This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com

I’m beginning to see stop losses and R multiples in a different light lately, and especially since my last trade. I wanted to write about what a stop loss is and what it isn’t.

What A Stop Isn’t

Many people see their stop loss as the point that they admit that they were “wrong” about taking a position. “If it goes against you to the point of hitting your stop, then you were wrong about the trade” is the typical mentality. Your initial stop should not be the point at which you admit you were wrong about a position. That’s not what it’s for! Unless the trade spikes down to the stop instantaneously, then you were wrong about the trade long before that. For example, I was wrong about my PALM trade pretty much as soon as I entered. I stayed wrong for a couple of hours, and finally capitulated at my stop. Do you see the difference? It wasn’t the stop that proved me wrong, it was the price action immediately after my entry that clearly said that my position was wrong. By the time price got to my stop, my position had been cold and dead for a while. PALM may take off later, but my position was wrong at the time I took it. Waiting for a losing position to hit a stop to be declared wrong is like calling back a mugger who just ran off with your wallet to tell him he missed some extra cash in your pocket.

Think of it this way: Say you’re a mountain climber, and you like to scale cliffs to see the beautiful scenes at the top. But there’s a big downside–straight down! So what do you do? You use a safety line. You pick a place to put a bolt into the rock, and you tie off your line there. That is your stop loss. Why do you do this? It’s there to catch you should you happen to slip and be unable to recover. Do you wait until your safety line catches you to realize that you have begun to fall off the mountain? No! If you always did that, one of those times it may fail and you’ll take the big plunge. If you begin to slip, you catch yourself and reposition. In climbing, you might grab another outcropping or dig into the surface with your tools. In trading, that means you get out when you find that you’re going the wrong way.

So What Is A Stop Then, Wiseguy?

A stop loss serves two functions: To cap your maximum downside and help to size your position. When you choose a maximum amount you want to risk on a trade, that is capping your maximum downside. You shouldn’t think of it as your ante, or your pay-to-play. You want to lose $0 on every trade! Of course that’s not possible, but you should strive for it. When you pick an R value, that should be your worst-case-scenario loss: a managed loss that lets you keep trading long term should the worst come to pass. After picking that R size, you pair that with your actual stop price level to size your position to maintain your capped maximum downside. Usually, it makes sense to choose a stop based on the chart, support/resistance, candle highs/lows, etc. However, don’t just blindly approach the stop as the point at which the trade is proven wrong! The stop level may invalidate the setup if it is hit, but the trade may be above the stop and still not be proven correct as with my PALM trade.

So How Do I Know When My Position Is Wrong?

This is the easy part–your position is always wrong! Until proven correct, that is. If you enter and price moves in your favor, it is correct for the time being, and you have the luxury of waiting around to see if it bears fruit. But if you enter and you go underwater, have a plan to determine for yourself when to throw in the towel. And your stop loss point should not be that plan! On my PALM trade, I should have removed my position when the breakout did not occur for 2-3 candles after my entry, and I was still below my entry point.

Hopefully these thoughts will help all of us to lose smaller and faster, which is the only chance a trader has to survive the losing game of trading.

EDIT: Per Richard’s comment (#5), I think that some clarification is in order. I think that your timeframe has to come in to play in all of this. The trade management should always be done based on completed candles in your timeframe, with the only exception being your stop, which is your worst case loss at any time. When I say price moves in your favor, I am imagining that the action according to your timeframe completely clears your entry, like this:

That doesn’t mean that you are correct or not based on profitability tick by tick (unless that is your timeframe!). If the trade stalls, even after being proven correct, you have to determine if you should take the profit or stay. Every trade has a beginning and an end, even the “proven correct” ones. My point is, you have no business waiting around for a clear loss (the inverse of the picture above) to turn into a profit.

This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com