In the first interview of Jack D Schwager’s “Hedge Funds Trading Wizards” global macro trader Colm O’Shea offers some excellent advice to traders on setting of stop loss and position sizing.
According to him a trader should first decide the point where his/her trade will be proven wrong and then set the stop. If the stop implies a loss which is larger than the trader’s comfortable level, then he/she should size the position to a correspondingly smaller level. Now, if the market hits the stop point, it will be consistent with the trader’s own beliefs that the original trade premise was wrong.
According to Colm O’Shea a trader has to embrace the logical consequences of his/her ideas, and that means that he/she has to have a stop loss that is wide enough. In his earlier days he used to set stop based on his pain threshold and not upon the underlying hypothesis for the trade. The market does not care about anybody’s pain.
He learnt from his mistake and now when he gets out of a trade, it’s because of the inconsistent price action with his hypothesis. In his words-“Hmm, that shouldn’t have happened. Prices are inconsistent with my hypothesis. I’m wrong. I need to get out and rethink the situation.”
So stop loss should be set at the point where the original trade premise is proven wrong and the total amount the trader will lose if the stop point is hit should be based upon the trader’s risk appetite.
As always readers are welcome to share and enhance knowledge.
[Contributed by Jitender Yadav]