This is where the rubber hits the road in managing money within a market environment that presents new information on a constant, flowing basis.
Trading is all about risk and reward. The stop loss contains the risk taken, and any subsequent reward can be measured against the risk you took.
The risk-reward ratio
There are many ways to stop loss and take profit.
When data is gathered to build a rule-based trading plan, stop losses can be analysed to develop the best method for the market being traded and the trader’s risk appetite.
The trader can then set take profit orders and stop loss orders at the outset of a trade.
As a trading system is built and implemented, the trader will then discover this is just a numbers game around a set of rules.
With the order systems we have available, portfolio management of the rule-based trader can furthermore be automated, so as to not require any discretionary decision making.
When discretionary decision making enters the trader’s mindset, it can be looked at as a type of unlimited risk.
Discretionary trading decisions can bring in unlimited risk for traders as they try to make rational trading decisions while deciphering flowing information.
The real repercussions of this become clear when a decision is made to stay in a position against the trader’s own rule-based system.
One of two outcomes will occur.
Either the position will continue to lose money and damage not only the account, but also the trader’s mindset.
Alternatively, the trade will go on to make a large profit, meaning the trader has been rewarded for the bad behaviour. Operating outside the rule-based guidelines, this is the worst outcome possible.
From here onwards, no trading plan exists and the trading results will return to a style of trading based on hope.