Stop Loss Orders

Having funds with Stops; Another Article on Using Stop Loss Orders - Are stops a good idea? Yep. Why? There are a few good reasons...

First, stop loss orders a good form of disaster insurance, though they are far from infallible. If the market is going to head in the wrong direction in a hurry, they can get you out of your position before the damage is too great. However, loss stops may not protect you against several days of limit moves, or extreme gap openings. When trading contracts, no matter what you do, there is no perfect way to explicitly define and limit your risk. Still, stops do take some of the intraday worry out of trading.

Second, stoploss orders are good for profit protection. Barring extreme price swings, a trailing stop can be an effective way to anchor a set profit. As the market moves and your profit improves, you can gradually move the trailing stop to take in more and more profit. When the market finally does move in an adverse way, the stop liquidates your position with a set profit, and no surprises.

Third, whether stop-loss orders are used to exit a trade with a loss or a gain, they take some of the cognitive dissonance out of trading. If you decide that you need to get out when the market hits a certain price, but you're not using a stop order, then as the market trades into that price it's very tempting to think, "But what if it turns up again? Okay, I'll give it ten more ticks. Okay, so that got hit, but it looks like a bottom is forming, so I'll give it five more..." And on and on it goes. With a stop, you're out without arguing with yourself, and you can look for another trade to take.

Also, if you've got a price level where a profit or loss should be taken for technical reasons, why not use a stop loss order? The alternative is to do weird things during the trading session to less-ideally execute the same concept.

Are stops perfect? No. As I said above, they won't do you much good in a market that is a complete runaway. They won't necessarily give you the fills you expected, especially if the market is volatile when your stop price is touched. There are anecdotes that describe floor traders using stops as targets, trading into them just so they get executed (I've seen blow offs on charts, but I've also seen the absence of this kind of behavior -- take it any way you want). And they can be carelessly placed, giving you losses that didn't necessarily need to occur had more care been taken. But they're a good tool to have, and you need to have a very good reason not to use them, in my opinion.

It is a myth that tight stops offer greater security and less risk (they don't). Tight stops give your spread bet position less chance of being profitable. They are more likely to be triggered by random noise price fluctuations and are thereby riskier. The key is to set the stop loss far enough from the current market price to allow some sway in the market but close enough to provide a safety net should you be wrong.

Setting stops on spread bets has its advantages but it can be an easy way to guarantee a loss if you set them incorrectly. But setting stops can also prevent a big loss -:

  1. Share prices can spike for various reasons and in various ways, including the spread widening dramatically. Any stop-loss strategy should take account of such effects, and if you use stop-losses, you should look carefully at exactly how they're handled, especially early in the morning. Even with large caps, there is a danger then: if 'uncrossing' the opening auction happens to take out all of the serious buy-side orders or all of the serious sell-side orders, the SETS order book system can be left with only "opportunistic" orders of that type immediately after the auction, resulting in an abnormally low "bid" price or high "ask" price. Serious orders of the missing type will almost certainly quickly re-appear - but even a fraction of a second without them can be enough to trigger a stop-loss and produce a very bad trade for you and a very good one for the person whose opportunistic order was matched.
  2. Be also wary that shortly after market opening prices can suffer an artificially wide spread which can trigger a stop. Setting tighter stops would make this worse. Having said that, large companies especially FTSE100 are less affected in this way. In fact looking at the BP trades this morning the bid/offer at 08.00 shows as 567/570. Some brokers therefore handle stop-losses specially early in the morning - e.g. by preventing processing of them in the first half hour of trading. Which is good for avoiding that type of early morning spike - but of course has the downside that if a company does release bad news first thing in the morning, the price has that much longer to plummet before the stop-loss takes effect...

So, what's the best way to work with stops? It's an intensely personal question. Some traders have stop movement explicitly built into their systems. Others just set them as loss limiters. Some people set them for technical reasons, while others have money criteria that they follow. You need to figure out your style and apply stop management rules accordingly; however, I'd be happy to provide my own opinions on how this might be done.

To me, if you're a technical trader and you've entered a market based on some combination of technical studies, or patterns that the market has made, it makes no sense to place "money stops." The idea with a money stop is that you put a loss-limiting stop a certain distance from your entry price so that a loss on the trade will be no more than a specific dollar amount (or percentage of your account). I have trouble with this because if you enter the market on some technical indicator's signal, then the only reason that you would abort the trade would be an invalidation of your reason for entering (i.e. the technical signal) .

So, if you shorted the market because you saw the last shoulder of a head-and-shoulders top completing, then you'd get out of the trade if that last shoulder suddenly headed up and threatened to become a double top. NOT because you were £375 in the hole; the money stop has no bearing on the technical picture. By using technical or mechanical entry criteria and a money stop, you are trading with apples and oranges, and you leave yourself open to being bumped out on an adverse move because it got too expensive, only to watch the market recover and head on its way as anticipated.

If you can't take a loss with a technical stop because it would be too much money down the drain, then just don't take the trade. This is one of the elements of risk management; if you can't afford a proper level of risk, then you are in over your head on that trade.

Is there ever a time when money stops are appropriate? Absolutely. You use money stops (both for profit and for loss) when you are doing statistical trading. As in, "90% of the time, given these conditions, the market will drop £1000. The other 10% of the time, if the up move is greater than £800, then it will go sideways or up." If you have a rule like this, then you short the market, and establish your loss stop just above the £800 mark. You also establish your profit stop right around the £1K mark. The idea here is that you aren't trading indicators with an open-ended, undefined result in mind. Here, you are playing with probable profits and losses, where the stop placement is based on a target return on investment over time.

So, now that you know where to put stop loss orders, is there anything else? For technical stops, you can consider using MOC (Market On Close) stops. MOC orders are not executed until the last minute or so of the trading day. This is especially useful if you are trading a trend line violation system, where you are going to enter a trade if the market penetrates a trend line. One of the problems with this kind of system, though, is that sometimes a breakout will occur, the market will trade through the trendline, only to later return back to the original side of the line and close there. With a MOC stop, you won't take the trade in these situations. You can also use a MOC stop when you need the market to close above a previous top, or when the market's close is needed to confirm some other indicator (moving average of closes, some kind of formation, etc.) .

You can also use MOC orders to avoid the syndrome where you put a loss stop several ticks below a previous bottom, then watch the market tick slowly towards that bottom price, and then suddenly explode downwards as it hits everybody's stops that are clustered there, taking out your further-away stop as collateral damage. Of course, having blown off everybody's stops, the market then heads back up into acceptable territory. If you've got a MOC stop, you'll still be in unless the collapse occurred at market close.

As a word of caution though, you may get burned using MOC loss stops in markets that frequently have aggressive intraday moves (Silver comes to mind here). By waiting until near the market close, the market may have in fact sailed past your loss point and kept right on going, so that by market close you have a much worse loss than you had intended. Also, keep in mind that "MOC" and "the closing price of the day" are NOT synonymous. A MOC order is executed near the end of the trading session. It is a market order (which means you get whatever price you get at the time), and after your fill occurs the market may or may not head sharply in any direction up to the close. Sometimes, there's just no right answer...

For securing profits, many people use trailing stops. The idea behind a trailing stop is that every time the market makes some kind of a marker or indicator that it is about to become more profitable, you place a stop just on the losing side of that marker. As the market makes successively more favorable markers, you keep moving the stop along, protecting increasingly large profits. For example, if you get into the market long, and it takes off for a few days, and then consolidates in a way that leads you to believe that there is support at that level, then you'd place your stop just underneath that support. As the market takes off and consolidates again, you move up the stop after each period of consolidation. The only reason this isn't a perfect strategy is that markets frequently don't behave as you would like, and your protective trailing stop can get taken out just like any other stop. So, if you get a little retracement that makes a perfect V-shape, you'd put your stop under the V. Next week, on some briefly-convincing fundamental information, the market tanks for two days, taking out your position, and once you're out of the market it moves freely in the profitable direction again.

Stop loss orders are no more infallible than any other technical trading tool. Market motion cannot be fully anticipated, so stop placement is not an exact science. However, trading without them is more foolish than trading with them, so a stop strategy becomes an essential component of an overall trading method.

My final word is that since every stop is a potential trade (like it or not), only place stops that represent trades you are prepared to take, and never enter trades where you aren't prepared to take the necessary loss stop if it comes to that.

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