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I have a little pile of reader’s questions here, so let me just get to them.

John asks: “Should I use stop or stop limit orders to protect profits and limit risk?”

John, like pretty much everything else in trading, the answer is a solid “it depends.” Your answer to this will come with understanding the tradeoff: a stop order might be filled at a truly horrible price, but a stop limit order might trade through (e.g., on an opening gap) and never be filled at all. Both order types have a way they can go wrong, so the question is which is worse.

And the answer, of course, is it depends. What does it depend upon? One key issue is the microstructure of the market you are trading; there’s a world of difference between a liquid, active currency and a very thin stock that might not print a trade for hours some days. The size of your order relative to the liquidity of the market is also a consideration, and this is something that has may have changed a bit with the HFTs–even moderately sized orders can have a surprising impact on a liquid market. It also depends on your trading style and what you’re trying to accomplish. It depends on your trading style and what you’re trying to accomplish with the trade. It might even depend on where the trade is in its lifecycle (i.e., just entered, old trade but hasn’t really moved, significant profit, or nearing an exit at a loss.)

In many markets, the question is basically solved for you, as there are no true market orders (meaning that a stop cannot elect to a market order, only a limit order.) You can still set the limit price so wide that the order is effectively a market order, and then you are subject to tradeoffs like I mentioned above.

Two readers asked a question that I can paraphrase as: “How do I think about all of the influences that might be acting on my trade? If I want to buy a stock, how much to I consider the market? How about the Dollar because that will move the stock. How about things that might or might not happen like the Fed raising rates? How about what is happening with the spread between this stock and its competitors? It seems there is an overwhelming amount of influences, so how do I know what’s important?”

This is another good question, and one for which there is no easy answer. Let me present the two opposite extremes: on one hand, a trader might try to look at everything you mentioned, and more. There certainly are traders who try to absorb all possible and relevant information, process it, synthesize it, and make a decision. On the other hand, there are traders who make a set of rules that might look at only price patterns. They are deliberately blind to every other influence and religiously exclude those other influences from their thought process. So those are the two extremes–look at everything or only look at one thing–and there are people who live on both extremes and do it very well.

Most traders fall in the middle somewhere, and I think we need to be careful of the middle. The problem with being in the middle is that it can work against discipline and consistency. Imagine if you are a technical trader who trades breakouts, and you’re looking at a trade in crude oil. Now imagine you get concerned about the trade over the weekend, and you do some reading on macro events, you do a little back of the envelope modeling with production, storage, and consumption, and you spend some time reading about OPEC decisions and you try to think about what might change there in the future. What have you just done? You’ve completely changed your trading process for this one trade, and that might be very dangerous.

I think the answer always comes back to discipline. Who are you and how do you make your market decisions? Define that, and then create a trading plan based on who you are and how you trade. That plan should clearly include the factors you will look at, and that’s your information set for every trading decision. In fact, one of the biggest warning signs of an impending break of discipline is when we find ourselves drawn to look at or to do something we would not normally do while we are in a trade (e.g., read articles, ask a friend, look at new indicators.) Short answer: be consistent.

Mattias asks: “What is the best way to transition from sim trading to real trading? How much of my sim experience can I expect to be similar with real money?”

The short answer (and I know some of my readers who have experienced this themselves are feeling a wave of emotion as they read your question)… the short answer is “probably not much.” Let’s think about why sim results might be different than real money. First, the accuracy of the execution assumptions is important. Let’s say you have a limit order to sell a market, and price trades there. Were you filled? Maybe, but maybe not. What if price goes bid at your level (yes) or trades through (yes)? Many sims do not model this correctly, and I would always take the worst possible assumption: assume it has to print through for you to be filled.

There’s also the obvious issue of slippage: Your sell order at $100.00 will rarely be executed at $100.00, and, depending on market conditions, may be executed at a very different price. These two issues alone can make all the difference between making or losing money, and it becomes more of an influence the more actively you trade. In the limit, if you sim test a daytrading strategy and are picking up an “extra tick” on most of your trades that you would not have in the real world, that, alone, can make a badly losing strategy look wildly profitable on sim. It’s hard to appreciate how powerful this influence can be until you’ve experienced it yourself.

However… the real issue is you! The way you react to having risk on in the market is totally different than how you will react to a sim. Yes, there are things you can and should be doing to increase accountability and to make it feel a bit more real, but the experience of seeing your P&L fluctuate often destroys every shred of discipline for a first time trader. (And many of my readers are knowingly nodding their heads right now–we’ve all been there, done that, and have the t-shirt.)

So, I think what you do is first adjust your expectations. When you move to live ammo you are basically starting a completely new leg of the journey. Some of your experiences and skills will carry over, but the goal of your first experience with real money trading is basically to not do anything stupid. (I say that with complete seriousness. That’s the best advice I can give a new trader–don’t do anything stupid.) Open a very small account, and trade with correct risk parameters and position sizing. (Maybe you’re risking $20 / trade, for instance.) Can you do that? I think that’s the smoothest transition–start with a very small risk per trade, and then gradually increase once you have earned the right to do so. How do you earn the right? Trade consistently, with perfect discipline, and don’t do anything stupid. 🙂