Wednesday, June 27, 2012

Proper stop placement

An important thing to remember when placing your stops based on the charts is that these are a solely a guide to the stop placement that you should use. You will see on plenty of charts where price has just touched the exit signals or pierced them very slightly, before price reverts to going in the direction of the trend. This can be frustrating, however what the chart shows may not necessarily mean that you have been stopped out.

You should always ensure that you take into account the bid/ask spread, using what the chart shows you as a basis. So, for example, if you were in a long trade and the chart was showing a stop at say 500p, but the bid/ask spread on that particular stock is say 497.5 - 502.5, then the stop should be placed at probably 497p.

How big a spread you have to deal with will vary from stock to stock, and also from trading platform to trading platform. When speaking to some US traders, they may have spread of only 1 or 2 cents to deal with, whereas on the same stock on my trading platofrm it could be as wide as 10 -20 cents. This potentially impacts therefore on where you place your actual stops, and also your position size.

Your trading platform may offer you the ability to use a guaranteed stop on your trades - particularly if you trade using either contracts for difference (CFD's) or spreadbetting. These stops can be beneficial for traders with small accounts, in that you can fully quantify your risk at any given time, and do not have to worry about gaps through non-guaranteed stops. Against this, not all stocks/instruments have guaranteed stops available as an option, so that can play a factor in determining which trades you take. 

In addition, these stops have to be placed a certain percentage away from current price - on liquid UK stocks, or on a lot of German and Italian stocks these can be as little as of 5% away from your intended entry price. So, depending on your chosen stop methodology, you may not be able to use them. If you wish to use them, then you need to check to see if the ideal stop as indicated on the chart tallies with the minimum guaranteed stop placement, or is as close as possible. This may knock some potential trades out of the equation, but gives you the best of both worlds in that you have the peace of mind of a guaranteed stop, without compromising on the potential reward:risk ratio on that trade.

Depending on your account size (and consequently the amount you risk on each trade) a disadavantage is that on smaller or less liquid stocks you may have to split your positions down, as you are only allowed to have a certain amount risked with a guaranteed stop - if you need to do this, you have to place the guaranteed stops on each tranche at certain distances apart from each other. This can be tricky to quantify and work out. If you start to hit this problem, you may want to consider reducing your risk per trade.

Of course, if you do not want to use guaranteed stops (or they are simply not available on your trading platform) then to minimise the risk of a larger than intended loss as a result of a gap through your intended stop level, then it would make sense to reduce your risk per trade.

Once you start to develop your skills, confidence and equity as a trader, you may either want or need to dispense with using guaranteed stops. You always need to be wary of the possibility of an adverse price move going against you, whereby you can lose more than your initially risked. So, as you progress, your ability to use strong risk control will be tested.

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