Why use Stops?

Gabe Velazquez

In talking to prospective students at the sales events that I conduct it is always intriguing to see how many of them don’t use stops.  The reasons vary widely why the majority of retail traders/investors don’t implement stops. Some don’t even know what a stop is and therefore don’t know any better. Others refuse to use them because every time they place one in their trades they always seem to trigger right before the market takes off in the correct direction.  Another motive for not using stops is refusing to accept that some of the time we’re going to be wrong.  You would think that being wrong some of the time is a common reality for most traders; however, you would be surprised how many traders operate this way.

So why use stops when trading? Would you walk a tight rope without a net? Would you jump out of an airplane without a parachute? If you did, it would only happen once. Admittedly, most of you won’t be walking a tight rope, nor jumping out of an airplane anytime soon, however anytime we engage in risky behavior don’t we always have some type of safeguard to protect us from catastrophe.  Why do you buy flood or fire insurance against your home?  The same reasons we  protect ourselves against a disastrous event in other areas of our life is the same reasons we need to have some type of stop loss on your trades.

Let’s now address the most common question about where a stop should be placed as to have a higher probability of not getting triggered. First, notice that it’s about odds not assurances. We have to accept that some of time we will be wrong and our stops will be triggered. This is just a cost of trading.

A stop order serves two distinct functions: First, it allows us to clearly define our risk in every trade, and secondly, it delineates where the lowest risk entry point would occur.  In other words, since the stop is going to be placed very close to the price on the chart where we will be proven wrong , the closer we enter to that price, the lower the risk on the trade.

Below is a recent example in the Mini Russell 2000 futures contract where we see  it formed a supply zone ( highlighted in yellow ). This zone created a low risk entry point for a shorting opportunity. The entry is to be taken at the origin of the imbalance as we anticipate that the price of the Russell will fall once it reaches this level of imbalance.

TF SET 01-09-2014

The stop is place only a few ticks above the highs of the zone because that is point where all of the sell orders will be absorbed and thus the trade probably won’t work.  As you can see the risk is very small, the probability is higher than average, and the profit margin is high, therefore it’s a good trade.

In the next chart we can  see that the trade worked as planned, but if it hadn’t the risk was very small as we had a stop to protect us in the event it continued to climb to an all-time high.  If you had shorted the Russell, and did not use a stop, then you would just be guessing as to how high it would go.

TF SET result 01-09-2014

Most of you I’m sure have heard the adage “pulling all the Stops.” That meaning is good in most other endeavors, however in trading pulling all the stops can spell disaster.   Stops are a must in executing a low risk strategy, if you are getting stopped out too often that is probably a function of the strategy that’s being implemented, and as such, it needs to be reexamined.  At Online Trading Academy we might be able to help in that area,  so please contact a center near you to explore some alternatives.

Until next time, I hope everyone has a great week

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.