In'Relevance of Exits' we highlighted the importance of exits in general and pointed out that it's the exits and not the entries which actually determine the outcome of our trades. Now that we have established the importance of exits we will be more specific and write about various kinds of exits. Probably the simplest and most critical exit is the money management exit or the timeless stop loss. This is the exit that shields our trading capital and prevents ruin.

To trade futures and other leveraged investments without a money management stop is sure ruin. Well-known trader and author Victor Niederhoffer lost thousands of dollars of his customer's money when he traded his finance down to zero and some twenty-million beyond. No real surprise there. The inevitable outcome of an investment with this ill-fated trader was obviously determined years back when Niederhoffer wrote:

I have never employed stops, to bail out myself. Somehow, having a fixed rule to exit provides my adversaries too great an edge. - Victor Niederhoffer, by The Eduion of a Speculator, page 376

Niederhoffer's passing was no real surprise to business professionals. The only speculation was on how long it would take for him to go bust. To his credit, he continued more than was generally anticipated. Niederhoffer's paranoia about money management stops is not uncommon among naive beginners but it's a mindset that's rarely seen among seasoned professionals. The very first priority in trading should always be to preserve our trading capital from the risk of astrophic ruin. Everything else becomes secondary to this objective.

Note carefully how we have stated this objective. We did not state that our goal was to eliminate or lessen the risk of reduction. Reasonable losses are an essential component of the trading procedure. Superior traders take losses as a cost of doing business. In fact I have observed that great traders probably take more losses compared to poor traders do. The important issue in this conversation is the size of the losses that are okay. Catastrophic losses must be avoided in any way costs and these losses can easily be prevented by always using a very simple money management stop.

Niederhoffer wrongly assumed that he was such a fantastic trader that he could violate the cardinal principle of trading and not make use of money management stops. The simple truth is that great traders really need money management stops greater than poor traders do. Bad traders will fail very quickly whether they use money management stops or not while great traders will endure and thrive forever. The better and longer you trade the more likely that you will eventually encounter a possibly astrophic event.

The money management prevent commits a trader to some last-minute reduction point that a trader can take and the stop will allow him to exit a losing commerce unemotionally. The trader who uses a money management prevent understands from the beginning that he can simply give the trade a limited quantity of room to maneuver against him, and after that, he'll cut his losses by exiting the trade based on his plan. This is a huge plogical advantage. Having a fixed stage to exit a trade with a reduction removes a whole lot of stress in dealing with almost any losing position. The trader with his quit in place always knows exactly when he must exit and avoids the pain of having to see the reduction grow larger and larger day after day.

This plogical advantage of money management stops also helps the trader before he takes a trade. Suppose the system called for us to choose a trade in a particular market tomorrow, and we had an unknown and unlimited potential for reduction. No knowledgeable trader would be willing to take this type of trade. However, in case you've got a money management stop and understand exactly what the worst reduction could be ahead, it's plogically simpler to pull on the trigger and confidently enter that commerce. We know and are ready for the worse case scenario and we have decided that the quantity of risk is acceptable to us. Money management stops provide the trader the benefit of a worst reduction estimate on any commerce. This understanding gives us the confidence to enter the trade and the plogical preparation to take the reduction should it happen. Of course money management stops may not always predict the exact quantity of the worst reduction, because markets may occasionally gap contrary to the position and cause a much larger reduction than intended. But in most cases the money management stop is a reasonable indiion of the worst reduction likely in a trade.

Over the course of this collection of articles about exits we will describe a few of the basic money management stops that all traders should be familiar with. We'll describe the simple Dollar Cease in this Bulletin and describe other advoed Money Management stops in following bulletins.

The Dollar Cease: The simplest money management stop is a stop that's put a fixed dollar amount from the entry price of a trade. Dollar stops are easy to implement and most trading software allow for easy incorporation of dollar stops into any trading system. Simple as this may seem, you will find incorrect and proper techniques to use a dollar cease on your systems.

The incorrect method to use dollar stops would be to find out the maximum amount you can afford to drop in the trade, and then set the dollar cease so. Alas, the market does not make adverse price movements based on how much you can afford to lose.

The correct method to set dollar stops would be to use market characteristics and system testing statistics to determine its placement. For example, dollar stops should not be placed too close to the markets because arbitrary price movement will cause the trade to be stopped out . Neither should dollar stops be placed too far from the market, since that means you're willing to bring a much larger reduction than is needed. In our experience, dollar stops should be placed based on some volatility measure of the market. As an example, if the average daily range of a market is $1,000, it's recommended that the dollar cease on such a market needs to be at least $1,000 if not more. This amount should continue to keep the stop from the arbitrary price movements while preserving its role of capital preservation. Again, it has to be stressed that sufficient egy testing and analysis has to precede the implementation of any dollar cease to ensure appropriate performance.

It's important to comprehend the volatility characteristics of the market you're trading rather than to blindly use a fixed dollar stop for all markets, nor for one market if that market has altering volatility attributes. The challenge then will be to develop money management stops that are flexible to current market volatility conditions.

by Chuck LeBeau

http://www.traderclub.com/