Avoiding Death by a Thousand Small Stop-Losses – A Different Approach to Risk – Reward For Traders

Advising beginners to “cut your losses and let your winners run” has become a cliche in trading books and web sites, often regurgitated but rarely applied effectively. The phrase often refers to the idea of trading with smaller, tighter, stop-losses and proportionately larger profit targets. It enforces a per trade risk/reward ratio in which every winning trade outsizes the inevitable losing trades for a net profit. The idea sounds great on paper but, when applied in a real market environment, tends to send most beginners into unnecessary losing streaks right off the bat.

In theory, small stop losses make perfect sense: if your losing trades are half the size of your winning trades (which produces a 1:2 risk/reward ratio per trade), then you only need a 33% win rate to break-even. Anything above that is net profit. The same principle would apply for any ratio where the reward is higher than the risk per trade. Rinse, repeat, and make loads of money. It sounds simple and is instantly marketable; consistency-challenged “traders” who post on internet forums preach it like a dogmatic religion to newcomers.

Few give it any thought and, in practice, even fewer have made it work profitably on a consistent basis.

Why? Because a real trade in the market is not a coin flip with the stop-loss on one side and target on the other. In other words, the probability of success per trade is never 50/50. Rather, each pip of price action is another price level with potential opposing orders standing in the way and needing to be filled before the market can reach the next price level.

At the risk of over-simplifying the scenario, imagine that each pip value between your entry price and your target is an obstacle on the road. Likewise for each pip value between your entry price and stop-loss. So in the hypothetical 1:2 risk/reward ratio, there are twice as many obstacles on your path to the target as there are on the way to the stop-loss. With all else being equal, a 1:2 risk/reward would give you 2 to 1 odds against your trade.

In fact, if you use a risk/reward ratio of 1:3, which sounds even better in theory (one winning trade wipes out three losses), the problem would be amplified: there are three times as many obstacles in the way of the target — 3 to 1 odds against your trade.

The averaging effect over time would simply bring you back to roughly break-even or a small profit/loss, less spreads and/or commissions. Either way, very few entry methods can achieve a high win rate in these conditions because the short term volatility will take you out even if the market ends up heading in your predicted direction.

What if we turn the tables and trade with stop-loss distances that are equal to, or larger than, the profit target distances? A 1:1 risk-reward per trade, or even 1.5:1 or 2:1, maybe even higher depending on the volatility of the currency pair and the strength of the setup.

Somewhere out there, a trader is yelling, “but then one trade could wipe out 2 or more winning trades!” And I agree… If you were making random entries. As a professional trader (or a serious aspiring one), that shouldn’t be a problem since absolutely none of your trades should be random, right?

Without stepping beyond the scope of this article, you should already know that your method of choosing entries and exits should be based on a criteria that is statistically sound and takes current volatility into account. The difference with an Newsrooms equal or larger stop-loss is that it should allow for breathing room and avoid being stopped out before being proven right. In other words, you can avoid death by a thousand small stop losses.

In order to add a layer of safety, start using a per period risk/reward model as a layer of risk control on top of your per trade risk management. For example, day traders can apply a strict per day loss limit, such as “stop trading when down 2% of trading capital in a single session”, coupled with a per day profit target that is equal or larger than the loss limit. For longer term traders, a per week or per month system might be more practical.

“Cut your losing days, weeks or months and let your winning days, weeks or months run” would be the motto.

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