Thursday, January 21, 2016

Some thoughts on stops

There are some inexperienced traders out there who seem to have a strange attitude towards the use of stops. A stop should be based on a price level where:

a) their trade idea should be proven to be invalidated;
b) the loss incurred tallies with the pre-determined amount they are prepared to lose on that trade.

Yet, once they get into position where price starts moving towards their pre-determined stop (which normally would have been calculated in a non-emotional state), these traders often decide to override that stop.

The strangest comment I ever got from a trader about overriding a stop was "I can't afford to take a loss on this position". I think you can guess how that ended up...

Successful traders know that this game is all about controlling your risk, and keeping their losses as small as possible. 

I can safely say that I've never placed a trade without a stop in place, and I can count on the fingers of one hand the times where I have overridden a stop. They were all very early on in my trading career, and I quickly learned the hard way not to do it again! 

So, there are three elements to good stop usage:
  • Placing your stops (both initial and trailing) correctly based on your trading rules;
  • Ensuring that, by using the correct initial stop placement, your position size and monetary risk does not exceed your risk parameters;
  • Finally, that when it comes to exiting your position, be it a winner or a loser, you honour your stops and avoid the temptation to override them.

When you get into a profitable trade, your focus will switch from initial preservation of capital to protecting your profits, by using some form of trailing stop. Ideally you want to maximise those profits and not give too much of them back, but at the same time you don't want the trailing stop to follow price so closely that you can get whipsawed out of the trade on a bit of 'noise'.

Adhering to stops is carried out unemotionally by the traders who have survived the longest in this game. They accept that losses are part of trading, and cannot be avoided. 

They know that small losses can develop into much bigger losses if left unchecked, potentially causing all sorts of psychological issues, as well as a big dent in their trading capital.

On the other side of the coin, they also know that, when they get an exit signal on a winning trade, the party's over. They collect their winnings, and move on.

Good traders want to restrict the downside on any position, but do not want to restrict the potential gains on a profitable trade.

On a losing trade, your initial stop is where the trade is automatically cut as it reaches the maximum monetary amount you are prepared to risk on that position. Therefore, you should think of them as a downside risk controller.

On a winning trade however, a trailing stop should allow you to keep the bulk of your hard-earned gains. Try thinking of them as a profit protector.

Indeed, as a trend follower, the trailing stop will automatically make them exit the trade. Generally, they will not manually close a trade - their exit strategy will do it for them! All they need do is continually update their trailing stop as the trade (and the trend) progresses.

There are lots of ways that stops can be calculated and placed - these may be based on some volatility measurement, by referring to support or resistance levels, x day highs or lows, or moving averages. There is no one right way that will work in all market conditions or on all stocks or instruments.

Have I been whipsawed around on some trades, only for price to start moving back in the direction I was trading? Yes, of course. However, I also have seen plenty of examples where my stops got me out of a trade before there was the start of a major move in the opposite direction that I was trading.

Stops are there to benefit you. They allow you to control the level of losses (notwithstanding price gaps through your stop which can occur), as well as control the parameters which determine the level of open profits you are prepared to give back, and which help to determine the end of a price move.

If you have a written trading plan, and have known initial and trailing exit parameters, then why would you look to override them?

It is all too easy for an inexperienced trader to override a stop, based on hope, fear, or greed. Take it from me, you may get lucky and end up with a more beneficial result on a single trade, but over the long-term, you will lose.

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