From the June 01, 2009 issue of Futures Magazine • Subscribe!

Using stop placements in trading

If you want to protect your house or car from unforeseen events, you can buy insurance. If you want to protect your trades from unforeseen events in the market, you can use a stop. Although a stop can work as an insurance policy for traders, figuring out where to place one is sometimes tricky. However, there are ways to place stops efficiently to get the protection you need while maintaining trading opportunity.

A stop is a buy order above the market or a sell order below the market which automatically becomes a market order when the “stop price” is touched in the market. It is often used to limit losses in an established position, though stops can be used to enter a position as well. “Once the market trades your price, if you have a stop order placed at that price it’ll be executed as a market order. If it’s a sell stop, it’ll be executed at the best available bid, if it’s a buy stop it’ll be executed at the best available offer,” explains Andrew Waldock, principal, Commodity and Derivative Advisors, LLC.

Placing a stop should be a part of your trading plan. When you place a trade, you decide the direction you’re going in, the entry and when you’re going to get out. Dan Cook, senior market analyst for IG Markets, says a stop is basically a spot where you determine the maximum amount you can lose on a particular trade if the market moves against you. Cook offers an example of stop placement strategy in “Getting out,” right. In the top chart on “Getting out,” the sell signal is at point A, with the sell level highlighted by the green line. Before you can execute this order, you need to look for your stop level. In this case, we referred back to the previous high point (B), highlighted by the black line. The theory is that if price continues beyond your entry (A), a previous level of resistance is the next logical place for price to turn around. Because of the spread involved and because these are more of a zone than a level, you do not want to put your stop (red line) exactly on support or resistance. In this case, the stop was positioned comfortably above the previous high/resistance to give the market some room to breathe. “When using this type of stop, always look at the amount you are risking on the trade. If there are too many points between your entry and the next level of support/resistance, you are typically better off not taking the trade,” Cook says.

The bottom chart on “Getting out” shows what happens as the trade progressed. Price moved past the entry (A) as it approached the previous level of resistance (B) it stalled and created a triple top before it fell. Because the stop (red line) was above the previous level, it was safe.

A stop can protect you if you are not closely watching your trade and help you lock in profits or limit losses. “A stop has to be placed where you’re wrong – where the scenario is not playing out,” says Abe Cofnas, president of Learn4X.com. “If you’re watching the position, there should be very little reason why it should go to your stop. If you’re not watching a trade, the stops become really important and you have to be careful in placing them.”

Where you place your stops will impact your profitability. The difficulty in placing stops is that unforeseen events in the market can sometimes wreck your plans. Consider things like economic release dates when deciding on stop placement.

“If you place a stop limit (a stop order with a limit of acceptable slippage) in a grain market, and a USDA report comes out after the night session’s closed and before the day session’s opened, and we open through that price and continue on, you never get filled. You’re stuck with your losing position, which continues to get worse and worse. The stop limit has to be filled at your price. If that’s an entry order, you missed the trade, it’s not that big a deal. But if that’s an exit order, you’re stuck,” Waldock says.

Experts differ on the best strategies for placing stops. However, they agree that where to place the stop is determined by how much you want to risk.

Waldock says stop placement depends on whether you’re a pattern trader or an algorithmic trader. He says if you’re a pattern trader and you think the market has reached a turning point or you have a trendline that you’re trading against, you’re going to place your stops according to what the pattern dictates.

If you’re an algorithmic trader, Waldock advises using a mathematical calculation, 2/3 of the average three-day range plus or minus the opening price, to determine where to place your stop. He says dollar-based stops are not effective. “The pattern or the algorithm dictates the stop, not the dollar value. If the dollar value is too high, you don’t take the trade,” he says.

Calculating stops is not always an exact science. “[Using a set amount or percentage] is a ridiculous thing to do because you need to understand each of the products,” Cook says. Cook uses support and resistance levels to determine where to place stops. “If I get in on a sell position, I look at the previous level where the market hit, and I put my stop beyond that. You look at the market swings,” he says.

Cofnas says although support and resistance levels are logical places for stops, “It’s never an exact location. It’s the location where your total profitability plateaus.” He says you can tell if your stops are in the right place based on changes in your trading record. “If you’re profitable and you widen your stops slightly and your record goes up, then your stops are too narrow,” he says. “The most efficient stop location is the location that has optimized your production. If you shift your stop and your profits don’t go up or down, that’s the best place for it. If you’ve altered your stops to the point where you can’t get any more profitable, over a long series of trades, then you’ve achieved the best location for your stops.”

While an initial stop protects your maximum risk, a trailing stop, a stop order set at a percentage level below the market price for a long position, protects your profits. Just as you want to limit your potential loss initially, you will want to protect profits as the market moves in your direction. Typically this involves moving the stop to the breakeven level once the position moves in your favor. Then if the position continues to move in your favor, you move the stop to lock in additional profits. Just as with the initial stop, you should leave some breathing room and move stops to logical support/resistance levels rather than using an arbitrary dollar amount.

Slippage, the difference between estimated transaction costs and the amount actually paid, can happen, so it’s a good idea to build that into your trading model.

“I use a 5% rule — if I’m expecting to lose $200, I might have to account for $10 [for slippage],” Cook says.

Waldock says that allowing for slippage is a question of liquidity, and it depends on what you’re trading and how much. “Slippage is not an issue except in the most extreme circumstances,” he says.

ENTRY STOPS

Stops also can be used to enter the market. Typically entry stops are used in breakout systems where you are waiting for a market to reveal its direction by taking out a resistance level in the case of a buy stop or taking out a support level in the case of a sell stop. Waldock notes the same algorithm or pattern as protective stop placement also can be used in entry stops. “We’re letting the market’s momentum get us into a trade and that’s why you’ll see lots of algorithmic stop orders as entry orders. We’re saying that an object in motion is going to stay in motion,” he says. Your stop must be filled at the price you specify. “If the market blows through it, you may never get in, but you won’t be filled worse than your stop price.”

“Stop entry orders are very good if you locate exactly where you think you would get in,” Cofnas says, adding that they’re also useful for breakout trades.

By using stops as entries, “You’re putting in a position where you don’t know what’s going to happen at the end of the day,” says Dan Pavilonis, senior market strategist at Lind-Waldock. “You want to stay far enough away with a stop so that it’s going to protect you. Initially, you put on the trade that would be your exit level, your worst-case scenario, how much you’re going to risk. From your entry point, you understand what your risk is. I try to wait for the market to hit a certain area before I enter [it]. That’s why I don’t place stops as entry levels.” He adds that current market volatility is another reason he’s against using stops as entries.

Although some traders don’t like using stops in general, you probably should not trade without them, as they do offer a certain level of protection. “Everything has to have limits and the refusal to put a stop on is a weakness of discipline. If you don’t put [a stop] on, you’re basically playing against the market and it’s an ego game,” Cofnas says.

Cook says that if traders don’t use a stop, “if the market moves against them and they don’t have a place that they’re willing to accept the loss and move on, they’ll end up blowing up their entire account. [Stops] are there to limit the loss and as a psychological buffer. [Not using stops] is trading suicide.”

And stops really can keep you in the trading game. “The trick is being able to take the next trade,” Waldock says. “You can’t take the next trade if you’re stuck in a losing one.”

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