Trading with tight stop-losses
When it comes to online trading, regardless of what you trade, there are certain mechanisms that you can set into place in order to ensure the safety of your investment. Stop-loss is a good example of this, as it can protect you from losing money, and you don't even need to keep an eye on the market 24/7.
However, there is such a thing as a stop order that is too tight, which may backfire and cause you to lose money, rather than save it and let your investment grow.
To help you understand this and prevent it from happening, let's talk more about trading with tight stop-loss, its advantages and flaws, and see what the best approach to protecting your funds with such an order is.
What is stop-loss?
Before we start talking about tight stops, let's first ensure that everyone is on the same page when it comes to terminology. The best way to start is to explain what stop-loss is in the first place.
As many likely know, regardless of what asset you use for trading, its price is going to be relatively volatile. If you trade stocks, that volatility might not be so aggressive as it would be if you trade cryptocurrency.
If you trade forex, the volatility will likely be somewhere in between, meaning that it won't exactly be slow, but it also will not be so strong, as it is in the crypto industry.
Simply put, the price is never the same — that's the very reason why trading is profitable, in the first place. It can change because of new events, speculation, or a number of other factors. Sometimes, it can simply change due to its natural behavior, a specific time of year, and alike.
The bottom line is that the price always goes up and down, up and down, and if you happen to invest when it is down, and then it goes up — you make a profit.
However, what if you invest when you think it is down, and then something happens to knock it even further down, instead of going up? That is when you typically see great losses, and your entire investment might be lost in the most extreme of cases.
One way of reducing this risk is by deciding on a certain price where, if the asset price were to fall to it, your position should be closed automatically. That way, you will still experience losses, but they will not be so severe as they might be if the price simply continues to go down and you do nothing.
This level is what is known as a stop-loss, and it's basically the lowest level you are willing to allow the price to drop before withdrawing from the market.
With that out of the way, let's talk about what a tight stop-loss is.
Tight stop explained
Obviously, when introducing a stop-loss order into your trading strategy, you want to make sure that your losses would be minimal, should the price decide to fall. That means putting the order close to your entry price.
That way, if the price suddenly starts dropping, it will hit the level where the stop order is, and you will exit your position automatically.
Some traders prefer to take a bit more risk for a greater reward, while others see it as reducing the risk of losing their investment. Regardless of their goal, they select a stop level that is very close to their entry price. This is what we call a tight stop. Tight stops can be very useful for protecting your investment, but they can also bring a negative outcome in certain situations.
Let's look into a few of the most common downsides, and why you should do your best to avoid them.
Mistakes when using tight stops
1) Placing a stop that is too tight
As mentioned, tight stops can help you protect your money from experiencing a huge loss if the price were to suddenly start falling. However, the problem is that you might select a stop level that is simply too close to your entry price.
As mentioned earlier, any asset suffers from price volatility, meaning that its price tends to go up and down. These fluctuations can be big or small, depending on the asset in question and outside influences, but they are always there.
In a way, you can say that these fluctuations show how the asset breathes. So, if your stop order is too tight — too close to the entry price — it might be triggered accidentally by the asset's natural fluctuations, rather than a sudden drop against which it is supposed to protect you.
Basically, you would always lose, even though the market is relatively stable, simply because you would enter at one price, and then automatically leave at a lower price when the tight stop gets triggered.
Sometimes, the price tends to drop a bit before spiking up, and you may easily miss out on an excellent price surge just because your stop was too tight, and you left the trade before the price had a chance to go up. Whatever happens, too tight stops are a sure way to lose money, even if little by little, until you are left with nothing.
2) Using position size as a basis for stops
Every asset is volatile, which we mentioned several times at this point. However, it is also true that every asset experiences a different kind of volatility.
For example, if the stock of one company tends to go up and down by $1 outside of any major events that would impact it more, that doesn't mean that other firms will see the same fluctuations.
This means that you cannot base your stop-loss order on a certain number of pips or a certain amount. Instead, you need to study every asset individually and check out its market performance. Some of them will see low volatility, while others can have it quite high.
And yet, this is exactly what some players simply don't understand, and they tend to use position sizing to calculate how far their stop should be. In reality, this has little to nothing to do with it, and you have much better chances of making a good decision if you rely on technical analysis.
3) Placing stops on supports and resistances
While placing stops too tight or too wide is not good, placing them on resistance or support levels is also not the best thing you could do.
The reason for this is simple — these levels often get breached/broken, even if only a little and only for a short time.
Basically, if you have an asset that fluctuates between $20 and $22, you might decide to go long (bet that the price will go up). If the price drops a bit to $20, your stop will get triggered. Even if the price goes only slightly beyond this level, to $19.8, before surging up, your stop will have gotten triggered, and you will have lost your profits.
Alternatively, if you go short (bet that the price will drop) and you set a stop at $22, the price could reach this level or go slightly above it before dropping. However, it would be too late to make a profit, even though you correctly predicted its movement, just because the stop was triggered at the resistance.
Instead, you should make it a bit wider, and put a stop at $19.5, or, even $19, if you go long, or alternatively, at $22.5 or $23 if you go short. Again, it all depends on how strong the fluctuations are, and you can get that information by studying the charts.
You can get it wrong even by doing this, but your chances of making a mistake will be significantly lower than if you simply rely on supports and resistances to stop the price drop/surge.
But, as mentioned, tight stops do have their advantages — if you play your cards right. Let's take a look at some of them, and see how they can improve your trading and give more favorable results.
Advantages of tight stops
You may have found many reasons against trading with a tight stop loss on the internet. That may have included disadvantages mentioned above, or maybe some other flaws of the approach, as well.
For now, just forget about those, and consider the positives of using tight stops. After all, there are two sides to each coin, so here is how you might benefit from implementing them.
1) You can improve your risk:reward ratio
When it comes to trading, you often have to take risks, and the amount of risk depends on the stop-loss distance. If your profit target is 150 pips, but you risk 50 pips, your risk:reward ratio is 1:3. In other words, if you are right about the expected price movement, you will make 3x more profit than what you risked when entering the trade.
However, if you reduce the risk to 10 pips, while your profit target remains at 150 pips, your risk:reward ratio will no longer be 1:3, but 1:15.
If you are correct in your prediction, you will win 15x more than what you risked, which can be extremely profitable. Of course, at the same time, your chances of losing your investment are much greater, as well.
This is an approach that is best used when you are sure that the price will go the way you want it to go. There won't be many opportunities when you can apply such tight stop with any real certainty, but when the opportunity approaches, it will be extremely beneficial for you, so do keep it in mind.
2) Reduce your losses to a minimum
The very point of stop-loss' existence is to help you minimize your trading losses. The tighter the stops, the lower the losses. At least, in theory. You should be careful when using this approach with assets that are highly volatile, as their price might go up and down, but remain stable on average.
These downwards movements might accidentally trigger the stop-loss, as explained before. However, if the asset price doesn't constantly make waves, approaching it a bit closer than usual can be beneficial. If its chances of sinking are low, but still possible, the tight stop-loss will prevent you from losing too much.
3) You can apply pyramid trading and boost your profits
You may know of the pyramid trading strategy, which is a great way of increasing your profits. The entire strategy works best when having a tight stop-loss, which is one example where this kind of approach can be very beneficial.
The reason it works is the fact that your stop-loss distance is tight. As such, it doesn't take very long for your trade to be profitable. Of course, you still need to get the timing and direction of the price movement right.
That way, you will see profits very quickly, and you will safely move away from your entry price.
4) You get to trade large contracts
With a tighter stop-loss, you can trade larger contracts. It is quite simple, really, and it works like this.
If you are trading forex, for example, and you have a balance of $20,000, trading 1 standard contract at 50 pips would mean that you are risking $500. These $500 represent 2.5% of your trading account.
However, if you decide to use a 10 pips stop-loss, you would only risk $100, or 0.5%. This means that you can have as many as 5 0.5% risks to reach the 2.5% risk that you were comfortable with in the first place.
As you know, diversification is one of the best approaches to secure investment, which means that you have much better chances of seeing a profit if you use multiple smaller, but riskier contracts than if you use a single contract that is a bit safer.
The bottom line is, your risk remains the same either way. But, the reward you'll get if you use 5 smaller contracts, as opposed to one larger one, will be significantly greater. And, even if some of them fail, you will still win more than you lost, and end up having a profitable trade.
There are many advantages and disadvantages to trading with tight stop-loss. Some of them we mentioned above, while you can find others through experience, strategizing, and further research. Tight stops increase your risk, and if you use them carelessly, you can end up seeing losses quite often.
However, if you know what you are doing and you use them in a smart way, you can see just as big, if not bigger benefits coming your way. In the end, trading with a tight stop-loss depends on your strategy, the asset you are trading, its price behavior, and more, and you need to have a good plan in place in order to make the most out of it.
Author: Ali Raza - A journalist, with experience in web journalism and marketing. Ali holds a master's degree in finance and writes extensively about the financial markets and fin-tech industries.