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Defining Profit and Loss Parameters
by Don Wellenreiter

Before you enter a trade, you should always pre-determine the amount of loss you will withstand before closing the trade. I firmly believe that you can tell how good a trader is based on how he takes a loss as opposed to how he takes a gain. Anyone can take a gain, that part is easy. But when do you get out of a loser? Probably the worst thing to have happen to you is to pre-determine your loss tolerance, then get stopped out, only to see the market turn around and go in what was your favor.

This will teach you a horrible lesson, because the next time this happens you'll think back to that trade and pull your stop order in what brokers call "cancel if close." The problem comes in when this trade doesn't turn around and you sustain a painful loss. If you get stopped out and the market turns around decisively, you can always re-enter the market. Don't hang on to losing trades. So, never change your stop loss just because the market is now close to your stop price. You originally placed the stop because that was the level of loss your account could afford to withstand. You must accept your loss and move on.

Most professional traders will not risk more than 5% on any one trade. For example, if an investor has an account value of $25,000 he should only risk $1250 on a trade. Assuming that he is long on S&P at 975.00, his stop should be at 970.00. Retail investors tend to risk more of their money when they trade. Some newsletter writers suggest risking as much as 30% on any given trade. While I believe this to be extremely excessive, the choice is clearly yours. If you keep your losses small your chance for eventual success goes up.

Besides setting loss parameters, you must also set reasonable profit targets. As you enter your trade you should decide upon your profit target. One of the ways to make this decision much easier is to trade multiple contracts. Again, if you have a $25,000 account, you could have four long Mini S&P contracts at 975.00. You may decide that you would sell one contract at 980.00, one more at 985.00, the third at 990.00, and either sell the last one at 995.00 or just put a trailing stop (mental only, because stops are not allowed with the Mini as of this writing) on the contract and let it run. Obviously, this is just an example but it does show how multiple contracts can give a trader more flexibility in his trading.

If, however, you only trade one contract you should either set a point to take profits (and stick to it) or use a trailing stop to protect your position. One way of setting a pre-determined profit point is to sell a call option that is close to your target price. This way if the market rallies to and above the strike price you sold, the futures will be called away. Keep in mind things look their brightest at the top and their worst at the bottom, so don't be swayed by what others are saying. Stick with your original target and get out.

 
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