Stop placement appears to be a topic that is on every trader's mind. Where do you place the stop?
One should consider four situations for using stops:
- Mechanical Stops: As dictated by mechanized trading systems.
- Protective Stops: To protect against loss, or to protect profits.
- Objective Stops: To cover costs.
- Entry Stops: To initiate a trade.
- Exit Stops: To terminate a trade.
General Considerations
At various times you will hear or read material from someone who tells you where to place a protective stop.
Of course, if you are following an adviser and taking that adviser's trades, you must utilize the adviser's stop placement. Why? Because when you follow an adviser, you are trading a mechanical system. The adviser is your system. You cannot possibly expect to achieve success until and unless yo do exacly as the adviser dictates. In addition, you also need to do a lot of praying. Pray that the adviser will have a good year in the markets.
The same consideration is true if you follow a mechanical system. If you expect to get the results you paid for when you purchased the system, you must place your stops as the system dictates. At times, the draw down against your margin will be virtually intolerable. That's the price you have to pay for trading a mechanical system.
There are few traders who can maintain the discipline needed to exactly follow a mechanical system, whether it be computer generated or derived from an advisory of some sort.
Should you place a stop at a certain number of points distant from current price action? Should you place a stop at a certain percentage distant from current price action? Or, should you place a stop a fixed money amount distant from current price action? Any or all of these may be an incorrect way to place stops.
I am thoroughly convinced that no one on earth can tell you where to put your stop.
The truth is, only you can decide. Unless you are trading a mechanical system or following an adviser, the responsibility is yours. If you are calling your own trades, there is no way you can pass that responsibility to anyone else.
Since proper stop placement is such an important responsibility, let's take a few minutes to reflect on some of the items that must be taken into consideration when placing stops.
Specific Considerations
- The size of the margin account. Certainly, the size of your margin account will affect where you are able to place stops. It will even affect the selection of markets in which you are able to trade.
- Margin requirements. The margin requirements set out by the exchanges, and any additional requirements set by your broker, will affect which markets you can trade, as well as where you place your stop.
- Your individual psychological and emotional tolerance for pain, that is, your individual comfort level, greatly affects stop placement. Provided you can afford to trade in the market you have chosen, this is probably the most important factor in setting stops. You might have a $100,000 account, but if taking a $200 hit will devastate you psychologically, then you cannot set your stop that far away,
- Your economic tolerance for loss. Your willingness to lose a certain amount of money and being able to afford it even though it makes no sense. If you are stopped out with a loss often enough, you will reach the point where you will no longer have money to lose. Therefore, you must have a rational approach to stop placement.
- The number of existing open positions already held. If you are already positioned in other trades, you may not be эЫе to set your stop properly in any new trades. In that case you may be forced to miss a good opportunity, or to set stops too close.
- Market volatility. This is a market generated criteria for setting stops. The market may be too volatile, causing you to need to set a stop beyond your affordabiltty or comfort level. Conversely, using a market-generated criteria, volatility may be not sufficient to even warrant entering a market let alone placing an effective stop. The stop would be too close to the price action and virtually certain to be hit.
- The rate of trading. Whether you are in a fast or slow market affects stop placement. If a market is moving quite fast, you may have to set a stop further away than is affordable or comfortable.
- Tick size. Usually, when a market is fast, or highly volatile, the tick size will also increase. That means your usual and normal stop will not suffice. An example would be if you limited your losses to $250 on a five minute S&P chart, and suddenly the ticks moved away from the normal five to ten points per tick to twenty-five points per tick. In other words, the market becomes fast. It would only take two of these super sized ticks moving against you to take you out of the market.
- Participants on the floor. When a large commercial, or large trader steps onto the floor, the market may begin to do strange things. These operators often have the resources to move the market. They may move it up quickly so they can go short from a higher price. They may sell it down quickly so they can go long from a lower price. Whatever their reasons, knowing who is down on the floor can affect where you place your stop, or even whether you should enter a trade.
- Liquidity. Whether a market is thin or liquid affects successful stop placement. Thin markets tend to be much more volatile than liquid markets. The operators in thin markets can „run“ the markets more easily than operators in liquid markets. This volatility can greatfy affect where you have to place a stop. In addition, operators can more easily run stops in thin markets.
- Turnaround time.
a. Your reaction time, in part, dictates stop placement. How long does it take you to see and react to a situation? If you are slow, plan on using larger stops.
b. Your brokers reaction time, in part, also dictates stop placement. If your broker is slow in getting your orders to the floor, you will need to use larger stops. You might consider placing stops ahead of time if slowness is a problem.
c. Your relationship with your broker. If you and your broker like to chat and exchange pleasantries, you will need to set your stops further away. Time is money. Markets can move quickly. The longer the time you spend in taking care of business, the more you will have to risk in stop placement.
- The time frame of the chart in which you are taking trading signals affects stop placement. Obviously, you can use smaller stops in lesser time frames than you can on the greater time frames. If you are trading from weekly charts, you can be a lot more casual and leisurely about setting your stops. You will also have to be able to afford larger stops, because markets move a greater overall distance on a weekly basis than they do on a five minute basis.
- Your overall objectives and strategy for the trade. For instance, if you expect to make a long term trade, you would place your stop a lot further back than if you were anticipating a short term trade.
In view of the preceding points, how can a trader expect someone else to tell him where to place a protective stop? You, and only you, are in a position to know all of these things. And while someone else may know some of these things, only you can know your comfort level.
Also, in view of the considerations I've presented, isn't it a bit ludicrous to set loss protection stops at a fixed number of points, a set money amount, a previously determined percentage away from the price action, or based upon the dictates of a mechanical trading system?
None of these methods has anything to do with the reality of price action in the market, or the trader's economic, mental, or emotional condition, or any of the other conditions mentioned.
Stop placement is truly the arena in which you separate the men from the boys.
