Stop Loss Orders to Increase Profits

Stop Loss Orders to Increase Profits

Primarily, a stop loss order is used for risk management purposes – to limit how much you can lose on a trade. An overview of what they are was discussed here http://www.tradingpimm.blogspot.com/2012/01/risk-management.html. However, stop loss orders can also greatly increase profits if used correctly as part of a set of trading rules. Let’s take a basic example:

Trading Rules

If every time that you invest you have a 50% chance of the stock going up 2% and a 50% chance of it going down 2%, and you exit the trade (through a stop loss order for -2% and a limit order for +2%) when either event occurs, you should make no money over the long run. 50% of the returns will be -2% and 50% will be 2%, cancelling each other out. One of the most important trading rules in forex, stock or commodity trading, is to cut your losses through stop loss orders and allow your profits to continue to rise. Never forget that one. 

Profit/Loss	Frequency
+2%	50%
-2%	50%
Net gain	0%

By applying this rule, we will still have 50% of the trades reaching -2% first, and are exited by the stop loss order, but of the 50% that reach +2% first, some will move higher still. Of that 50%, the positive momentum of the stock may cause the stock price to increase another 5% (to 7% gain) 50% of the time, and to fall 4% (to the -2% stop loss order) the other 50% of the time (it may have been going to fall to -3%, which is a 5% fall from it's starting point of +2%, but you cut your losses before this happened through the stop loss order). The long term average now looks like this: 

Profit/Loss	Frequency
+7%	25%
-2%	25%
-2%	50%
Net gain	0.25%

So long as you don’t take your profits too early (generally don’t accept a smaller profit than the loss you were originally prepared to take), your average profit will remain higher than your average loss since your average profit can rise above +2%, but your average loss cannot fall below -2%. This is assuming that the stock rises 50% of the time and falls 50% of the time. Some stock trading models may have a lower success rate but a much higher profit when they are successful, but they will be explored at a future date.

This method of limiting your losses and letting your profits run is most effective in high frequency trading, rather than long term investing (where it is still useful), since you place more trades and converge to a long run average quicker. It also means that this risk management strategy allows you to slowly build up a few large profits that outweigh the more numerous but smaller losses that occur when your stop loss order is reached.

In the pipeline: What to trade: stocks or forex?

Bullish on: Gold mining stocks (not pricing in a high gold price, profit margins are soaring)

Bearish on: US Treasury yields (US economy performing well and have rebounded in line with S&P)

As always, please leave any questions or comments that you may have, or suggestions for future topics.