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How can spread betters use stop losses to save the fortunes they have without risking the fortunes they seek by stopping out ultimately profitable trades? Jeremy Lacey finds the secret is in knowing where to place the stop, which can allow you to chance your arm without losing your shirt

As a piece of advice for newcomers to spread betting, the much-quoted ‘cut your losses and run your profits’ seems like a statement of the glaringly obvious. A bit like suggesting that the way to make money at the racecourse is only to put your money on horses that are going to win – easy to say, a lot more difficult to do.

But financial spread betting, despite its name, is quite different from punting at the track. If it were not for their reluctance to risk losing the instrument’s tax-free status, most firms would have been calling it ‘spread trading’ by now. Once a horse is out of the starting gate, a gambler has no chance of cutting his losses unless he is able to lay the bet on an exchange such as Betfair. With spread betting, however, traders enjoy the power to control their exposure by using stop losses.

And yet... so many don’t. David Jones, chief market strategist at spread betting provider IG Index, says, ‘The sad truth is that most people do not use stop losses. Hope springs eternal – too many people have a tendency with financial markets to think about the upside and how much profit they’re going to make and not give equal – and I think it should be more – consideration to the downside.’

Some readers’ reaction to this will be that they tried using stop losses and it cost them a packet. Following the accepted wisdom, they set a stop loss on each trade, only to get stopped out before watching the market change direction and go the way they had expected all along. It’s a frustrating and expensive experience and understandably many people feel stop losses are a waste of time, even though without them they risk losing their shirts.

The crux of the problem is where to position your stop. Get this right and you are a long way towards being able to cut your losses and run your profits. While there is no guaranteed route to success, learning to avoid common mistakes in placing stops is a valuable start.

One of the things inexperienced traders frequently get wrong is to place their stops almost randomly, without taking sufficient account of the nature of the market they are trading, and usually too close to their entry level. Foster Bowman, managing director at iDealing, comments, ‘The closer their stop is to their entry level, the more their trading performance will resemble coin tosses.’

A significant factor is what constitutes a point in various markets. Let’s take some popular markets and what one point with a spread betting firm generally entails. For an index bet such as the FTSE 100 or Dow Jones Industrial, it’s mostly one index point. For currency bets, one point may mean 0.0001 for, say, euro/dollar or 0.01 for dollar/yen. Commodities vary from market to market: crude oil bets move in cents per barrel, gold in dollars per troy ounce.

That in itself doesn’t signify much until you consider the size of the market and what a move of x number of points involves. Say you think the Dow is going to move 500 points over the next week: to a newcomer, the obvious thing to do might be to buy or sell the index and place a stop, say, 30 points away, looking for 500 points of upside and risking only 30 points on the downside. The trouble with this plan is that 30 points on the Dow (which at the time of writing stood at around 12100) is just a flea-bite – a move of 0.25%. You may have a time horizon of a few days but the index will probably skip through your stop loss in ten minutes. Check the daily highs and lows on the chart and you will see a trading range of 200 points or so is quite normal for the Dow.

‘On volatile markets such as the Dow, the important thing to think about is what sort of time frame you are trying to trade,’ says Jones. ‘If you’re looking for a shorter-term trade, you’re going to have tighter stop losses, but if you’re looking to trade something for days or weeks you need to give the market room to move around and prove you right. You don’t want to get taken out just on market noise.’

Compare the Dow with the FTSE 100, at around 5600: a move of one point in London is more than twice as significant as a similar move on Wall Street. So where would be the logic in placing a stop loss the same number of points away on either market?

Bet sizes and volatility

Perhaps the reason many people trade in this illogical manner lies in the same mentality that leads others to avoid setting stop losses altogether. Tom Hougaard, chief market strategist at City Index, says, ‘The vast majority of people will not put a stop loss in because they are unable to accept a loss, or essentially to be proved wrong in their assessment of the market.’

He regards coming to terms with the human factor as an important step: ‘It is perfectly natural to lose on a position. Many traders will operate with a win/loss ratio of 60/40. They are still able to make money because they have mastered one of the hardest parts of trading – sitting tight.’

A key to success, then, is being prepared to accept not only a loss, but a loss of a certain magnitude in relation to the volatility of the market. However, where many people go wrong is to set their stop losses according to how deep their pockets are, deciding on a fixed maximum amount they are willing to lose if they are wrong.

It’s all very well buying the Dow at £10 a point in the hope of making £2000 if it rises 200 points, but if you’re only prepared – or can only afford – to lose £250, the stop loss will be sitting just 25 points away. Instead of being guided by what the market tells you, you’re being led by the size of your trading account.

None of this would matter if there were no such thing as a minimum bet size. Volatility would be irrelevant. Unfortunately, it doesn’t work like that, which means that for those with modest-sized accounts some bets are just too rich.

‘Think about what markets are available to trade for the size of account you have,’ Jones advises. ‘If you’re looking for a move on the Dow over a few days, you will need a stop loss in excess of 100 points, but if all you have is £500 at £1 a point you’re risking 20% of your account. Maybe you should be trading something a bit quieter, such as Vodafone, rather than the big volatile stuff.’

Even those with fatter trading accounts need to tailor the size of their bets to the market in question. Foster Bowman comments, ‘The way to handle volatile markets is to reduce your stake size. In the final analysis, your position size should be a function of the daily volatility of a market, not the asset class. That said, bonds and major forex pairs often exhibit lower volatility and you can load the boat with these. Commodities and single stocks typically swing around more. In these cases, you should rein back a bit.’

Less risk and more reward

Placing a 100-point stop loss implies that for every losing trade, you will need a winning trade of more than 100 points simply to break even, depending on the size of the spread in that market. Or to put it more technically, your risk/reward ratio should be greater than 1:1. Conventional wisdom suggests that the ideal risk/reward ratio should be around 2:1 – for example, buying the FTSE 100 at 6000 with a stop loss at 5900 and a target of 6200 – which implies that you will break even (minus the spread) with a winning ratio of one trade in three.

Is this achievable? Of course... if, as Tom Hougaard says, you have the discipline to sit tight. It’s simple enough to automate the process by setting a limit order to exit the trade if and when your target is reached. However, smart readers will have observed the catch in all this – that the wider you position your stops, the higher you need to set your profit targets to maintain the risk/reward ratio.

This is where at least some basic knowledge of charting is more or less essential. The charts can help you not only in setting stops and limits but in deciding when it’s a good time to trade. As a method, Jones favours the ‘old chestnut’ of support and resistance, looking at levels that have held in the past and letting the market tell you if sentiment has changed.

Let’s say your market has a range of 500 points between the lows that have held over the previous 12 months and the highs where resistance has come into play. Clearly, if the market is currently trading in the middle of that range, with a stop loss at 250 points you are risking 250 to make 250. But by waiting for the market to fall to100 points above the support level, you risk 100 points to make 400. And if the market does move in your favour, there’s nothing to stop you locking in some of that profit by trailing your stop loss.

Hougaard believes support and resistance is a ‘very viable method for choosing entry and exit in the market’. He adds, ‘Another way, which can be used in conjunction with support and resistance, is to use some method of trend indication. There are many to choose from in this area, and none are better than the other.’ At iDealing, Bowman agrees that support and resistance provides a good basis for choosing entry and exit levels, ‘especially when a market is range-trading’. He says, ‘I also like buy-stops placed on breakout points just above ascending triangles.’

A number of the spread betting firms present seminars and produce educational material to help traders. IG Index is also about to begin a series of online ‘webinars’ in addition to its seminars. At City Index, Hougaard conducts weekly trading at which he offers a course on both basic and advanced technical analysis.

One word of advice from Jones: think long rather than short-term. ‘For most people, it’s less difficult to forecast the market over days and weeks rather than hours and minutes... short-term price movements are pretty random.’

By its nature, spread betting attracts thrill-seekers, but industry commentators say the consistent winners are those who run their profits for days, weeks or months rather than buying and selling all day long.