Trade Optimization: The Importance of Tighter Stops

I was looking at my charts yesterday and I suddenly had this revelation. At this very moment, I dare say that I finally understand the importance of optimizing my entries, especially setting tighter stop losses.

Before I go into an all out explanation, let's start at the beginning. I've always had this habit of setting wider stop losses. This was done possibly as an excuse for considering intraday fluctuations as mostly noise. To a certain extent, I still hold this belief as we see greater algorithmic activity.

However, I do have to admit that my stop losses may sometimes be wider than what is deemed required. After all, how should the placement of a stop loss be determined? Essentially, it should be at a price level where your directional bias no longer holds true. If you think that price is going to go up, the stop loss is the point at which your bullish signal no longer holds true. This is simple enough.

I to place my stop loss further away to "let the trade breathe." This is probably a poor excuse for not having the patience to optimize my entries. The consequence of this is that I end up having a poorer R-multiple. I never gave this much thought until recently when I incorporated third-party live and post trade reviews into my system.

If you recall in an earlier post, I reviewed a book written by Scott Adams that explained why one should have systems rather than goals. For my trading development, I continuously commit and refine my system. Most recently, I've been getting in tune with the live trade analysis videos uploaded by 2ndSkiesForex. While I hate the majority of the videos on YouTube, I have to admire Chris Capre's dedication for making each video analytical rather than a pathetic attempt to sell some trading course as seen on the rest of YouTube.

Over the course of a week or so, I played back all the live trade analysis that they did at 1.25x speed. What I wanted to get out of this was the following:

• How their trading room identified trading ideas, managed those ideas, and produced what results. I wanted to gain a different perspective, especially as I, admittedly, have struggled during the summer months.
  
  
• Gain a different perspective on the type of analysis done and how others trade price action around critical levels.
  
  
• For the more recent videos, I wanted to see what pairs were being focused on in 2020 and see if they line up with what I've been monitoring. I wanted to see if it's possible that I'm focusing on pairs that don't have much volatility by nature or if there was some way I could further optimize my trade selection.
  
  

Upon concluding the video series, I had one disagreement and this was the praise given for how tight the stop loss placements were. The way I saw it, the majority of these trades would probably fail because there was no breathing room. Why have the majority of these trades gotten stopped out in order to show one trade with an 11R outcome? Personally, I didn't like this focus on tight stops but, then again, it simply wasn't possible for me to say that they were wrong. Instead, I focused on myself and continued to set wider stop losses in order to give the trades breathing room... until this one recent trade made it all click.

This EURUSD example isn't a trade analysis where I go through my entry decisions. Instead, it summarizes my change in belief that 2ndSkiesForex was correct all along. I was just too dumb to think critically and realize it.

In summary:

• Tighter stop losses maximize your R-multiple, which is why I believe 2ndSkiesForex analyzes the stop loss placements and considers them optimal rather than tight.
  
  By analyzing the the larger structure and trading in the dominant direction, the optimal stop loss can be tighter than mine.
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• By increasing your R-multiple, this sets a lower win rate requirement.
  
  
• Depending on the R-multiple and win rate, you can determine if you'll achieve positive expectancy in the long run.

Naturally, I didn't just sit still and think for days until it all clicked. Take a look below at the actual trades I took on EURUSD.

EURUSD 1-Hour

I took a total of two trades. I initially shorted EURUSD and got stopped out. After sensing a change in the order flow, I got long. The second trade resulted in a profit of 5.6R.

In both of these trades, I had rather tighter stop loss placements. If I had set wider stop losses for both trades, I would've only secured a profit of slightly over 1R on the second. Instead of producing a net profit, I would've barely broken even.

If I continuously averaged a profit of 5.6R, or 5R for the sake of simplicity, I only need a win rate of 17% in order to achieve positive expectancy. This means that the majority of my trades can be losers and I'll still come out on top.

When I set a wider stop loss, my R-multiple drops to 2 or maybe even 1. If my average profit is 1R, that means I need to have a win rate of over 50% in order to achieve positive expectancy.

Does this mean having a higher R-multiple is always better? The answer is no, here's why:

• R-multiple is simply assessed against the win rate to determine your expectancy. It doesn't mean higher is better.
  
  
• R-multiple and win rate are strategy based. They can be optimized over time as you refine your strategy.
  
  
• If you're a scalper, you need to target a very high win rate. As a result, your R-multiple is really low and you can still be profitable.
  
  
• In my situation, I trade momentum on a larger market structure. This means that there will be more situations where I'm going to be wrong. As a result, I need to fully maximize my potential when I'm right. This means a lower win rate and a higher R-multiple, which is partially achieved by optimizing my stop loss placement.
  
  Specifically, I need to optimize my entries so that I will know when my directional bias fails sooner. The identification of "sooner" is simply being able to plot my stop loss closer to the entry point.
  
  Consequently, this also means having to sit out on more potential trading opportunities where the signal quality isn't as high. If I can't get a solid read on the order flow, which is essentially price behavior, I should sit out.

To conclude on a final note, 2ndSkiesForex live trade analysis video series is still a part of my system for self-development.