Risk Management: Stop-losses, Leverage, Position Sizing

Stop-Losses

A stop-loss is a preset price at which your order will close if price goes in the wrong direction.

In my view, most new traders set stop-losses too tight. Having a tight stop allowed you to take trades with greater risk:reward, and I would presume it is more appropriate for scalping than anything else. It's tempting when you start trading to wack up the r:r on a trade so that you're getting 8 to 1 on your money, and I know a lot of the literature advises looking for at least 3 to 1. I will say, some of the best traders I've seen will enter with conditions barely better than 1:1.

The problem with tight stops is that you often get forcibly closed, only for price to resume trending in the desired direction. In other words, you can be directionally right, but still lose money. This has to be one of the most frustrating feelings as a trader; "I f***ing knew the market was weak and it took me out to the tick and bounced off my stop."

When entering a swing trade, you intend to hold that position from anywhere between a few hours to a week or 2. If you enter a trade on the 15 minute chart and place your stop above or below the last 5-10 candle consolidation or swing, you're likely to get taken out.

Your analysis for a swing trade is usually done by identifying trends or ranges on the daily and weekly timeframes, and then zoning in to lower timeframe market structure, and then executing perhaps on the micro timeframes (1-5-15min).

Your stop needs to go beyond a key swing point, and these are best identified back on the 1h-4h timeframes. The stop gets placed here because there is liquidity at or just beyond the swing-point, and we want that liquidity to act as a barrier between us getting liquidated.

Your stop is to protect you from absolute loss. Typically that means if there is some drastic market move overnight or when you are away from the pc, you only risk your isolated margin. If you are trading actively throughout the day, you can set a wide stop, but actively manage the trade. If the pattern or signal you used to enter the trade has been violated, even if your stop hasn't been triggered, you can manually exit the position and re-enter if conditions return to favour.

You should also get in the habit of implementing a time-stop. That is, when you enter a position based on a signal, you're expecting price to behave in a particular way... and soon. In your head, you should develop a timeframe where, if price hasn't reacted as you would expect, you get out - and again, re-enter when favoured conditions resume.

Stop-loss management and a look at Evolving R

When you enter a trade based on a trade idea, conventional wisdom is to place your stop at a point which would invalidate your idea. That is, "If price goes here, my short thesis based on my system telling me price should drop from here is incorrect." That's fine, place your stop at an invalidation point, and as mentioned above, make sure its beyond a level which is hard to read. The problem becomes when price has moved in your desired direction, maybe you're already up 1R and have a nice amount of unrealized profit. There are people who would criticize moving stops to break-even, or moving stops closer to price to make sure some profit is guaranteed.

They'll say "oh but your idea.. your thesis isn't invalidated here, its dumb to get stopped out here." Lets back up for a second. The thesis is that you think price should go down from here, based on the current information. Your target is a target, the objective is to enter when price is most likely to move towards that target. Once your trade is a day old, and you get to a point where price has moved in the desired direction, your system provided you with solid information to enter the trade. If price starts showing strength later on, it is prudent to start moving your stop closer. If it then round-trips to the supply level you originally entered at, you wait again to see that it has held, and you re-enter.

Evolving R

And even if no low timeframe consolidation was there for me to move my stop to, I'm still not willing to be THAT wrong on my 'thesis' anymore. The goalposts have moved, and I am now much further from my original stop. If someone accidentally exited your position at this point in the trade, you almost certainly wouldn't re-enter the same position under the same risk parameters. That's all evolving R is. As price moves in your direction, your original stop (which is what your leverage, position value and everything else is based on) is getting further and further away. When you have 1R or 2R of unrealized profit in your account, that is essentially your new initial margin. It's what you stand to lose to be 'proven wrong.' You are inherently taking on more risk as you build profit.

Capital preservation is #1. Price doesn't move in a straight line, so give it room to breathe when moving your stop, but move it nonetheless. Don't move it for emotional reasons, but move it because you realize that if you're 1R up on a 1:2R trade, you're now risking 2R to gain 1R. It doesn't matters whether your 'thesis' or 'idea' is invalidated or not, you're just no longer within your risk parameters.

Calculation

You want to short BTC @ $30,000 down to $20,000, with a stop-loss at $33,000

Assuming your account size is $10,000 and you want to risk 2% of capital.

You want to risk $200 (2% of $10,000),

Using the TradingView short tool, you can see that your stop is 10% away

(10% of $30,000 is 3,000)

If you want, you can also use this calculation;

distance to stoploss (%) = ((entry - stoploss) / (entry)) *100

= ((30,000 – 33,000) / 30,000) *100

= (-3,000/30,000) *100

= (-0.1) *100

= -10% (the minus sign doesn't matter here)

Now the most important calculation and one every trader should know;

Position size = amount at risk / distance to stoploss (%)

= $200 / 10%

= $2,000

This means that you would short $2,000 BTC

Now, just to finish this up, if we reach our target of $20,000

distance to target (%) = ((entry - target) / (entry)) *100

= ((30,000 - 20,000) / (30,000)) *100

= (10,000 / 30,000) *100

= (0.333) *100

= 33.3%

We would of course just use TradingView's tool to calculate the distance to target for us.

If we hit our target then, we make $2,000 * 33.3% = $666

and lose $200 if our stop-loss is hit.

Leverage

The primary use of leverage is to allow you to trade with your whole trading capital while only having a portion of it on the exchange.

For example, if I have $100,000 worth of trading capital, I might not want to risk keeping it all on an exchange because as we know, these exchanges can often be bad actors and we might not be able to get our money back when we want it. As a result of this, I can keep say $10,000 on the exchange, and trade on 10 leverage. Or say I want to trade with 1% of my entire stack on any one trade, I keep that $10,000 on the exchange, and each individual trade I make is with $1,000 (1% of my original $100,000) and I lever that to wherever the price action permits based on my trade idea.

The amount of leverage we use is really a function of where we are wrong on the trade idea. This dictates our stop-loss and the leverage we use.

When we introduce leverage, we have whats called 'Maximum Adverse Excursion.'

All this really means is; how far can price go against me before I get liquidated?

The calculation is (1/leverage)*100% but it's very intuitive without knowing a calculation;

At 100x Leverage, price only needs to go 1% against my before I'm liquidated. 1% adverse price movement, amplified 100x, is 100%.

At 50x leverage, price needs to go 2% against me. At 10x leverage, 10% and so on.

What this means is that your stop has to be between your entry and your leverage liquidation point. If you get liquidated due to a 1% price move at 100x leverage, your stop-loss needs to trigger before this point.

One final note. Any funding you are required to pay is calculated on your notional trade value, not your initial margin.

If you have $10,000 leveraged 20x, your position size is $200,000. If the funding rate is 0.001% you are paying that funding on the $200,000, not on the $10,000.

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Stop-hunts

or; "market manipulation and are they out to get me?"

Just watch the video;

From a technical standpoint, or what you can do to counteract this phenomenon... You must remember to think of Support & Resistance levels as bands.. Flexible bands, rather than hard lines in the sand.

Also take a hint from what David says,

"The stop needs to be where the stop needs to be." (beyond key levels)

"Try putting your entry at the stop-loss level"