Rules for short-term traders

Set a maximum loss limit and don't set a hard 'maximum price' target

Some of the more difficult aspects of short-term trading involve taking decisions on changing timeframes and loss targets. A day-trader has to operate on very thin margins and hence, set tight stop-losses. Let's say a day-trade is not stopped out near the close of trading. It's running either a small profit or an acceptable loss, less than the stop loss limit. I'm assuming here that the trader isn't entering with a pre-set stop loss but keeping a stop loss level in mind instead.

Should you carry over the position and if you do, how do you reset your stop limit? The instant a position is carried over and converted to an overnight holding, the stop loss has to be widened considerably to allow for greater volatility.

This is more an art than a science. While a trader can look at price history, average volatility levels, effect on margins, etc., the decision also involves key psychological factors such as the personal risk-appetite.

There are few hard-and-fast rules. The only two I can think of are 1) Set a maximum loss limit 2) Don't set a hard “maximum price” target. The underlying logic of the first rule is pretty obvious. At some stage, increasing losses become unacceptably high and any sane trader has to bite the bullet, no matter how much faith he may have in his judgement.

The exact stop loss level may vary according to personal inclinations but the trader must have the discipline to exit if the stop is triggered. If you are holding overnight, be prepared to increase your acceptable loss limit by 50-100 per cent.

The underlying logic of the second rule is not quite so obvious. It can be viewed in terms of risk:reward. When you enter a trade, you set a stop loss and you presumably hope to make more than you expect to lose.

On a losing position, you will generally lose a little more than your stop loss. You can expect to be successful roughly 50% of the time on trades and the returns when you are successful will vary. If you cut off the winning positions early, you will, contrary to the old saying, go broke taking profits.

When you have a winning position, one way to try and extract the maximum is to move your stop loss up. However, if you do this too hastily, you will limit your profits anyway because you will be stopped out soon. If you don't shift your stop loss up at all, you stand the risk of losing all your profits if an adverse trend develops. Managing this situation is tricky but essential.

The author is a technical and equity analyst