From the July 01, 2012 issue of Futures Magazine • Subscribe!

Controlling losses: Stop placement techniques

“Using ATR” (below) applies the ATR indicator to June T-notes. The indicator is plotted beneath the price chart. The chart reflects a long trade that occurred on April 4 at 129-00. A stop loss was calculated at two times the value of the ATR (0.7600 x 2 = 1.52), setting the stop loss at 127-16.

System & trailing stops

Many technical strategies, such as those based on breakouts, produce both an entry signal and a recommended stop loss. In these strategies price action determines when an entry is signaled and consequently at what level that trade has been proven wrong (it is important to accept a trade is wrong and have a price that defines “wrong”). This type of stop works well in combination with hard dollar value and percentage stops.  The problem with the dollar value or percentage stop is that they are arbitrary. When a stop based on the logic of your system falls within a certain comfort level (value or percentage stop) it indicates a strong risk/reward profile for that trade. The combination of those types of stops serves also as a system overlay indicating a low risk opportunity. You take only the trades where the appropriate stop falls within a predefined low-risk level. 

Once a trade has moved in a favorable direction, the stop loss level does not have to remain where it was placed initially. It can be moved to follow price. Trailing stops are designed to maintain a stop loss level while protecting profits. For example, once a trade has reached a certain profit, the stop loss could be moved to a breakeven level (equal to the entry price of the trade). As profits continue to climb, the stop can move correspondingly with price, thereby limiting the maximum loss on the trade.

In theory, trailing stops are an excellent means of protecting profits. In practice, however, the results are not always as favorable as simply sticking with the initial stop loss and exiting based on the prevailing analysis methods. 

Risk management methodologies are intended to help investors manage the downside, but the most important goal is to avoid catastrophic losses. A stop loss works well because it defines losses in advance, making it easier to preserve both the trader’s capital and his or her emotional well-being. The method used to calculate stop levels is a matter of personal preference and risk parameters, but one guideline is universal: Protect your account from disaster. Do not let aspirations for perfection detour a journey toward self-preservation.

Jean Folger is the co-founder of, and system researcher with, PowerZone Trading LLC. She can be reached at www.powerzonetrading.com.

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