Ask Colin

How do you feel about setting very tight initial stops?

The detailed question was:

How do you feel about setting very tight initial stops? What I am suggesting is positions either move ahead virtually from day one or get stopped out and take a small loss. My reasoning is a loss of $500 could be used more effectively to open more (researched) positions which may or may not move in the right direction. I have noticed in your notes that your stops seem to be, (in my mind), pretty generous.

The closeness of the stop is not an issue for me. My method is based on identifying a trend or potential trend. My stop is where I am wrong about that premise, based on technical analysis. Sometimes this means the stop will be close and sometimes it will be very wide. My stops are determined by where I am wrong on the logic of my investment plan assumption of what I expect to happen i.e. an uptrend will unfold.

The key point is that the stop determines the risk (entry price less stop equals risk). I always risk only a small part of my capital on any one trade. So, the bigger the risk, the smaller the position. Therefore, the closeness of the stop will only impact on the size of the position, not the amount of money at risk. That is always the same.

If you want to risk less than $500 on a trade, say only $250, do this calculation. Take your total trading capital. Divide $250 by your trading capital and multiply by 100. That is how much capital you risk on your trade as a percentage of your capital. For example, if you have $50,000 trading capital, your risk percentage is 250/50000*100 = 0.5%. So, you should not risk more than half a percent of your trading capital (or $250) on a trade. Now, determine your stop. Calculate your position size. What you will find, of course, is that where the stop is very wide, you can not now buy a worthwhile parcel. That is why people with small capital have to take greater risk, or be more selective in the trades they can take. It is also why they bomb out more often - they usually opt to take too much risk, because they are too impatient to wait for the right trades.