One evening, while giving a trading seminar in the Los Angeles area, I was approached by an attendee who asked me why TradingMarkets.com had many articles on patterns and strategies, but none on how to get out of a trade, and few on trade management.

I thought his question brought up a very salient point. Go into any bookstore and you can find a multitude of books concerning methodology, systems and theories on how to trade -- particularly how to spot a setup and nail down an entry point. You will be lucky to find enough books on trade management to make up a stack that would get much higher than your shin.

Part of this is for good reason: Each trade is unique and must be managed by the trader himself or herself. This is an area of trading, however, that is neglected in education, and is worthy of looking at in greater detail. While this article will not give you hard-and-fast rules to follow, I will show you some things you should consider at important inflection points within a trade, and possibly shed some light on how top traders might manage some of the following.

The Initial Protective Stop (IPS) -- The Trader's First Safety Net

Regardless of the setup, the most important part of your entry is determining an Initial Protective Stop (IPS). This will determine your maximum initial risk, in the event the trade should go against you, and prevent a potentially small loss from turning into a big one. How you place your IPS is up to you -- depending on the type of trader you are. It is reliant upon the time frame of your trade, the size of your position, your account size, and the amount of risk you are willing to assume. Most traders determine the placement of their IPS by analyzing factors such as:

• Technical Patterns: Many traders will use technical levels like support, resistance, or previous highs or lows. This method is used by many swing traders, as well as those who work on an intraday basis.
  
• Point-Based Stops: These are most often used by daytraders, and depending on the size of their initial position, may even be as low as 1/2 or 1/4 point.
  
• Volatility: Dave Landry has written an excellent three-part series on determining an instrument's volatility and how to use it to determine appropriate stop placement. You can access the first installment of the series by clicking here. Volatility is an important factor to consider if you are going to use point-based stops.
  
• Position Size: The size of the position will also affect how much risk you will take, either making you set a tighter stop (with a greater likelihood of being hit) on a larger number of shares, or using a looser stop (more points being at risk) on a smaller position.

Burlington Resources (BR | Quote | Chart | News | PowerRating) is an example of a stop based on the technical pattern of the chart. A swing trader after determining his entry point in this simple pullback pattern, would most likely place the Initial Protective Stop one tick under the prior day's low. (Chart courtesy of Quote.com)

Daytraders who play price swings on an intraday basis can also employ this technique. (Chart courtesy of Quote.com)

Point-based stops, while used mostly by daytraders, are used effectively by swing traders as well. In using a point-based IPS as a swing trader, you must consider the volatility of the equity or future you are trading as well as position size. For example, it would not be a very successful strategy to risk 2 points on a swing trade (three- to seven-day period) on an equity like SDL Inc.(SDLI | Quote | Chart | News | PowerRating) which has a minimum daily range of 15 points and many times will rise or fall 30 points on an intraday basis.

To successfully trade a volatile stock such as this, a more prudent plan would be to use the average daily range to determine the amount of points to risk, then determine the amount of your trading capital to venture that will correlate to your protective stop. If you want to risk 2% of a $50,000 trading account = $1,000, have decided to place your IPS 10 points from your entry and the stock is trading at $100 per share -- your position size would be 100 shares (10 point possible loss X 100 shares = $1000).

Daytraders can get by risking a tighter IPS (anywhere from 1 point to as little as 1/4 of a point) since they usually go home flat and re-enter trades throughout the day with greater frequency than swing traders do. Most successful daytraders who use point-based stops for initial protection employ strategies that entail the position to move in their favor immediately, or they are out in a short period of time even if their stop has not been hit.

How To Keep Profits In Your Account

Now you have found a prime setup and determined how you are going to enter and where you are going to place the Initial Protective Stop. The stock or futures contract make a nice move in your favor. How do you now proceed? Where you go from here can be determined by a few factors, but as a short-term or swing trader there is one very important rule that you must adhere to if you are going to survive in the trading jungle:

Never, under any circumstances, allow a profit of 1 point or more to turn into a loss.

This is a must to preserve your all important trading capital. There are different ways of doing this, but the tenet of the rule is paramount. Anytime you have a profit of at least 1 point, you must, at the very least, move your protective stop to the level of your entry fill - guaranteeing at worst, a breakeven trade. Following this simple rule will turn potential losers into scratched trades. You can survive a great deal of breakeven trades (even allowing for commissions) much longer than the same amount of losses.

Trailing Stops

Trailing stops are used by top traders to retain profits once a position has moved in their favor, be it on an intraday or swing trading time frame. All you do is "trail" the stock higher (or lower for shorts) as it moves in your favor. The simplest trailing stop is to place the new stop one tick under the previous low, or one tick above the prior high for short sales.

(Chart Courtesy of Quote.com)

(Chart Courtesy of Quote.com)

Two-For-One Money Management

Practicing simple two for one money management will make you look like a genius even it you don't know anything about rocket science or gas stoves. All that two for one money management entails is that when your profit is double your initial risk, you sell half of your position and raise your stop on your remaining shares to breakeven. If the position continues to move in your favor, just keep trailing the stop on the remaining shares. Nothin' to it.

Here Hispanic Broadcasting (HSP | Quote | Chart | News | PowerRating) broke out from an ascending triangle and rose more than 6 points intraday. By selling half the position, a trader will insure at worst a breakeven trade. In this example, the trade continues higher before the trailing stop is hit. (Chart Courtesy of Quote.com)

In the two examples above, both trades turned out to be favorable. This will not always be the case. Remember that top traders focus on a return of capital rather than a return on capital. Winners will take care of themselves.

Scale-Out Selling

One of the best parts of my job is being able to work closely with the best traders in the world. Jeff Cooper taught me a technique he uses to exit winning trades profitably. He takes the two-for-one money management principle a step further, selling out of a profitable intraday position in three pieces. He refers to this practice as "scale-out selling." If his position size is 3000 shares, he will exit the first third of the position when he has doubled his initial 1 point risk and move his stop on the remaining shares to his original fill price. If the stock continues to move in his favor, he will sell the second 1000 shares of his remaining position, and again move the stop to the level of his second sale. He has now locked in 2 points of profit on the first third of his position, 4 or more on the second and is sitting on the third piece with another 4 points of gains being the worst-case scenario if the last stop is hit. Think for a moment just how powerful a money-management technique this is -- even on a 100-share lot that the average trader is capitalized for:

• First piece - 2 points X 100 = $200

• Second portion - 4 points X 100 = $400

• Remaining shares - 4 points X 100 = $400 + ?

Granted, this is a best-case example and is contingent on the trade being profitable on the outset, but even if you just get to stage one, you have locked in 2 points on section one:

• First piece - 2 points X 100 = $200

• Second and third - Stop is hit at breakeven

• Profit - $200

Would you take at least 2 points on every trade? I know I would.

Conclusion

I have touched on some of the techniques I use in my own trading and that I have learned from others. This is far from complete with regards to utilizing stops and money management. Other traders like Dave Landry, Mark Boucher and others have written other articles on this subject in our Education Section on what truly is the most important part of being a successful trader. The greatest pattern or system discovered or yet to be is utterly worthless without proper money management.

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