‘Hope for the best, plan for the worst’ – Lee Child.
While we tend to evade the word ‘hope’ in trading, the opening quote resonates rather well with the trading world.
But do traders really plan for the worst, or are they just relying on hope?
Planning for the worst
There will be instances where you find yourself so caught up in the motions of trading that you lose sight of your primary objective: PROTECTING CAPITAL.
To help keep from veering off track, selecting cut-off points could be something to consider adding to your trading plan.
What is a cut-off point?
A cut-off point is the point at which a trader’s pre-determined risk tolerance has been reached. Think of it as a safety valve in the form of a mechanism designed to notify a trader when to pull their finger off the trigger and stop trading.
As each trader is different in terms of risk appetite, cut-off points will be subjective.
The three key points we believe should be placed in everyone’s trading plan are as follows:
- Daily cut-off point.
- Weekly cut-off point.
- Overall cut-off point.
Daily cut-off point
This will likely apply to intraday traders, but could also affect swing traders in the event of a big move.
We are sure you’ll agree that it is not unusual for intraday traders to execute at least two trades in a day. Using the example of a 2% risk profile (risking 2% of account equity on each trade), and assuming that one experiences two losses for the day, this would translate into a 4% loss.
A daily cut-off point of perhaps 4% would help avoid exacerbate these losses beyond this level, allowing one to revert back to an objective state and live to fight another day tomorrow. However though, this is assuming that the trader honours the cut-off limit and has the discipline to walk away from the desk until the next trading day!
Weekly cut-off point
Similar to the daily cut-off point, the weekly cut-off point will come into motion should the trader experience consecutive daily losses. Think of this as an additional safety valve.
Following on from the example above where a daily risk tolerance of 4% was set, what’s stopping this individual from encountering five consecutive daily losses, totalling a whopping 20%? Absolutely nothing is the answer! This is where the weekly cut-off point steps into the fray. A weekly cut-off point placed at 8%, for example, will help control the account’s losses in the event of a persistent losing streak. Again though, this will only be effective should the trader honour the limits in place and stops trading for the remainder of the week.
Overall cut-off point
In our opinion, this is critical. An overall cut-off point determines the risk tolerance for the trading year. With this parameter in place, it will help avoid one from depleting their entire funds, which can easily happen in a few nasty trades if not controlled. An example could be 50% of the account’s equity. This, though, will vary among traders.
Don’t be that trader without a plan!
Losses will happen. This is guaranteed. Risk is such an important factor in this business and it is unfortunately so often disrespected, and in some cases, overlooked entirely. Don’t be one of those traders. Without capital you have zero skin in the game.
As we come to the end of this article, keep in mind that cut-off points work both ways. While it can help protect one from devouring their account in a spate of revenge trading, it can also help avoid greed. Using cut-off points as a strategy to plan for gains is also something traders may want to focus on. Greed, in our opinion, is just as powerful as fear.