Stop Loss and Take Profit

Technical Analysis is not a magical solution to determining where financial markets will go in the future. Taking technical signals on their own is a risky strategy. Avoiding false signals can be done by avoiding trading in range-bound markets. Any downsides caused by a false signal can be taken care of by performing risk management using stop-losses and take-profits. 

In the last two articles, we talked about efficient analysis of two of the most important backtest performance metrics, Sharpe Ratio and Maximum Drawdown. In this article, we’re going to talk about using risk management techniques like stop-losses and take-profits to help improve your trading strategy performance by increasing returns and reducing downside. We’re going to talk about the following topics in depth:

  1. Stop-Loss
  2. Trailing Stop-Loss
  3. Take Profit
  4. Trailing Take-Profit
  5. Trade Analysis

Stop Loss (SL)

A stop-loss is determined as an order that you send to your exchange, instructing them to limit the losses on a particular open position or trade. With a stop-loss order, if a share price dips to a certain set level, the position will be automatically sold at the current market price, to prevent further losses.

For example, if you placed a bullish buy order at $500 using your strategy, but the signal turns out to be a false positive and the prices instead of rising, start falling. This is where with the help of a stop loss you can minimize the downside. With a stop-loss of say 5%, a sell order will be placed automatically if price falls beyond $475 booking a loss of 5% but hedging any further downsides.

Knowing how to calculate stop-loss is important, but it is crucial to mention that exits can end up being purely emotion-based. For instance, you could end up manually closing a trade just because you think the market is going to hit your stop-loss. In this case, you feel emotional, as the market is moving against your position, despite any price-action-based reason to exit manually being present.

The ultimate purpose of the stop-loss is to help a trader stay in a trade until the trade setup, and the original near-term directional bias is no longer valid. The aim of a professional trader when placing a stop-loss is to place the stop at a level that grants the trade room to move in the trader’s favour.

How much is a reasonable stop size then? 

Essentially, when you are identifying the best place to put your stop-loss, you should think about the closest logical level that the market would have to hit to actually prove your trade signal wrong. Therefore, stop-loss traders want to give the market room to breathe, and to also keep the stop-loss close enough to be able to exit the trade as soon as it is possible, if the market goes against them. This one of the key rules of how to use stop-loss. 

A lot of traders cut themselves short by placing their stop-loss too close to their entry point, merely because they want to trade a bigger position size. But the trap here is that when you place your stop too close, you are actually invalidating your trading edge, as you need to place your stop-loss based on your trading signal and the current market conditions, and not on the basis of how much money you anticipate to make.

Therefore, your assignment is to define your stop-loss placement prior to identifying your position size. In addition, your stop-loss placement should be determined by logic. Do not allow greed to lead you to losses.

Stop-loss percentage will heavily depend on your total capital and the amount of money invested. A reasonable stop loss size is no more than a few percent of your total account balance. A common figure is 2-3% at most, and we would agree that it’s a good guideline to follow. The danger of risking more is that you quickly will find yourself in drawdowns that become very hard to get out of. For example, if you decide to risk 10% on each trade, you would only need 5 consecutive losers to have a 50% drawdown. Such a drawdown would require a massive return of 100% only to be back at breakeven. Instead, if you instead were risking 2% of your capital on every trade, you would be in a modest 10% drawdown which is much easier to recover from!

Trailing Stop Loss

Stop Losses are intended for reducing losses when the market moves against your position, but they can help you lock in your profits as well. While that may sound a bit counterintuitive at first, it’s actually very easy to understand and master.

Let’s say you’ve opened a long position and the market moves in the right direction, making your trade a profitable one at present. Your original Stop Loss, which was placed at a level below your open price, can now be moved to your open price (so you can break even) or above the open price (so you are guaranteed a profit).

To make this process automatic, you can use a Trailing Stop. This can be a really useful tool for your risk management, particularly when price changes are rapid or when you’re unable to constantly monitor the market. As soon as the position turns profitable, your Trailing Stop will follow the price automatically, maintaining the previously established distance.

Following the example above, please bear in mind, however, that your trade needs to be running a profit large enough for the Trailing Stop to move above your open price, before your profit can be guaranteed.

Formally: Traders can enhance the efficacy of a stop-loss by pairing it with a trailing stop, which is a trade order where the stop-loss price isn’t fixed at a single, absolute dollar amount, but is rather set at a certain percentage or dollar amount below the current market price. When the price increases, it drags the trailing stop along with it. Then when the price finally stops rising, the new stop-loss price remains at the level it was dragged to, thus automatically protecting an investor’s downside, while locking in profits as the price reaches new highs.

Trailing Stop Loss Graph

For example, if your purchase price was $500 with a trailing stop loss of 4%, the immediate effective stop-loss value will be at $480. Now if the market price climbs to $700, your trailing stop value will rise to $680. If now for some reason the price begins to fall beyond $680, a sell order will be placed locking in profits so far, while hedging any further downsides.

Take Profit (TP)

With a take-profit order, if a share price rises to a certain set level, the position will be automatically closed at the price of the take-profit order. Most traders use take-profit orders in conjunction with stop-loss orders (SL) to manage their open positions. If the security rises to the take-profit point, the TP order is executed and the position is closed for a gain. If the security falls to the stop-loss point, the SL order is executed and the position is closed for a loss. 

Frankly speaking, the most feasible approach of how to use stop-loss and take-profit while trading is perhaps the most emotionally and technically complicated aspect. The trick is to exit a trade when you have a respectable profit, rather than waiting for the market to come crashing back against you, and then exiting out of fear. The difficulty here is that you will not want to exit a trade when it is in profit and moving in your favour, as it feels like the trade will continue in that direction.

How much is a reasonable profit size then?

After identifying the most logical placement for our stop-loss, our attention should then shift to finding a logical profit target placement. The ratio of the amount of take-profit pips to the amount of stop-loss pips is popularly known as the risk to reward ratio. It is important to be sure a decent risk to reward ratio is viable on a trade, otherwise it is definitely not worth taking. Therefore, you have to identify the most logical place for your stop-loss, and then proceed to define the most logical place for your take-profit. If after doing this, there is a decent risk/reward ratio possible on the trade, this trade is probably worth taking.

Although there is no general way of structuring your stop loss and take-profit orders, most traders try to have a 1:2 risk/reward ratio. So, if you are willing to risk 10% of your investment, then you can target a 20% profit. But this mostly depends on the situation that the market is at the time.

Nonetheless, you have to be honest with yourself in such a situation – do not ignore key market levels or apparent obstacles that are in your way in terms of reaching a satisfactory risk/reward ratio, simply because you want to enter a trade. Also, don’t forget to use the correct stop-loss/take-profit ratio. Try to define whether there is some key level that would make a logical take-profit point, or whether there is some key level obstructing the trade’s path to making an adequate profit.

Trailing Take Profit (TTP)

Traders use a TP order only when they want satisfactory gains and are sure that the uncertainty with the market price of the security will increase after a certain jump in price. The stock could start to breakout higher, but the TP order might execute at the very beginning of the breakout, resulting in high opportunity costs. To outmaneuver this opportunity cost, Trailing Take Profit can be used. The TTP is set as a trailing percentage on Mudrex, and if the price is breaking out above the take profit limit, the TTP will trail the upward moving price and execute the trade only when the price goes down by the set TTP percentage. All this is happening only after the price breaks above the TP order thus booking in more profits than exiting at TP preemptively.

TTP Example

Trade Analysis on Mudrex

Since manually taking care of Stop-Losses and Take-Profits is an almost impossible task due to the requirements of instantaneous and correct calculations, Mudrex has your back! You can easily set-up SL or TP percentages in the Trade Signal Panel of the Mudrex Strategy Canvas as shown:

Stop-Loss

We will be using a trailing stop-loss of 5% solely for experimental purposes. You can choose your own values depending upon the market volatility and risk tolerance by backtesting on Mudrex.

Stop-Loss Dialogue Box on Mudrex
Trade Analysis

The buy signal [B] was generated when the buy condition of the trading strategy was fulfilled. A trailing stop order [marked as ‘L’ in the above graph] was called when the prices fell by more than 5% of the peak price. If we had not used a stop-loss, the sell signal would’ve been generated a few candlesticks later when the sell-signal due to your trading strategy would’ve been called, leaving behind the profits and booking in more losses than the trailing stop order. This is how important false signal filtering can be, when it comes to preventing losses due to false signals. 

Take-Profit

For experimental purposes, we will be using a TP of 10%. This would mean that a long trade will exit as soon as the price rises 10% above the buy price. Using a TTP of say 2% would mean that now the trade will only exit once the price breaks above TP and then drops down by 2%. The values set are solely for experimental purposes and you can choose your own values depending upon the market volatility and risk tolerance by backtesting on Mudrex.

Take Profit Dialogue Box on Mudrex
Trade Analysis

The buy signal [B] was generated when the buy condition of the trading strategy was fulfilled. As soon as the price rose more than 10% of the buy price, the TTP started trailing the price. At the red candlestick, when the price fell more than 2% of the peak price, the TTP sell signal was generated (marked as P in the chart above).

Every trade is basically a business deal. It is essential to weigh the risk and the reward from the deal, and then to decide whether it is worth taking or not. In trading using technical analysis, you should consider the risk of the trade, as well as the potential reward, and if it’s realistically practical to obtain it according to the surrounding market structure. To trade more profitably, it is a prudent decision to use stop-loss and take-profit. With a suitable usage of stop-loss and take-profit combination, you can make the most use of your designed trading strategy by minimizing risk and all this can be automatically done on Mudrex. In the next and final article of our MasterClass on Backtest, we will be talking about how to understand the Order Book to deduce useful insights about the current market sentiment.

Stay tuned for the same!

Links

A few quick references below: