In addition to controlling risk on individual trades, nearly every professional day trader I know also uses a daily stop loss. Just as a day trader isn’t likely to let one single trade ruin their day (although this does occasionally happen), professionals also don’t want one single day to ruin their week or month. Trading for a living is a tough business, and taking a huge single day loss takes a toll psychologically as well as potentially financially. Day traders rely on their trading capital to live, so taking a huge hit on one day can feel the same as others might feel if they got fired from their job. Manage your risk on each trade, but even more importantly manage your risk each day so one day’s loss doesn’t kill your income. Here’s how to do it.
Managing Trade Risk
Managing trade risk and position sizing have been discussed in many other articles on this site. As a general rule I encourage all traders to never risk more than 1% on a single trade. If you have a $10,000 account, that means you set a stop-loss on your positions so you don’t lose more than $100 on a single trade.
The idea behind this guideline is that with several (or many) trades placed each day, even a string of losing trades won’t significantly draw down your account capital. On the other hand, if risking 10% per trade, as many novices do, then the account can be cut in a half (or worse) by several losing trades in a row.
This method of risk will control may vary slightly depending on the winning percentage of your strategies though. If you have a very high win rate, you may be willing to risk slightly more each trade, since the higher the win rate the less likely a long string of losses (without some offsetting gains) is to occur.
Therefore, managing risk on individual trades is very important, but equally important is for day traders to set a daily stop loss.
Why to Use a Daily Stop Loss
When trading forex I ascribe to the 1% rule listed above; I don’t risk more than 1% of my account on a single trade (usually less). With leverage and the number of trades I can make each day with a forex broker that provides a near zero spread, there is no reason to risk more than that since even with keeping risk low, great returns are possible.
Since I risk less than 1% per trade, if I lose 3% in a single day that means I have lost 3 trades in a row, or my losses are greatly outnumbering my winners. In either case, if I lose 3% of my account I am done for the day--that is my personal day trading daily stop loss.
If I see an excellent set-up (not every trade is created equal) I may decide to risk to risk a bit a more on that trade, possibly even my whole day, but no matter what happens I don't lose more than 3% of my account on a single day.
Since it is impossible to predict the future with absolute certainty, it is rare that I decide to risk my entire day on a single trade, but it does occur. It is not on a whim though; it only happens when certain conditions materialize and an extremely high win-rate strategy can be employed.
Please note, hitting your daily stop loss should be extremely rare--maybe a once a month to every several month occurrence. If you continually lose three trades in a row each day right off the bat, your strategies or implementation need more work. If you do have winning trades during the day, but you are still hitting your daily stop, then your trades may have some risk/reward issues.
The main function of the daily stop loss is prevent a single day from hurting the overall monthly income. Say your average winning day is $200/day, but when you have a losing day you lose $600 or $700. Under these conditions, even if you win about 80% of trading days (16 out of 20 days a month) you are just barely breaking even.
On the other hand, if you applied a daily stop loss on yourself you could greatly reduce the amount you lose on losing days, which turns this performance into a consistent monthly day-trading-income.
Incorporating a Daily Stop Loss
One type of daily stop loss is based off of the average winning day. If you add up just the winning days each month and then take an average (divide the total sum by the number of winning days in that month), your daily stop loss should be pretty close to that number. Say your average winning day is $2500, then you shouldn't be willing to lose much more than $2500 on a losing day. Using this method means your daily stop loss will change with your performance over time.
In this way, a losing day doesn't wipe out more than one prior winning day, and it only takes one average winning day to recover the loss. Stop yourself from trading when you have lost more in a single day than you usually make on a winning one. While occasionally you may be able to recover the loss if you keep trading, more often than not you are not in the right mind frame, are more prone to gambling and will likely only make the loss bigger if you keep trading.
Another option is what I call the 'consecutive loss daily stop loss'. In my case, if I lose 3 or 4 trades in a row I am done for the day. This will vary slightly based on how much I am risking on each trade; if risking 1% per trade I done if I lose 3 in a row, if risking less than 1% per trade I may let myself lose 4.
Since I know how my strategies perform, it is very rare that I lose 3 trades in a row without a winner in there. If 3 losers occur in a row I may not be in the right mind frame or my strategy may just not work under those very particular conditions--in either case, the consecutive losses let me know I am missing pieces of information and therefore shouldn't be trading. Losing trades and losing days happen, and that is fine, the daily stop loss just contains it.
Don't let one trade ruin your day, and don't let one day ruin your month.
Daily Stop Loss - Final Word
These are ideas on how to implement a daily stop loss and how to manage risk. Plot your own method for controlling trade-risk and daily-risk based on your own personal style, strategies and capital.
In my opinion the daily stop loss is a huge factor in determining how long a traders stays in the game. Ultimately if you want to make an income from day trading you need to make more from your winning days than you lose on your losing days. One way to do that is through a daily stop loss. You may choose to limit to daily losses to the amount of your average winning day, using such an approach means your daily stop loss may change over time depending on performance. You may also choose to stop yourself out if you lose 3 (or some other number) trades in a row, or if you lose a certain percentage of your account.
If you are consistently hitting your daily stop loss, it indicates your strategies or implementation need work, if your daily stop loss based on performance is so small that it doesn't allow you trade, then go back to the simulator and work on your skills.
Cory Mitchell, CMT