As I write this, we are in the middle of “Le credit crunch”. Volatility has returned to financial markets as Europe comes apart at the seams. During times like these, you’ll hear many trading gurus utter phrases such as “keep tight stops”, yet as I aim to demonstrate in this article, keeping tight stops could increase your losses not decrease them.

The Problem With Using Tight Stops

I also remember reading an argument put forward by a fund manager who said that a managed fund’s ability to know when to step in and cut off a stock that has lost a lot justifies the higher fees charged by many such funds. This sounds great in theory, but the track record of managed funds is not great – often they pull the plug on stocks at exactly the wrong time, just as prices recover.

First I must make it absolutely clear that you must always have an exit strategy and always manage your trading funds carefully. There are also some methods of trading where a stop is an absolute necessity. I must also say that this approach is not without controversy either.

Before explaining when you might or might not use stop losses, we first need to fully understand leverage. Leverage is what attracts most people to trading – the ability to make a large profit from a small initial commitment. For example, with spread betting, you can take the equivalent of a £10,000 position on the FTSE 100 with just £1,000 in your account. Most forex brokers offer leverage of 100:1 or higher, with spread-betting firms offering leverage in the region of 10 times your deposit amount.

Why brokers love leverage

Recently, one of the biggest forex brokers released its annual results with some shocking statistics revealed in the small print.

The average client deposit was $3,000.

The average client loss was $2,800!

It’s also well known that the size of leverage a firm offers is generally correlated with the profits the brokerage makes.

Why is this?

Most people start trading forex attracted by the ability to make thousands with very little money down. The trouble is that most people don’t release that leverage works both ways and the way most traders use it is a recipe for making money for the broker.

Whether it’s short-term scalping of the forex market or spread betting the FTSE 100, leverage is the root cause of many a trading account blowing up.

Leverage: Just because it’s offered, doesn’t mean you should take it

On the face of it, this is one of the attractions of spread betting, the ability to make a huge profit from a small position. The trouble is, most of the time, the only people profiting from such leverage are the brokers themselves.

In the What Really Profits Forex Trading Success DVD, I feature Turbo Terry vs Patient Pete. These are two fictional traders who on paper make the same trading profits, except Terry does it via multiple small trades while Pete does it by giving his trades more room. In reality, the spread is likely to eat into Terry’s profits less than Patient Pete. However, most people who start spread betting are more attracted to Pete’s approach because they over- leverage and can’t afford big stop losses.

I recently reviewed the excellent Free Capital by Guy Thomas, which covered interviews with various successful traders. These traders came in many different shapes and sizes, but one common theme running through the book was the minimal leverage being used. Some of the traders made use of spread betting, but this was done with minimal leverage!

If leverage is available, why wouldn’t you use it?

Leverage itself is not a bad thing, but the size of leverage available by default (10 times for spread betting, 100 times for forex) is what makes it dangerous, especially for beginner traders. When beginner traders start, they are often attracted by the idea of taking on big positions with a relatively small amount of money. To do this they need to use tight stops and tight stops lead to trades being stopped out frequently, especially in volatile markets.

Reducing leverage and improving your exits

By using too much leverage, you are forced to make tight stops in order to keep your losses within margin limits. The problem with tight stops based on a fixed loss, such as 10 pips is that most of the time they A) do not give your position enough room to manoeuvre, and B) Stops like this are reactive, not proactive.

Ever wondered why your trades are being stopped out only to reverse the very next bar in the right direction? Part of the reason is that brokers and market makers love stop losses because they create trading volume. Most people place stops in obvious places which makes them fodder for hungry market makers.

Intelligent exits

I stress once again I am not arguing for taking trades with no exits or hanging on to positions in the hope they turn around. What you need are intelligent exits based on what the market is telling you rather than a rigid stop-based exit.

Stops – When they help and when they don’t

Stops and leverage go hand in hand, and understanding stops and leverage goes hand in hand with safeguarding your account balance.

There are two main types of trade exits:

1) Stops based on the size of losses incurred on a trade position. E.g. 30 pips stop loss or 1% stop loss.

2) Exits based on technical signals or trading strategy. E.g. exit when the price drops below the Bollinger band, or, exit after 2 bars.

You absolutely must have a trade exit in place, but it doesn’t necessarily have to be a loss size exit.

There are times that you absolutely must use stops and these are primarily times when you are using leverage. If trading 5 minute bars on the forex markets with 100:1 leverage, there is no question about it, you absolutely must use stops. You don’t have to use 100:1 leverage though and this more than anything may be causing the most damage to your trading account.

When you absolutely must use stops:

• Day trading on leverage.

• Highly volatile stocks with leverage.

• When you don’t have a specific exit strategy.

When you might consider not using stops:

• When trading stock indices such as the FTSE 100 or S&P 500 with minimal leverage.

• When trading Forex with minimal leverage. • Especially when trading counter-trend trading strategies with minimal leverage.

Trading with minimal leverage means you can trade with exits that give your trades room to manoeuvre. So how do you trade with less leverage?

How to spread bet with minimal leverage:

Stock markets:

1) To spread bet with no leverage, the aim is to match a 1% move on the market with a 1% move in your account balance. For example, if the FTSE 100 is at 5500 and you happen to have £5,500 in your trading account, then you would be betting £1 per point. If the FTSE rose 1% (55 points), your account balance would rise 1% (£55).

2) Go to your spread-betting firm’s main dealing screen and check what index value corresponds to a “point”.

3) Take your account balance and divide it by the index value in spread-betting points. E.g. your account balance is £2,000 and the index value is 1,200. £2,000 divided by 1,200 = £1.67. A 1% drop in the index is 12 index points. 12 index points at £1.67 is a drop of £20, or 1% of your account balance.

4) Double-check you’ve got it right before placing a full trade.

Forex markets:

1) For forex markets, the principle is the same, but make sure you are sure of the number of decimal points being used to represent a “point”.

2) To spread bet forex with minimal leverage, go to your spread-betting firm’s main dealing screen and check what index value corresponds to a “point”. For example, the GBP/USD is 1.6500, but the broker might display it as 16500.

3) Take your account balance and divide it by the number of spread-betting points. E.g. Your account balance is £2,000 and spread betting points on the GBPUSD is 16500. £2,000 divided by 16500 = £0.12. A 1% drop in the GBP/USD is 165 index points. 165 index point at £0.12 is a drop of £20, or 1% of your account balance.

Adding leverage

Leverage is not necessarily a bad thing, but I firmly believe that it is not suitable for most beginner traders. In my experience it is far better to start with no leverage then slowly increase this as you become more experienced.

Even then, you may wish to only leverage up to two or three times, rather than the 10X on offer.

To increase leverage slightly, follow the steps above, but multiply your per point amount by 2 or 3. The golden rule is that leverage should only be used to increase returns from a solid trading edge. If your trading edge is weak or inconsistent, then adding leverage will dramatically increase your losses.

The bottom line

This article does challenge many conventions and much of the advice you may have heard about spreadbetting and forex trading, but I don’t think this is a bad thing. Most people start spread betting and forex trading because of the attractive idea of making big

profits from little money down via the use of leverage. Many will be turned off by the idea of trading without leverage, but then again, the majority of people who trade forex lose money. I would advise you to flip conventional wisdom on its head and not

start with positions that make use of huge leverage, but use minimal leverage while you learn the ropes and only then increase it slowly and cautiously.