Money management is very important to traders, so much so that it is considered the second biggest ingredient for successful trading after the psychological factor, which is the most important of all factors. Money management comes down to calculating the correct size for the next trade, figuring out how to survive through hard to predict markets and through periods of intense confusion. And the problem of where to place the stop loss order with each trade is one of the biggest problems in trading. Most often, traders make mistakes in calculating risk tolerance for each new trade, believing that they have to use some kind of fixed stop loss size, one that makes trading performance calculations easy at the end of the month. The problem is that fixed stop loss orders do not work well in the markets, in fact they tend to fail way too often in limiting losses and maintaining profitability.
Fixed stop loss orders are a bad idea because the strategy fails to take into account the dynamic behaviour of the markets, which produces different risk levels each day. Especially the idea of having to risk a fixed, X amount of dollars on each trade is totally wrong, it makes money management easier to calculate, but it fails to adapt to the changing behaviour of the markets. Also the idea of placing stop loss orders very close to recent highs and lows is wrong, as the market tends to test these levels again in the coming days.
Wise trades work out levels for placing their stop loss orders based on major support and resistance levels, momentum of trend and other factors. They use different risk tolerance with each trade, they might risk $100 in one trade and $600 in the next trade. Each trade is unique, and so should be risk control. They tend to use large stop loss orders, making the trade appear as though it has some nonsensical risk-reward ratio, and in most cases the risk-reward ratio does not make sense at all. But the risk control set in place is trade specific, and it works. They are also willing to leave these large stop loss orders on, for as long as their strategy requires, if the trade becomes a loser they will look at their market again and again, whilst they might also hedge the open losing trade with an opposite one until they figure things out.
Generally the idea of using tight stop loss orders, is not a good one, as these stop loss orders tend to be triggered by the market even when the market ends up going in the direction that the trader had originally and correctly predicted. So despite all the popularity of low risk-reward ratio strategies, the fact is that these ratios simply fail far more often than they ever work. So in reality, it is the high risk-reward ratio strategies, using large stop loss orders, that offer the greatest probability for a profitable trade. And not only that, but they also offer the trader plenty of time to hedge a losing trade and look at the market again, a day or two later, when things become clearer. The tight stop strategies can have their stop loss orders triggered in minutes, and the market can reverse so fast that the trader has incurred an unnecessary loss, but is also now out of the market and at risk of missing the correctly predicted move altogether.
The above daily chart shows the price of crude oil, one of the most technical markets where levels of support and resistance tend to be respected most of the time. And despite all that, one can see how the market produces false signals, such as the sell signal at the blue bar level. Also this market tends to have variable daily ranges, where not only fixed stop loss orders do not work, but also fixed profit targets do not work either. Both risk control and profit targets need to be dynamic and specifically tailored to each trading week and day. In this highly technical market one would be better off letting the market settle for the day, and make the decision to take profit or close a losing trade right at the daily close. If price targets need to be set in place, these have to refer to previous levels of support and resistance, ideally as seen on the weekly chart, and ignoring the highs and lows of the past few days.
Because the market is made up of both short time frame and longer time frame traders and investors, the levels of support and resistance set by the longer time frame traders and investors will always override those set by the day to day traders and day traders. Therefore it makes no sense to place stop loss orders and set profit targets near the support and resistance levels seen in the past few trading days. The market can easily breach these levels and still reverse back in the previous direction it was moving. On the above crude oil chart, the market rose from $42 to $62 because that is how far previous levels allowed it to move. These previous levels can sometimes be found years back, so they are not always easy to identify. The bottom line is that traders utilizing tight stop and low risk-reward ratio strategies, find themselves getting stopped out way too often, and also missing much of the profit on the profitable days. Therefore one has to focus on the markets, their dynamic ranges, and not on the dollar figures. Correct money management rules can still be used, as the trader can have flexible limits and guidelines as to how much, as a percentage of their trading account balance, should be used from period to period, but that money management guidance cannot determine the exact size of a specific stop loss order or a specific profit target.
