have triggered a legitimate entry.
Once those areas have been evaluated then the issue of money management comes into play. At this point you need to determine potential loss. Adjustments might need to be made to the number of lots or your entry price in order for the established plan to fall in line with your money management. And that is how money management plays a roll. You first establish the stop points for the trade and then look for how your money management will fall into place with your established plan. Until your money management falls in line you wait and adjust accordingly, but you do not trade. The first object of any trader is to protect the capital that you have, the second being to manage risk.
Following these principles functions as a fail safe to keep you from compulsive trading. Compulsive trading is a common problem among new traders and a danger to your capital.
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