Stops That Make Sense - INO.com Trader's Blog

By: Jonathan Williams

Stops are a very important component to trading. In my opinion, the most destructive mistake when trading is NOT placing a stop. In this article, we will review types of stops, placement techniques, and at the conclusion, you will understand how to implement stops no matter your trading style. Not only will we cover the basics, but we may be able to troubleshoot existing trader’s issues with stops. If you are being stopped out too frequently, you might want to keep reading.

Stop orders do not necessarily limit your loss to the stop price because stop orders, if the price is hit, become market orders and, depending on market conditions, the actual fill price can be different from the stop price. If a market reached its daily price fluctuation limit, a “limit move”, it may be possible to execute a stop loss order.

Stops are typically risk measures that allow the trader to exit a long or short position when the market reaches a certain price level. Stops are almost always “stop loss” orders — meaning that these orders are executed to cap losses. In ideal situations, they are used to lock in profits. It should be noted that some traders also use stop orders to enter the market. However, I have chosen to deal with the risk management aspect of stop usage for this article.

It is also important to note that the use of stop orders does not imply that some form of a guarantee is in place to limit losses. At all times, stop orders, like any order, are in place at the will of the markets. Under certain market conditions, you may not be able to exit the markets (and limit losses) therefore negating the effect of stop orders.

There are a few variations, such as:

Straight Stop — gets executed as a market order to ensure that the position is covered; the fill price might be different from the order price.

Eli is long one June Gold contract (GGCM2) at $1600. He is placing his sell stop below the market at $1575. Some positive economic news was released and gold traded to $1550; his stop was hit and filled at $1572. Eli experienced some slippage because his stop order was triggered and entered as selling one gold at the market. The difference between the order price and the fill price is called slippage.

Stop limit — ensures a fill at the price you specify, if you get filled. These orders stand the chance of not being filled if the market quickly trades past your limit price. If you are concerned about slippage, then you may benefit from using stop limits.

Lisa is short two June E-Mini S&P (ESM2) at 1400. She has placed a buy stop limit above the market at 1420. The market trades to 1450; Lisa’s stop was triggered and filled at 1420. The limit order prevented any slippage, but it was possible for the market to “jump” right over her stop, causing her to be in a more adverse situation.

Trailing stop — attempts to capture profits as a market moves in your favor. For example, should you enter a long position and the market begins to go higher (in your favor), in turn, you would then move your stop exit order higher as well. In this way, as the market moves in your favor, the stop moves for you.

Aaron bought two June Dollar index contracts (DX-MM2) at 81.000. His target of 81.500 has been reached and is now trading at 81.750; he thinks the rally could continue. So he changes his initial sell stop order to a trailing sell stop below the market with a .150 point trigger, otherwise known as a trailing delta. Every tick his position moves up, the stop follows it, and when the market trades against him, he has a .150 point cushion before his stop triggers a market order to sell two Dollar index contracts (DX-MM2).

Trailing stop limits — operate the same way as a trailing stop with the exception that the stop order gets placed at a limit price. Trailing stops are generally used to lock in profits and not for covering an initial speculative position. The trailing stop triggers should also be intentional and allow you to reevaluate why you have chosen a specific point value for your trailing delta.

Melissa is long June Crude Oil (GCLM2) for the day at $98 and is reaching her target price of $101. She is modifying her original stop below the market to a trailing sell stop limit at $99.75 with a trailing delta of .50 to protect as much of her profit as possible. If the market trades back to $99.75 she would be filled at that price or better, depending on how far the market rallies.

Smart Stops

Now that we covered the different types of stops, let us focus on determining where to place them. Emotions run high when trading, especially in the faster moving futures markets like Crude Oil. Smart Stops are placed at areas that factor in market noise, thus recognizing the potential for whipsawing and preparing for significant trend changes. The examples below will demonstrate different methods for stop placement. The dt Pro platform comes with the tools and indicators I use in the following examples.

Support and Resistance Stops

While we keep in mind the potential limitations of stop orders to control losses, it is still relevant to use these orders to exit the market. In all phases of trading, money management plays a critical role; the increased visibility of monetary risk makes this form of stop assignment the benchmark for traders. This concept has two parts:

Part 1 Determine support levels (or resistance in the case of short positions)

Support and resistance varies on the time period you view the charts. Support in 15 minute charts look significantly different from support on daily charts. Generally speaking, a stop is most effective a few ticks below a support level, possibly allowing the market to hit support or resistance and bounce off which might prevent premature stop execution.

Tight stops would be at initial support, or support 1, and a more relaxed risk tolerance would be around support 2. Think of your trade as your family dog — the more confident you are that the dog will not bite the passing postman, the looser you are with the leash. If you are stopped out, then you’re likely to gain confidence in a trade and develop greater tolerance for error. However, it’s possible that your analysis conveyed the wrong decision. As such, you would rather cover your losses, reevaluate, and have the capacity to try again. Now think about that dog again. If you are not sure if the dog will react negatively to the postman, you’ll probably grasp the leash tighter to protect not only the postman, but yourself as well!

Part 2 Assign dollar values to our stop orders

Now let’s put this into action. Below is a chart of the E-Mini S&P 500. We have evaluated the chart and drawn in support and resistance areas. The next step is to determine what the potential dollar value impact would be if we were to get stopped out at those support or resistance levels. Once the trader is armed with this information, they can then determine if the trade is viable for them in light of their risk tolerance and account capitalization.

Stops at 10% or 20% are arbitrary and involve no significant thought process — everything the trader does should be intentional and deliberate. The point being that if you cannot stand the nominal risk based on support and resistance, you should not be in the trade. Percentage and nominal stops are used because they take less time to construct. However, if you find a method that works and practice it, the subsequent skills developed will be well worth the time invested. Put another way, before the trader enters the market, they should know what the risks are and be able to translate that value into a stop. Of course, there are no guarantees when it comes to exiting the market and stop orders, but at least you will have a plan prior to executing the trade.

High/Low Stop

Trends are important in determining the stop. Lower highs and higher lows generally indicate an upward moving trend, and inversely, lower lows and lower highs tell of a downward moving trend. The chart below has these levels marked with an indicator built into dt Pro for intermediate to long term trades. Placing stops at previous highs and lows is another way to allow your trade the space it needs to develop, provided you can weather the fluctuation risk. A break below previous lows could mean that the magnitude of the trend change could be significant. Therefore, you would rather be out and be able to play again than to let the dog continue to chew the postman’s pants off.

Indicator Stop

I think one of the most compelling reasons to use our dt Pro trading platform is its flexibility, especially for this type of stop. By electing to use this function of the platform, you can attach a stop order to a price based indicator and execute that indicators signal! I have included an example below which shows the Fibonacci Bollinger Bands a trader could use to attach stop orders at various levels. Depending on your preferences, an indicator stop may help in diligently following the progress of any market condition. The automatic feature eliminates the need to constantly change your orders and encourages traders to approach the markets systematically.

Moving average (MA) stops are a combination of moving average stops with support and resistance stops. Sometimes prices hover or bounce off of the MA; widely used time periods are 200, 50, and 9 days. Parabolic SAR and Pivot Points are also some indicators that act in this fashion, or any indicator that uses price as its value.

Option Stop

Options are intricate instruments, and the details involved with the option stop will go beyond the scope of what I can cover in this article. I will respond to any questions regarding option stops in the comment section below, or you may contact your Broker.

Essentially, options provide insurance. However, the trader has to pay a premium. The degree of protection varies — the better the protection (at-the-money option), the more expensive; the more relaxed the coverage (out-the-money the option), the less expensive it becomes. The function of the option is to offset the losing futures position, effectively becoming a hedge (theoretically, the delta of the option dictates how effective the hedge is). Also, it offers some peace of mind of having the choice of remaining in the futures position or exiting either leg. The option stop is not profitable until it pays for itself by gaining intrinsic value and offsets losses in the futures position. In comparison, traditional stops cost nothing except commission and fees once the trade is executed while there is a premium paid for the protection of an option plus fees.

A long futures position would require buying a put option on the same contract while a short futures position would mean buying a call option in the same contract. Should the position go against you, the value of the option could offset some losses in the future, allowing you to exit or stay in the trade.

Summary

We have covered the types of stops as well as different placement techniques. Utilization of these orders depends on your individual goals, and practice is a prerequisite to successful implementation. Make sure to take into account time periods, trade duration, and risk capital before translating our newly found knowledge to live trading. A solid approach to stop orders helps define the risk and employs a methodical approach to risk management. Your Daniels Trading Broker can review any of these concepts and develop them to further suit your goals.

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