Stop loss distance, commissions and the impact in trading

Whenever I’m trying new short-term trading strategies, I end up forgetting about the eternal “detail” of commission costs and the impact they have on a trading strategy that we could consider almost intraday.

At times and doing backtest strategies, I come to the conclusion that we have a trading system with a lot of potential.

What happens is that many times I tend to be tempted to use a fairly high leverage, much more than would be more reasonable, which in the end makes it end up operating more than it would in the case of using less leverage.

I’m going to put an example.

Stop loss and commissions

Imagine that you have studied a system with the EURUSD using a stop loss of 12 pips, which is quite low but that is still acceptable to do something similar to “scalping”, only instead of looking for four pips here and there you are looking “Let the profits run.”

The result of the backtest tells you that it is quite possible that we have a pretty good system and that it is worth putting it into practice.

Later, before putting it into practice you decide that the same system could try it with a lower spread, of, let’s say 6 pips, looking to make “scalping” something more extreme.

If with 12 pips of stop it went well, then with 6 it could go well too.

What’s more, as with 12 pips I used x contracts, with 6 pips of stop I can use x by 2, that is, I can be leveraged to double, which in theory would give me much greater benefits.

If with the previous system I thought to earn 60% a year, with the new I hope to gain 120%, which is not bad, except for the day trading gurus who tell you that this is what you have to earn per month.

The result with the stop loss of 6 pips also goes well and therefore I am encouraged to try the system.

Also, as I am aware that with the same I will pay more commissions, I already take it into account and apply them when it comes to having an acceptable estimated result.

Well, the time comes when I apply the strategy.

After a month of hard trading I end up realizing that, as always, the results of the backtest do not end up being perfect in live trading, because we always have 100 unexpected events in the form of news, strange slippages, untimely executions, “Errors”, etcetera.

With this, we see that the system no longer has the potential to earn 120% a year, but rather less.

How many commissions do you pay in the stock market per year?

What’s more, with the amount of frantic trading I end up doing, I realize that at the end of the month I have paid a commission amount equal to 10% of the original account. That is what has to use a lot of leverage and operate with such low spreads: that you are operating a lot almost every day.

The issue is that having used the strategy of 12 stop pips with the same “technical indicators”, I would have paid about a quarter in commissions, since not only the stop loss is higher, so you would have fewer transactions closed by the same, but also, by operating a single contract, you will end up paying less to the broker.

There, at the end of the paragraph, came the keyword of the matter: the broker.

They are interested in operating with as much leverage as possible.

As is obvious and I have explained, at the end of the same month you will end up paying many more commissions a year, and that is what the broker is interested in.

In the previous example, let’s look at how at the end of the year I would end up paying more than 100% of the value of my commission account, and that without counting the spread and the slippages. You can already be making calculations so that your system is so good that it can defeat this negative probability of entry.

However, with a system that uses half of contracts and almost half of operations, we will pay an equivalent to 25 or 30% of our account in annual fees, which is still an outrage, but no longer puts us in such a complicated entry situation.

This is something that any futures, forex, CFDs, stock, or even sports betting or poker operator should do: study the cost of commissions at the end of the year, to get an idea of ​​what they are having to pay the broker in a regular way.

With this many will discover that their strategies were not so bad after all, but not enough to overcome an entry barrier of having to earn more than 100% of the account on an annual basis to pay for the use of such large leverage.

In an example like this you can clearly see the danger and problem of leverage, which is a double-edged sword, usually with the most dangerous edge facing the trader, of course.

As I just mentioned, this is something that affects all sectors of trading, from Forex to futures, passing through CFDs and stocks.

Even if you operate the DAX 30 or the S&P 500 you will have to take into account this cost of the commissions (and especially the spread). As in the case of the EURUSD (which you can trade in both Forex and futures), it is better to use less leverage and fewer contracts.

What to do in these cases?

Well what common sense tells you: use less leverage and looser stops, and with that, pay less money to the broker, or at least take more money to get it.

Although you’ve always heard that cutting losses is the best, even a phrase as wise as that has a limit, and it’s always better to let them run a little more if this is saving a substantial amount in what the broker ends up charging you at the end of year.

The example I put before, where in one case we pay 100% of our account in annual fees, and another in which we pay 25% shows us that the second option is more sensible for us, despite having a looser stop (do not cut losses so fast), and therefore with “less potential” gain and less leverage (not to risk more we have the most efficient system).

This should serve to remind us that when it comes to trading, the best thing to do is always use decent stops and not get carried away by the stories of day trading.

If you manage to get a good system that uses loose loss orders, such as 1% of the price of the DAX, S & P500, IBEX, gold, oil, or 50 pips in assets such as the EURUSD or GBPUSD, you will be in a better position to get more sensible results.

Of course, with that type of stop you have to forget about doing day trading, obviously.

Greetings and good trading