Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

STOP-LOSS PRICE RISK MANAGEMENT

Perhaps one of the most effective and fundamental aspects of managing price risk is the placement of stop-loss orders on a per-trade basis. Stop-loss placement forces us to exit positions when the market is no longer behaving as our trading models anticipated. Although there are no absolute answers regarding the placement of our stop-loss orders, it is generally agreed that they should be far enough from the current market price to prevent “normal” fluctuations from resulting in realized losses, without being placed so far away that their election would result in endurance of a loss that jeopardizes our ability to return to profitability.

Studies of recent volatility on the markets traded, for our specific trading time frames, are probably the single most important element in successful minimization of losses due to normal market fluctuations. The second aspect of stop-loss placement, the jeopardizing of our ability to return to profitability, requires that this market volatility analysis be reviewed in relation to our total equity under management.

For example, if typical recent volatility levels on IMM Japanese yen futures for our specified trading time frame suggest that stop-loss orders should be no less than $1,500 from entry price, then the Japanese yen is probably an appropriate trading vehicle if our equity under management were $100,000, because one contract would represent 1.5 percent risk of total equity under management (generally considered ...