Are Stops Necessary?
I imagine this is going to be my least popular article ever. It deals with stop-losses!!!
If you are a typical retail home trader, you might think stop-losses are unnecessary, but no professional trader with proper supervision will be able to trade without an exit strategy of some sort. If you want to trade like a professional, you are forced to consider the possibility you are wrong about the trade. Your job depends on it.
This article is not about why you should use a stop-loss. Rather it is where you should place the stop loss.
WHAT QUESTIONS DOES ARTICLE ANSWER?
During a trip around Denmark I gave talks about trading and investing. I came face to face with both traders and investors. I discovered that investors are lousy risk managers. They have an attitude of invincibility. They think because they invest for the long-term they don’t have to use money management.
Up in Aalborg I came face to face with a particularly ignorant investor who said he didn’t need stop losses. He bought for the long-term. asked him about his most recent purchase. He had bought Novo Nordisk at 310. It was now at 290. I asked him if he would hold it if it fell to 270. He said he not only would hold it, but he would buy more. What if it fell to 250? He said he would consider it cheap, so he would probably buy more. What if it fell to 200? He said if it got to 200, he would get out. That would have been too much for him.
Bottom line, the man DID have a stop-loss. He just wasn’t aware of it until he came face to face with a big loss. Everyone has a stop if you go through this mental exercise before your trade or your investment. I imagine that his stop loss could have been at a better place than at losing 33% and adding to the losing trade.
This article will focus on the techniques for placing stops on your positions. Before we come to that, there are some DO’s and some DO NOT’s when it comes to stops:
Stops don’t come natural – so you have to train yourself to use them
Everyone knows that placing a stop-loss is like admitting the possibility that you could be wrong. As no one knowingly goes into a position with the thought they might be wrong, placing a stop-loss is not a natural action. However, if you learn to place your stop-losses well, you might end up enjoying the process. At least consider it as natural and as necessary as the surgeon her their hands before operating on you.
Your capital is your life blood – stops keeps you alive
I seem to have taken a step into the medical metaphors so why not stay there for a moment. Your trading capital is your life blood. If you don’t protect it, you will die. All stops do is to protect you.
DO place stops when you are thinking straight
DO place stop-loss when you are thinking straight – not when you are under stress because position is losing you money. It is hard to think clearly when you are about to be hurt.
DO NOT move the stop-loss further away EVER
Stops are a one-way street. When you are long you can only raise the stop. When you are short you can only lower it. We all know how frustrating it is to have our stop-losses taken out, and then see the market move back in our favour. However, that is not an argument for not having stop-losses or for moving a stop further away – and giving the trade “a bit more room”.
So let’s focus our attention on the learning how to place good stops.
Do all market professionals use stop losses? NO.
There are many segments within the trading and investment community that do not use stop-losses. Hedgers don’t use stops. They sell out future inventory. Option traders may use options as a hedge (stop loss) against a position.
The market is often like a chess game for big traders. They don’t want to tip their hands. If they put a stop-loss in the market on a big position, it is like a red cloth to a bull. The market will seek to move to where there is liquidity. If there is a big order resting somewhere, the market may see this and be drawn towards it.
Big traders may not place stops. We are talking BIG here, probably not people like you and me. These iron-willed professionals will have mental stops but probably not physical stops. They don’t want the market to know where the stops are or they don’t want their broker to know where the stops are (remember a broker makes money from executing trades, so it will be in his interest that the client is stopped out).
When their levels are touched they will take their loss without remorse or second thoughts. Taking losses is part of the process of making profits.
Placing a stop loss is a challenge. We want to place a stop close enough to protect your capital but not so close that it is sucked up in the „noise‟ of the market. What is “noise” I hear you ask? Noise may mean different things to different people, but to me “noise” refers to the back-and-forth movement in the market, which doesn’t change the trend.
The DAX trend looks negative, but within the two black lines the market is oscillating around 30 points up and down – without changing the trend or continuing the trend. I define this as noise.
However, you can’t ignore noise as if to say it doesn’t matter. I was short the DAX in this example, and I defined the noise as the trading range between 12740 and 12710. I placed my stop-loss outside the noise. Soon after this screenshot was taken, the market flew up to 12800.
Noise means different things to different people. Short term traders see backing and filling activity as noise. Some call it the ebb and flow of orders and business being executed – without meaning – and it does not change the direction of the market.
For long term investors, the daily volatility is just noise in a big bull run and they may not even pay close attention to it. They know not to get sucked into the emotional fray of short-term movements if they want to secure big profits. Noise could be measured in percent in their world. It is all a matter of perspective.
Stop Loss Techniques
Let’s look at a number of techniques suited to short term trading. I am a short-term trader and so are you likely to be. Short term here means day trading and trading for a few days but really not beyond 2-3 weeks.
A Hard Stop is one in which you simply place a stop a certain number of pips or points or percent from your entry price. For example, you always use a 12-point stop loss in DAX or a 25-point stop loss in Sterling Dollar.
This stop-loss doesn’t make much sense, because it assumes the market is always in the same state of volatility. It sure as heck isn’t. I have seen the Dow Jones index trade in a 20-point range all day – the day before Xmas. I have seen the Dow Jones jump in 50 point increments – the day Lehman Brothers went bust.
Why would you place the same 12-pip stop in both a quiet market and one showing volatile market conditions? Similarly, why would you risk the same 25 pips in both quiet and volatile market conditions? The stop is not related to the market in any way.
Despite its obvious flaws this technique is one of the most common methods used for placing a stop loss. This is also the preferred method for professionals and their risk managers. When I traded for a company, I was told I could not lose more than 50 points. As long as my losses were 50 points or less I was fine. The end result was that I always risked 50 points, even though my stop loss could have
been far less.
A trader friend recalls a story from his days trading at a prop desk. “We had a risk manager who let us get away with murder – as long as our losses were less than 35 points. It was insane because we could lose 35 points and then put on the same trade again – again with a 35-point stop loss. Even when we needed a much smaller stop-loss, we would still use a 35-point stop, because it gave our position much more leeway. The problem was that whenever we lost, we always lost 35 points.”
I don’t think hard stops should be used. They are plain dumb to use.
Volatility Stop I
Volatility is a two-edged for traders, but I remind myself that as traders we live by the sword and we die by the sword. I love volatility and at the same time I hate volatility.
For example, how often have I bought into a signal during the morning hours in the DAX, and built up an acceptable position, and then seen my stops hit because the US markets open, and volatility cranked up 100% for 30 minutes or so.
As a short-term trader, I like the mix of quiet and volatile markets. Volatility is often associated with losses and is often blamed for them. For a day trader, this is not true. Yes, higher volatility does mean higher risk as a direct result of higher fluctuations in the price. However, while it is concern for some, we do need volatility to make money as short-term traders. Really, volatility is a degree of uncertainty. Without volatility, there is no opportunity for short term profit.
The Volatility Stop technique adapts to the market. It dynamically self-adjusts. As such it is a much smarter way of placing a stop-loss than the “hard stop”.
What tools can you use under the heading of “Volatility Stops”.
There are a number of ways to measure volatility but a simple technique uses the Average True Range (ATR). This was developed by Welles Wilder. All charting packages will have this function.
Volatility Stop Method 1
ATR is a measure of the underlying volatility of an instrument. If the Daily ATR is 100 over a 14- period setting, then it tells me the average High Minus Low is 100 points. Can I use this for anything as a day trader, who trades a 5-min chart? I believe I can.
On the FTSE chart I have established that the daily ATR is about 55 points. The average of the high minus low is 55 points over the last 14 trading days
I will be in touch soon.Close