Basic knowledge of risk management

Basic knowledge of risk management

Every investment is subject to risk due to potential unfavorable price changes. As the financial markets constitute a complex system with many factors influencing the demand and supply at the same time, it is important to know that the result of practically any given transaction is uncertain.

Risk management depends very much on the types of assets the trader is interested in. In this text we would like to discuss the tools that can be used in order to minimize potential losses resulting from adverse price changes:

• study the different types of assets
• plan your strategy
• establish the maximum acceptable risk
• use the different order types.

 

Study the different types of assets

It is crucial to first understand the liquidity.

 

Depending on the type of asset you are interested in, there may be more or less volatility related. The higher  the volatility, the higher the financial risk associated with the given market. This means that operating on a such market involves potentially higher profits and losses than in the case of markets with lower volatility. There are markets where there is not much movement, while others change very often and the price changes may be quite significant.

 

Another important issue is the spread - i.e. the difference between the ask price and bid price. Different assets have different spreads, as the spread size depends on such factors as liquidity of the market, its volatility or time of the day. As the spread represents an indirect cost of the transaction for  a trader, it can be related to the volatility in order to compare the cost of transaction between the given markets. For example, the cost of operating on  a market where the spread is 4 points and the difference between daily maximum and minimum is equal to 60 points, can be considered to be more attractive than in the case of a market where the spread is 2 points, but the daily price range is just 20 points.

Plan your strategy

It is imperative to decide what type of investment strategy is to be implemented

 

The strategy shall define the key aspects of the trades, including their time horizon. There are assets where it is difficult to trade in the short term, as the cost of transaction is relatively high in relation to the size of  typical price movements. However, it is still possible to consider such markets for the purposes of investment in the longer term, cost carry transactions or possible arbitrage. On the other hand, assets that change very often could provide a good possibility for transactions in the short and ultra short term.

 

 

Establish the maximum acceptable risk for an investment or trade

 Important step that many investors seem to ignore

 

It may be a good idea to establish a maximum amount of money that he/she is willing to risk in any given transaction. Such an amount can be defined as a percentage of the available capital. Considering an example where the trader is willing to risk no more than 3% of the portfolio, 3% of that amount would mean that the investor is willing to “risk” no more than $300 USD in a trade.

 

The limit calculated as shown above, or using any other method, can be taken into account when considering where to set the stop loss or close the transaction by any other means. In order to do that, one should also consider a value of  pips. Assuming that for a specific asset the pips value is equal to $10 USD, and the acceptable risk is $300 USD, then a trader may consider placing a stop-loss with a value of 300/10 = 30 pips from the level where the transaction  was opened.

 

Use the different orders.

Understanding the possibilities behind the pending orders of the trading platform may contribute to more efficient trading plan

 

There are many different orders available at the MT5, which can potentially help to realise profits or limit the losses during the investment process:

• Market orders - buy/sell
• Stop loss
• Take profit

 

Market orders (or instant execution orders): these are simply orders (buy or sell) that are executed instantly  at the  time they are placed.

 

Stop-loss: stop-loss orders are additional orders available for both pending orders and market orders. They can also be attached to already opened positions on  a given market. These types of orders are the most basic orders designated for limiting the potential losses, for  example when an investor is not able to follow prices all the time. A trader establishes stop-loss levels by either specifying the level in points from the current price or by specifying an exact price level. For long positions, the stop-loss value must be lower than the current price. For short positions, the stop-loss value must be higher than the current price.

 

Take-profit: Take profit is an additional order available for both pending orders and market orders. They can also be attached to already opened positions on  a given market. The difference between this order and the stop-loss order is that in the take-profit order, a trader will fix the exact profit he wants to realise. Sometimes, investors are not actually sure how much a price will continue its direction, so they fix a value for which a profit is guaranteed if the price reaches that level. For long positions, the take-profit level must be above the current price. For short positions, the take-profit level must be lower than the current price. 

 

Pending orders: Pending orders will be placed immediately but executed only when the price has reached a previously determined price. There are six types of
orders available as pending orders:

• Buy limit
• Sell limit
• Buy stop
• Sell stop
• Buy stop limit
• Sell stop limit

Buy limit: an investor is willing to buy an asset when the price has reached a certain level.  At the  time of placing of  an order the market price must be higher than the one specified as the buy limit price. In this situation, investors believe that prices will fall to a certain level and will later rise.

 

Sell limit: an investor in this case is willing to sell an asset when the price has reached a specified level. At the  time of placing  an order, the market price must be lower than the one specified by the investor (sell limit price). This approach reflects the belief of the trader that prices will reach a certain level (the sell limit price level) and then start falling.

 

Buy stop: by placing a buy stop order an investor expects that if prices reach a certain level (buy stop price), they will keep on rising. The price at which the transaction  is concluded will be less favourable than the current market price. However , the fact of reaching that level could be interpreted as a confirmation signal. Once executed, this order will buy an asset after reaching a level defined by the investor. The market price at the time of placing the order must be lower than the defined buy stop level.

 

Sell stop: by placing a sell stop order a trader expects the prices to keep on falling, once a certain level (sell stop price) below the current market price  is reached. Reaching this level can also be interpreted as a confirmation order of the investor’s prediction. Once executed, this order will sell an asset after reaching a level previously established by the trader. The market price at the time of placing the order must be higher than the defined sell stop level.

 

Buy stop limit: It is combines both buy stop and buy limit features. This order will place a pending order (buy limit order) only if the price previously reaches a defined price by the investor. One may say that this is a conditional pending order, that will only be executed when the price reaches a certain level. To place this order the current price must be lower than the conditional price level - i.e. the price which activates the pending order.

 

Sell stop limit: This is a conditional pending order. An order will be placed if and only if a price reaches a price level previously defined by the investor. To place this conditional order, the current market price level must be higher than the conditional price. Once  prices start falling and reach the conditional price level a new sell limit order will be placed.

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Money Management

 

Protecting your capital (or money management)

The biggest risk that any trader faces is that they will lose their capital. Often new traders will start out with a string of successful trades and their confidence grows: they never learn to apply sound money management and limit their downside risk. Sooner or later they encounter a string of losing trades that either wipes them out or wipes out a big enough portion of their capital that they quit trading.

Uncertainty

No trading system can deliver 100% accuracy. Prices can go up or down at any time: it is only the probability that varies. The best we can hope for is a probability of about 80% (that price will move in a specified direction). That means that at least one in five times you will be wrong and price will move against you. There is no such animal as a "sure thing". In fact, whenever you hear or use those words, you are at more risk of losing your capital than at any other time.

If you can't be 100% accurate, how can you make money?

In the same way that a casino makes money. If the odds are stacked in your favor (compare 80% to the house advantage of less than 55% on a roulette wheel) you will be able to gain more than you lose -- provided that you do not risk all your capital on a single trade.

The market is a dynamic system. I often compare trading to a military operation, not because of its' oppositional nature, but because of the complexity, the continual uncertainty created by conflicting intelligence reports and the element of chance that can disrupt even the best made plans. Prepare thoroughly, but allow for the unexpected. The formula is simple: trade when probabilities are in your favor; apply proper risk (money) management; and you will succeed.

Money Management: The 2 Percent Rule

The 2 percent rule is a basic tenet of risk management (I prefer the terms "risk management" or "capital preservation" as they are more descriptive than "money management"). Even if the odds are stacked in your favor, it is inadvisable to risk a large portion of your capital on a single trade.

Larry Hite, in Jack Schwager's Market Wizards (1989), mentions two lessons learned from a friend:

1. Never bet your lifestyle -- never risk a large chunk of your capital on a single trade; and
2. Always know what the worst possible outcome is.

Hite goes on describe his 1 percent rule which he applies to a wide range of markets. This has since been adapted by short-term equity traders as the 2 percent rule:

The 2 Percent Rule: Never risk more than 2 percent of your capital on any one stock.

This means that a run of 10 consecutive losses would only consume 20% of your capital. It does not mean that you need to trade 50 different stocks -- your capital at risk is normally far less than the purchase price of the stock.

Applying the 2 Percent Rule

1. Calculate 2 percent of your trading capital: your Capital at Risk
2. Deduct brokerage on the buy and sell to arrive at your Maximum Permissible Risk
3. Calculate your Risk per Share:Deduct your stop-loss from the buy price and add a provision for slippage (not all stops are executed at the actual limit). For a short trade, the procedure is reversed: deduct the buy price from the stop-loss before adding slippage.
4. The Maximum Number of Shares is then calculated by dividing your Maximum Permissible Risk by the Risk per Share.

Example

Imagine that your total share trading capital is $20,000 and your brokerage costs are fixed at $50 per trade.

1. Your Capital at Risk is: $20,000 * 2 percent = $400 per trade.
2. Deduct brokerage, on the buy and sell, and your Maximum Permissible Risk is: $400 - (2 * $50) = $300.
3. Calculate your Risk per Share:
   If a stock is priced at $10.00 and you want to place a stop-loss at $9.50, then your risk is 50 cents per share.
   Add slippage of say 25 cents and your Risk per Share increases to 75 cents per share.
4. The Maximum Number of Shares that you can buy is therefore:

$300 / $0.75 = 400 shares (at a cost of $4000)

Quick Test

Your capital is $20,000 and brokerage is reduced to $20 per trade. How many shares of $10.00 can you buy if you place your stop loss at $9.25? Apply the 2 percent rule.

Hint: Remember to allow for brokerage, on the buy and sell, and slippage (of say 25 cents/share).

Answer is--

---

Answer: 360 shares (at a cost of $3600).
Capital at Risk: $20,000 * 2 percent = $400
Deduct brokerage: $400 - (2 * $20) = $360
Risk per Share = $10.00 - $9.25 + $0.25 slippage = $1.00 per share
Maximum Number of Shares = $360 / $1 = 360 shares

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Is 2 Percent Suitable For All Equity Traders?

Not all traders face the same success rate (or reliability as Van Tharp calls it in Trade Your Way to Financial Freedom). Short-term traders normally achieve higher success rates, while long-term traders generally achieve greater risk-reward ratios.

Success Rate (Reliability)

Your success rate is the number of winning trades expressed as a percentage of your total number of trades:

Success rate = winning trades / (winning trades + losing trades) * 100%

Risk-Reward Ratios

Your risk-reward ratio is your expected gain compared to your capital at risk (it should really be called the reward/risk ratio because that is the way it is normally expressed). If your average gain (after deducting brokerage) on winning trades is $1000 and you have consistently risked $400 per trade (as in the earlier 2 percent rule example), then your risk-reward ratio would be 2.5 to 1 (i.e. $1000 / $400).

Risk-Reward ratio = average gain on winning trades / average capital at risk

Confidence Levels

If we have three traders:

Trader:	A	B	C
Time frame:	Short-term	Medium	Long-term
Success Rate:	75%	50%	25%
Risk-Reward Ratio:	1.0	3.0	10.0

Trader A

Trades short-term and averages 125% profit over all his trades.

Winning trades:	75% * 1	0.75
Less: Losing Trades	25% * 1	-0.25
Average Profit		.50
As a percentage of capital at risk		50%

Trader B

Trades medium-term and averages 200% profit over all his trades.

Winning trades:	50% * 3	1.50
Less: Losing Trades	50% * 1	-0.50
Average Profit		1.00
As a percentage of capital at risk		100%

Trader C

Trades long-term and averages 325% profit over all her trades.

Winning trades:	25% * 10	2.50
Less: Losing Trades	75% * 1	-0.75
Average Profit		1.75
As a percentage of capital at risk		175%

This does not necessarily mean that Trader C is more profitable than A. Trader A (short-term) is likely to make many more trades than Trader C. You could have the following situation:

Trader:	A	B	C
Time frame:	Short-term	Medium	Long-term
Average Profit/Trade	50%	100%	175%
Number of Trades/Year	300	100	40
Times Return on Capital at Risk	150	100	70
Capital at Risk	2%	2%	2%
Annual % Return on Capital	300%	200%	140%

Relative Risk

We now calculate the relative risk that each trader has of a 20% draw-down. Use the binomial probability calculator at  http://faculty.vassar.edu/lowry/ch5apx.html:

Trader	A	B	C
Success Rate	75%	50%	25%
Probability of 10 straight losses	0.0001%	0.1%	5.6%

Obviously, the higher your success rate, the greater the percentage that you can risk on each trade.

Bear in mind that, with a higher risk-reward ratio, Trader C only needs one win in 10 trades to break even; while Trader A would need five wins. However, if we compare breakeven points, it is still clear that lower success rates are more likely to suffer from draw-downs.

Trader	A	B	C
Number of wins (out of 10 trades) required to break even	5	2.5	1
Normal Success Rate	75%	50%	25%
Probability of making a net loss in 10 trades	2.0%	5.5%	5.6%

Low Success Rates

Although your trading system may be profitable, if it is susceptible to large draw-downs, consider using a lower percentage of capital at risk (e.g. 1 percent).

Back to the Real World

In real life trading we are not faced with a perfect binomial distribution as in the above example:

• gains are not all equal;
• some losses are bigger than others -- stop losses occasionally fail when prices gap up/down;
• probabilities vary; and
• outcomes influence each other -- when stocks fall, they tend to fall together.

Covariance

The biggest flaw in most risk management systems is that stock movements influence each other. Individual trades are not independent. Markets march in unison and individual stocks follow. Of course there are mavericks: stars that rise in a bear market or collapse in the middle of a bull market, but these are the exception. The majority follow like a flock of sheep.

Thomas Dorsey in Point & Figure Charting gives an example of the risks affecting a typical stock:

Market risk Sector risk Stock risk

66% 24% 10%

The risk of the market moving against you is clearly the biggest single risk factor. How do we protect against this?

Protecting your Capital from a String of Losses

The 2 percent rule alone will not protect you if you are holding a large number of banking stocks during an asset bubble; insurance stocks during a natural disaster; or technology stocks during the Dotcom boom. We need a quick rule of thumb to measure our exposure to a particular industry or market.

Independent Sectors

Limit your exposure to specific industry sectors. Not all sectors are created equal, however. Industry groups in the (ICB or GICS) Raw Materials sector have fairly low correlation, and can be treated as separate sectors, while industry groups in most other sectors should be treated as a single unit.

We can see from the above chart that Chemicals and Containers & Packaging tend to move in unison and should possibly be treated as one industry sector, but other indexes shown are sufficiently independent to be treated separately.

Sector Risk

As a rule of thumb, limit your Total Capital at Risk in any one industry sector to 3 times your (maximum) Capital at Risk per stock (e.g. 6% of your capital if you are using the 2 percent rule).

This does not mean that you are limited to holding 3 stocks in any one sector. You may buy a fourth stock when one of your initial 3 trades is no longer at risk (when you have moved the stop up above your breakeven point on the trade); and a fifth when you have covered your risk on another trade; and so on.

Just be careful not to move your stops up too quickly. In your haste you may be stopped out too early -- before the trend gets under way.

I also suggest that you tighten your stops across all positions in a sector if protective stops are triggered on 3 straight trades in that sector (within a reasonable time period). By protective stops I mean a trailing stop designed to exit your position if the trend changes (e.g. a close below a long-term MA). A reasonable time period may vary from a few days for short-term trades to several weeks for long-term trades.

Market Risk

You can limit our market risk in a similar fashion.

Limit your Total Capital at Risk in the market to between 5 and 10 times your (maximum) Capital at Risk per stock (e.g. 10% to 20% of your capital if you are using the 2 percent rule). Adjust this percentage to suit your own risk profile. Also, the shorter your time frame and the higher your Success Rate, the greater the percentage that you can comfortably risk.

It is also advisable to tighten your stops across all positions if protective stops are triggered on 5 straight trades within a reasonable time period. Protective stops do not have to be the original stops set on a trade. You may make an overall profit on the trade, but the stop must indicate a trend change.

Money Management Summary

A general rule for equity markets is to never risk more than 2 percent of your capital on any one stock. This rule may not be suitable for long-term traders who enjoy higher risk-reward ratios but lower success rates. The rule should also not be applied in isolation: your biggest risk is market risk where most stocks move in unison. To protect against this we should limit our capital at risk in any one sector and also our capital at risk in the entire market at any one time.

 

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Stop Loss Orders

Stop loss orders ("stops") are limits set by traders at which they will automatically enter or exit trades - an order to buy or sell is placed in the market if price reaches a specified limit.

The first discipline that any trader should master is to always limit your losses.

A stop loss order is set to limit a trader's potential loss. The stop loss is placed below the current price (to protect a long position) or above the current price (to protect a short position).

      Example: If you purchase 1,000 IBM at $90.00 you may decide to place a stop loss as follows:
                      SELL 1,000 IBM IF price is less than or equal to $87.00
                      If price falls to $87.00 your order will be activated.
                      Your loss is limited to $3.00 per share (plus brokerage).

 As a rule: avoid markets with low liquidity where extreme price fluctuations are possible.

Stop Loss Order Types

• Market Stop Orders
  This is a conventional stop loss order - the stop activates a market order to sell (or buy) at the prevailing market price.
• Limit Stop Orders
  The limit stop activates an order to sell at the prevailing market price but not below a specified limit (or buy at the prevailing price up to a specified limit).
• Fixed Price Stop Orders
  The stop loss activates an order at a fixed price. Some exchanges refer to these as limit stop orders so check that you are using the correct stop loss order.

Limit stop orders are recommended for entering a trade: they have a greater chance of success than fixed price orders but are not as open-ended as market orders (where your order will be executed no matter what the market price is).

Market stop orders should be used to exit trades: to ensure that the order has the best possible chance of execution. Never hold on to securities if price falls sharply - in the hope that they will recover. Edwin Lefevre sums up the predicament in Reminiscences of a Stock Operator :

It was the same with all. They would not take a small loss at first but had held on, in the hope of a recovery that would "let them out even." And prices had sunk and sunk until the loss was so great it seemed only proper to hold on, if need be a year, for sooner or later prices must come back. But the break "shook them out," and prices just went so much lower because so many people had to sell, whether they would or not.

Evaluation of Stop Losses

Stop loss orders do not always work perfectly. If a major support level is breached, a large number of stops may be activated at the same time. Sellers will far exceed buyers, causing price to fall sharply and leaving sell orders unfilled. In extreme cases there may be no buyers at all for a security -- not at any price.

Imperfect as they are, stops are still an effective mechanism for limiting risk and protecting capital.

If stops are not accepted in a market, set your own limits and place buy or sell orders when the price is reached. Use SMS alerts if they are available from an online broker. Self-discipline is required to execute stops without hesitation.

Steps Required

1. First, determine your maximum acceptable loss;
2. Set stop loss order levels based on sound technical levels;
3. Adjust your stop loss levels over time to lock in profits;
4. Use trailing stops to time your entry and exit from the market.

Setting Stop Loss Orders

Stop loss order levels need to be technically consistent, otherwise they will cost you money. Arbitrary levels are likely to be activated by the normal cycle.

Base your stop losses on technical levels, such as:

• Support/ resistance levels,
• Above/below the most recent peak/trough,
• Above or below reversal signals; or
• At the crossing of moving averages.

Example

This example illustrates the use of 2 different technical levels for stop losses:

1. The first stop loss is placed just below the level of the most recent trough.
2. The second stop loss is placed below the support line (on a reversal signal above the support line).

Support and Resistance Levels

Avoid placing your stop loss exactly at the support or resistance level for two reasons:

1. Trends often reverse at these levels and you may be stopped out unnecessarily;
2. A large number of stops may be set at the support or resistance level, especially where it has formed at a round number.

Rather set your stop loss one or two ticks below a support level or one or two ticks above a resistance level. For example: If a support level has formed at $20.00, set the stop loss at $19.90 so that you are only stopped out if the support level is penetrated.

Adjusting Stop Loss Orders

Adjust your stop loss orders, over time, in the direction of the trend being traded:

    In an up-trend move your stop loss up to below the Low of the most recent trough.
    In a down-trend move your stop loss down to above the High of the last peak.

Only a break in the trend (or large correction) will stop you out.
Using Moving Averages

An alternative approach, that may prevent you from being shaken out of a trend too early, is to use a long-term moving average in conjunction with the above. Stan Weinstein (Secrets for Profiting in Bull and Bear Markets) suggests using a 30 week moving average. This is suitable for investors following the primary trend, adjust the length of the moving average if trading in a shorter time frame.

In an up-trend move your stop loss to below:

•     the Low of the most recent trough, or

•     the moving average, whichever is lower.

In a down-trend move your stop loss to above:

•     the High of the most recent peak, or

•     the moving average, whichever is higher.

Example

Johnson & Johnson is charted with a 63 day exponential moving average. Stop loss order levels are depicted by horizontal trendlines.

1. Go long [L]. The signal is taken when price respects the moving average. A stop loss order is placed at [S1], below the Low of the most recent trough or below the moving average, whichever is lower (shown by the start of the trend line).
2. At [S2] move the stop loss up to below the moving average at the next trough.
3. At [S3] move the stop loss to below the Low at the next trough (this is lower than the moving average).
4. At [S4] move the stop loss to below the moving average at the next trough.
5. The stop loss order is activated [X] when the next correction falls below the previous trough.

Ranging Market

In a ranging market adjust your stop loss based on the cycle in one time frame shorter than the cycle being traded. For instance, if trading an intermediate cycle (in a ranging market), move your stop loss orders up or down in accordance with the short cycle.

Maximum Acceptable Loss

Set the maximum loss that you are prepared to accept on any single trade. This is usually expressed as a percentage. Avoid trades where the difference between your entry level and the stop-loss exceeds the maximum acceptable loss.

Consider the following factors when determining your maximum acceptable loss:

• Whether you are investing or trading;
• The time frame that you are trading in;
• Whether you are trading on margin;
• Your overall risk profile; and
• Your level of diversification.

A long-term investor/trader with reasonable risk diversification may find 6%, or even 10%, an acceptable limit. A short-term trader may set a limit of only 2%.

Trailing Stop Loss Orders

Trailing stop loss orders have three uses:

• To limit your losses,
• To protect your profits, or
• To prevent you from entering (or exiting) a trade too early or on a false signal.

Stops can be based on the high/low of the daily trading range or on a trailing percentage. Welles Wilder's Parabolic SAR is a further form of trailing stop.

The rules below are based on Screen 3 of the Triple Screen trading system, described by Alexander Elder in Trading for a Living.

Buy-Stop

When you get a signal to go long - place a buy order one tick above the High on the signal day. If price rallies, you will be stopped in on the next day. If price falls, the buy order will remain untouched. Move the buy order down to one tick above the High on the second day. Continue to lower the buy order on each subsequent day until price rallies and you are stopped in.

When you are stopped in, place a stop loss below the Low of the recent down-trend (the lowest Low since the signal day).

Sell-Stop

When you get a signal to go short - place an order to sell short one tick below the Low on the signal day. If price falls, you will be stopped in on the next day. If price rallies, the buy order will remain untouched. Move the sell-stop up to one tick below the Low on the second day. Continue to raise the sell-stop on each subsequent day until there is a correction and you are stopped in.

When your sell-stop is executed, place a stop loss above the High of the recent up-trend (the highest High since the signal day).

* Day 4 makes a new High and a new Low. If the High was made before the sell-stop is reached, the stop-loss will be placed as shown. If the sell-stop was activated before the new High was made, then the stop-loss would have been placed above the High of Day 3 and the trade would have been stropped out on making the new High.

Example

Intel Corporation is shown with a  21 day exponential moving average and 7-day Stochastic  %K and  %D.

1. %K falls below 20. Place a trailing buy-stop just above the day's High of $33 1/2.
2. Move the buy-stop down to $33, above the High of day 2.
3. Move the stop down to above the High of day 3.
4. Move the stop down to $32 1/2 - one tick above the High on day 4.
5. The day opens with a new Low of $31 3/8 and then rises until we are stopped in at $32 1/2. Place a stop-loss below the Low (i.e.. the lowest Low since day [1]). Thereafter, price falls back to the day's Low, but fails to activate the stop-loss one tick below.

Inside Days

The rules for sell and buy stops are sometimes varied by excluding inside days:

• no adjustment is made to a buy-stop if the day does not make a new low;
• no adjustment is made to a sell-stop on days that do not make a new high.

Trailing Percentage Stops

Trailing percentage stop orders are offered by some online brokers. The stop order works with a ratchet effect - it trails price movements by a set percentage, but only in the direction of the trend. If price reverses direction, the stop remains at its previous level and will be activated if price reverses by more than the trailing percentage.

Buy-Stop

Buy-stops are used to enter long positions or to close short positions.

In the example below, the trailing stop is set at 6%. The trader will be stopped in if price rises 6% above the lowest Low.

The buy-stop ratchets down on each day that price forms a new low. The stop loss for each day is set at 6% above the lowest Low since the signal (Day 1).

Note that the stop loss remains unchanged if the previous day does not form a new Low.

Sell-Stop

Sell-stops are used to exit long positions or to enter short positions.

Compare the 10% trailing stop, in the example below, to a 6% trailing stop. With a 6% sell-stop the trade would have been exited at 48.9 on Day 3 (52.0 - 10%).

Setting the Trailing Percentage Stop

When setting the trailing percentage, consider the following factors:

• If the stop losses are being used to limit your losses, decide on your maximum acceptable loss beforehand.
• Determine the magnitude of the intra-day cycle - you do not want your stop loss to be activated by normal intra-day fluctuations. Use intra-day charts or in-depth information from an online broker.

A Word of Caution

Check how your broker calculates trailing stops!

Many brokers calculate trailing stops on the last close and do not adjust on an intra-day basis. If price runs up from $20.00 to $28.00 during a single session and then falls back to close at $21.00, you will not be stopped out with a 5% trailing stop calculated on this basis, because price is still above yesterday's high, even though it has fallen 25% intra-day!

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