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TRADING #101 COURSE – PART II TWO: SUCCESSFUL TRADING PIE – WWW.TRADERSCOACH.COM

4. Liquidity risk. If there are no buyers when you want to sell, you will experience
the inconvenience of liquidity risk. In addition to the inconvenience, this type of
risk can be costly when the price is going straight down to zero and you are not
able to get out, much like the experience of Enron shareholders in the year 2001.
One defense against this type of risk is to diversify among a spectrum of market
sectors.
5. Overnight risk. For day traders, overnight risk presents a concern in that what
can happen overnight when the markets are closed can dramatically impact the
value of their position. There is the potential to have a gap open where the price
is miles away from where it closed the day before. This gap possibility can
negatively impact your account value. One defense for this is simply to not hold
trades overnight; instead, convert your positions to cash at the end of the day.
6. Volatility risk. There is the risk of a bumpy market that may tend to stop you out
of trades repeatedly, creating a significant drawdown. This occurs when your
stop-loss exits are not in alignment with the market and are not able to breathe
with current fluctuations. Defense against this risk is to use an entry/exit system
that considers the current market dynamics.

Risk is inevitable in the markets and there is an art to managing the possibilities. It is not
a matter of fearing the risk, instead focus on playing the what-if scenario so that you can
adequately prepare yourself.

Stop-Loss Exits Can Save the Day

The topic of where to set stop-loss exits generally falls under the heading of “trading
system.” You must carefully coordinate your exits with your entries, and this is a trading
skill that you will develop with experience.

The theory of stop selection is a separate topic from money management, but the two
are so connected that it is important to give you an outline of stop theory as part of our
discussion.
There are many stops that you can incorporate into your system, and the following six
are the ones I find most valuable:

1. Initial stop. This is the first stop set at the beginning of your trade. It is identified
before you enter the market. The initial stop is also used to calculate your
position size. It is the largest loss you will take in the current trade.
2. Trailing stop. A trailing stop develops as the market develops. This stop enables
you to lock in profit as the market moves in your favor.
3. Resistance stop. This is a form of trailing stop used in trends. It is placed just
under countertrend pullbacks in a trend.
4. Three-bar trailing stop. This type of trailing stop is used in a trend if the market
seems to be losing momentum and you anticipate a reversal in trend.

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