the-daily-trading-coach-101-lessons-for-becoming-your-own-trading-psychologist-brett-steenbarger-_2009_-a23

252 THE DAILY TRADING COACHstop-loss point captures the amount of adverse movement we’re willing toincur prior to exiting the trade and declaring our hypothesis wrong.The trader who lacks clearly defined targets and stop-losses is like thescientist who lacks a clear hypothesis. You can trade to see what happens,and scientists can play around in the laboratory, but neither is science andneither is likely to prove profitable over the long run. A firm hypothesisand objective criteria for accepting or rejecting the hypothesis advancesknowledge. Similarly, a clear trading idea and explicit criteria for validatingor rejecting the idea can guide our market understanding. Frequently, ifyou get stopped out of a seemingly good trade idea you can reframe yourunderstanding of what is going on in the market. After all, scientists learnfrom hypotheses that are not confirmed as well as those that are.With the target and stop-loss firmly in mind, we now have the basis forexecuting our idea. Good execution mandates that we enter the trade at aprice in which the amount of money we would lose if we were wrong (ifwe’re stopped out) is less than the amount of money that we would makeif we were right (if we reach our target). When traders talk about getting agood price, this is what they mean: they are entering an idea with relativelylittle risk and a good deal more potential reward. A good way to think aboutthis is to think of each trade as a hand of poker: where we place our stoplosslevel reflects how much we’re willing to bet on a particular idea.Many traders make the mistake of placing stops at a particular dollarloss level. Rather, you want to place stops at levels that clearlytell you that your trade idea is wrong.Let’s say my research tells me that we have an excellent chance ofbreaking above the prior day’s high price of $51 per share. We are currentlytrading a bit below $49 after two bouts of morning selling took the stockdown to $48, which is above the prior day’s low of $47.50. A news itemfavorable to the sector hits the tape and I immediately buy the stock at $49,with $51 as my immediate target. My hypothesis is that this news will bea catalyst for propelling the stock higher, given that earlier selling couldnot take out yesterday’s low. I’m willing to lose a point on the trade (stopmyself out at $48) to make two points on the idea (target of $51).Suppose, however, that the stock was trading at $50, rather than $49when the news came out. Now my risk/reward is not weighted in my favor.If I’m willing to accept a move back to $48 before concluding I’m wrong, Inow have two points of potential loss for a single point of targeted profit.While the idea is the same, the execution is quite different. It is difficult tomake money over the long haul if you’re consistently risking two dollars