Today we're going to look at how you can potentially reduce losses and improve your return by managing your stop loss's price.
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What is it?
Bumping your stop loss to entry is when you edit your stop loss price to the price you entered the trade at after your trade moves some distance into the positive. It is also commonly referred to as "moving your stop loss to breakeven".
- Reduce your losses
- Lock in your gains
- Increased chance of being stopped out
Why is it so appealing?
Traders love the idea of eliminating risk. Being able to avoid suffering a loss seems to be hard-wired into our brains. In fact, the bias of loss aversion is so strong that people tend to favour reducing losses roughly 2x higher than the equivalent gains.
What does the math say?
From statistics there are Type I and Type II errors, more commonly known as false-positive and false-negatives. What this means for traders is that the closer the stop loss is to the current price, the higher the probability that it is hit by a random fluctuation in price. The tradeoff here is that the further it is placed from the price the larger the loss if the decrease in price is a legitimate trend, and not just random noise.
When choosing a stop loss in the first place, it will be chosen at a value that strikes a nice balance. So when deciding to bump a stop loss to entry, that balance should be maintained. A simple way to do this is just keeping the same deviation. Ie) if the stop loss was -10%, then it will be bumped to entry when the current price hits +10%. Another, slightly more precise, way to do this is to use the standard deviation indicator (or an indicator which captures this, such as bollinger bands).
Given that locking in gains and reducing losses is a key component of turning a positive ROI, it's worth looking at how different combinations of target and stop loss prices play out.
Scenario 1. Let's look at an example with a trade involving 2 take-profit targets and a stop loss, and assuming a 50/50 split of amount between the targets.
Stop loss -5%
Target 1: 7.5%
Target 2: 10%
Assuming the stop loss is NOT moved to entry, let us say that target 1 is hit, selling half of the trade and then the price drops down and hits the stop loss, selling the remaining half. The resultant ROI will be +2.5%.
Scenario 2. On the other hand, the following trade can achieve an identical ROI by bumping the stop loss to entry.
Stop loss -5%
Target 1: 5%
Target 2: 10%
In this trade, target 1 is hit, selling half of the trade and then the stop loss is bumped to entry and then later hit. Since half of the trade sold for 5% and half for 0%, the overall ROI is +2.5%.
When choosing to use a strategy of bumping your stop loss to entry, you are effectively saying that you believe scenario 2 has a higher probability of succeeding than scenario 1.
When to use it?
With this analysis, you might be able to guess that it typically works better in Bear markets, where higher targets are harder to hit. Similarly, any strategy which prioritizes smaller wins is better suited to bumping your stop loss to entry.
You might be surprised to learn that it can also work well in a bull market under the right conditions. In this case, what you want to do is wait until the graphs have provided you with more information. Usually in the form of higher highs, lower lows, and maybe even new supports (if you're lucky). Then simply do your TA and choose a new, higher price to bump your stop loss to. In this case it probably won't be your entry, but will be around that area and give you the same result of reducing your losses.
When not to use it?
If there is high volatility then you will want to hold off on moving it until you are confident it won't be accidentally triggered.
If the overall trend is Bullish, then it often pays to trade more aggressively. This means that setting higher targets and opening your stop loss up more tends to be a better choice.
Hopefully this helps clarify bumping your stop loss to entry and how it can be useful when incorporated into your trading strategy correctly.
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Disclaimer: This is not financial advice. Invest at your own risk.