General uses of Stop orders

GENERAL USES OF STOP ORDERS         

          This chapter will focus on protective stops used to offset a position and to protect against losses and against accrued profits. You can also use a stop to enter a position. There are a variety of stops that can be used depending on your situation, the market you are trading, and what you are trying to accomplish. There are various types of available stops and several techniques that can be used with these stops to help you manage your position and reduce your overall risk.

• Dollar Limits. Stops can be based on a dollar amount per position. The dollar amount is categorized under money management for trading systems. If you are risking $250 per futures contract in an e-mini Standard & Poor’s (S&P) contract, then your stop level would be placed at a five-point distance from your entry price. This method is used less frequently by professional traders because it has no relevancy to a mechanical trading model, especially systems that are in the market all the time, such as a moving average system. However, there are benefits to this feature with setting a daily dollar amount on a loss limit for active day traders. Some electronic order platforms allow you to set a daily loss limit. Rather than per trade, it sets an overall loss limit on your account.
• Percentage Figures. Most traders hear of using a stop of a certain percentage of the overall account size. Generally speaking, that number can be 2 percent up to as much as 5 percent of the overall account. Unfortunately for most traders in futures or foreign exchange (forex) markets, the average size trading account is $10,000, which means the stop is $200 to $500 dollars per trade. This leaves little room for error. Normally, you want to use at least a two-to-one risk/reward ratio on your trades. So if you risk 5 percent on a $10,000 account, you should expect to risk $500 and make $1,000 per trade.
• Time Factors. After a specific time period, if the price does not move in the expected direction or if the velocity of such a move does not warrant holding onto the position, then exit the trade. If you see a low close doji (LCD) or a high close doji (HCD) signal, it is my experience that the market generally demonstrates an immediate reaction within two or four time periods. After a long period of the market not responding to this type of signal, liquidate the position. The timing of the trade did not correspond with the historical tendency and did not generate the desired results in a given period.

Another consideration in the art of placing stops using a time element is the aid of a moving average. A moving average is simply a trend line that is considered a time-driven price-directional tool. One time factor that one can use as a stop placement method is the crossover point of reference created when using two moving average values. Once the shorter-term moving average crosses the longer-term moving average, it reflects a value change in the market. In Figure 9.1, once the market triggers a signal to go long with the high close doji, combining a close below doji low and the crossover point (using both the one-period pivot point and the three-period pivot point moving averages) can act as a stop placement level. Once again, you would want to look at the point of crossover of the two moving average values; and if the market closes below the low of the doji’s low and the moving average (M/A) values, then a trigger to exit the position would be war-ranted. As you can see, a bullish trend develops with the golden sequence of events: higher highs, higher lows, and higher closing highs. The stop-loss was placed at a critical point.

• Price Levels. Traders often use basic statistics to measure the degree of price volatility that can occur on a daily basis in a given market. These measures can then be used to place a stop order or a limit order that takes into account these natural daily price movements. Statistics that are often used are the mean, the standard deviation, and the coefficient of variation. The best trailing-stop approach has been explored by many technicians. The various methods include placing a stop using a set price amount, which could be as much as 50 percent of the average true range of a given time period, either above or below the 10- or 20-day moving average.

Why is this an important method? If you place a stop near a specific chart point of interest, such as an old high or an old low, that level is obvious to every chart watcher. Markets do “test” and penetrate from time to time those levels. If you set your stop too close, such as setting a sell stop below an old low point or a buy stop above an old price high, chances are that your order may be executed if it is too close, such as what the jackhammer or shooting star represents. So generally, a certain factor or distance should be calculated for your stop placement. Since most traders believe a market has reached a peak, they will place  a stop slightly above an old high or below an old low. Depending on where you place your stop, the market may demonstrate a spike pat-tern that will hit your order and then proceed to move in the desired direction, without you, of course. Figure 9.2 shows an example of when the market is at a major turning point, how a price spike occurs. You may want to take the average daily range of the most recent 10 or more periods and then use a factor between 20 percent and 50 percent of the 10-day average daily range. When entering a short position you would use a protective buy stop based on a percentage above the 10-day average range. For example, if you take the average daily range for the 10 trading sessions from the low back on October 12 up to the first peak on October 25, you have an average daily range for that 10-day period of 174 PIPs (percentage in points), or points. The first spike top exceeded the prior high by 34 PIPs.

If you established a short position and wanted to place your stop out of harm’s way, then using a stop of 20 percent of 174 PIPs above the predetermined high would not have worked out, as that was 34 PIPs, the exact amount by which the market exceeded the high. If you increased the stop amount by 50 percent of the 10-day average daily range, then you would have an 87-point stop above the high; and this would have kept you from getting stopped out.

By using 120 percent of the average of the last 10-day period range, this method would accomplish the goal of not getting stopped out. Realistically, that may be way too much risk for an individual trader. But examine the risk/reward ratio on that particular trade. A risk of 150 percent of the average daily range from the most recent 10-day period would have been 261 PIPs. The stop would be placed above the high on October 25 at 181.30. The low was at 170.65, made nearly one month later on November 22. Granted, depending on your risk tolerance, this may seem excessive; but you can select and back-test any percentage variable of an average daily range stop placement.

The key idea here is to keep your stops out of harm’s way. If a trade is to become profitable, there should be signs, such as in the case of selling short, that you see immediate results with lower highs, lower lows, and lower closing lows. Even in the days where we see spike highs or spike lows, notice where the market closes in relation to their respective highs and lows. The price penetrates the highs but closes back below the prior highs. The reverse is true at the spike lows. This is a good clue that the market has exhausted a trend and is ready to reverse. Keeping a stop out of harm’s way will allow you to participate in the move using a variation of an average daily range stop placement.

• Conditional Changes. A conditional change is defined as a higher closing high in a downtrend or a lower closing low in an uptrend. Such as the case with a spike top, the market does not close above an old high. Therefore, one factor such as the stop-close-only order will be of great use to a trader not looking to get bumped out of a position. There is, as with any stop, the unknown risk that there is not a guaranteed price at which your stop order will be filled. This order has a negative connotation among traders because it spells too much risk. A buy stop will be elected and will knock you out of a position if the market closes above the stop price; and a sell stop will be elected and will knock you out of your position if the close is below your selected price level. The unknown is how far away the market will close from the selected stop price. The key benefit in using a stop-close-only order is that it keeps your risk defined to a conditional change and helps you from getting knocked out of a position from intra-period volatility. Stop-close-only orders (SCOs) are for end-of-day trading and can be placed on most trading platforms. The SCOs can be used for day trading; however, they must be used manually, as most platforms do not accept intraday SCOs. Some consider these mental stops, which are predefined risk factors. However, many traders violate the rules once a signal calls for an exit but they do not exit, thereby increasing their losses. A trader needs to have a strict disciplinary approach.

The challenge in selecting the right stop is to reduce risk while not being shaken out of the trade by market volatility. It is important to try to maximize your trading results and to stay in profitable trades as long as possible. Employing random stop-losses and profit targets can ruin a trading strategy, making it perform significantly worse than it would have otherwise. One successful method is to use trailing stops that adapt to market volatility so that the stop is placed far enough away, which combines enough sensitivity to price changes with flexibility to fit your risk/reward parameters. Using this combination may provide profitable consistency from a stop-placement aspect for the intermediate-term trader. The trailing stop is used as an attempt to lock in some of the paper profits that could accrue should the market move in the direction desired. Like an ordinary stop, the trailing stop is started at some initial value but then is moved up (in a long trade) or down (in a short trade) as the market moves in your favor.

Testing has demonstrated that a proper combination of even simple exit methods, such as placing a stop below the low of the prior past two trading sessions, can substantially improve the behavior of a trading strategy, even turning a random, losing strategy into a profitable one!

Another less complicated method to use for a bullish trending market condition is placing a stop below the lowest low from the most recent 10-day period. Another method is a trailing stop method using the lowest low from the last conditional change. I define the last conditional change as a higher closing high. This is a much more important event than a higher high. Buyers who stepped in on the open have a strong conviction that price should expand to new higher territory once the market established a new high ground. Therefore, if the lows are violated, then the market is demonstrating weakness. In Figure 9.3, we are looking at the daily chart on gold. Starting from the low on November 4 near 465, the market does not make a lower closing low. On December 1, we see a close at a doji low but not below the low of the doji. The trend then continues higher with a sequence of higher highs, higher lows, and higher closing highs.

It is not until the shooting star develops that the intermediate top is made. A stop placed beneath the low of the candle prior to the star would be the last conditional change or the last higher closing high that occurred. That would be where you would want to place a sell stop. Using the two-period lowest-low method, you would have been stopped out at 528. If you used a stop-close-only below that low, your fill was the next time period’s close; and that was not as friendly or as profitable, as the market closed at 514. However, using the lowest low for the most recent 10 periods, your stop-out point was all the way down at 497.

Let’s examine this method with a day trade using a chart example on the spot forex British pound market from 2/6/2006 using a 15-minute time frame. Figure 9.4 shows a low close doji trigger to sell short at 176.07. The initial stop per the LCD trigger states to use a stop-close- only above the doji high. That would be 176.28. As you can see, the market stalls in a traditional sideways channel, as forex markets are known to do. But, sticking with your trading rules, as the market starts to deteriorate, you would change the stop from a stop-close-only to a regular stop one tick above the high of the second conditional lower closing low candle. You now have the option to move stops above the highs of the last reactionary high points; and if you follow the trail of the market, you will notice the high from the last conditional lower closing low. This failed reactionary high was the perfect spot to move your stop down to just one PIP above that high point. At the end of the run, you want to trail the stop to the point one PIP above the high of the second-to-last candle that made a conditional change, which would be a lower closing low.

Let’s explore this method further for day traders in the stock index futures. Figure 9.5 shows a 15-minute candle pattern showing another low close doji trigger to sell short. The fill would be 1279.25, and the initial stop would be a mental stop-close-only above the doji high at 1283.5. As we want to see when short, immediate results materialize with the sequence of events such as lower highs, lower lows, and, best of all, lower closing lows. We now have the option to change and trail a hard stop above the high of the second conditional change candle. Here, a conditional change is a candle that makes a lower closing low. Prices now decline to 1270.75; we have over an eight-point gain, or $400 per contract. We can do several things, such as taking profits on half of our positions, because the market has reached a move equal to the average daily range from the most recent 10 trading days, or moving stops down to lock in profits and letting our winners ride. We should now place a trailing stop above the high of the last conditional change or an SCO to exit the balance of positions. 

In this example, you would not have been able to sell the high or buy the low using a set of trading rules. However, a solid chunk of middle of that trading session was captured with having little-to-no risk pressure. The trailing stop method would allow you to stay with the trade until the bearish conditions changed. The chart in Figure 9.5 is also a great illustration of how a market moves from a trending condition to a consolidation phase. Once you have captured the profit, it is time to wait for another trade setup.

There are many different variations to placing stops. The key is watching for conditional changes; for example, in a declining market, you should watch for the last reactionary high as the peak at which to place a trailing stop once you are in a short position. You should use a stop-close-only above a conditional change candle especially on a two- period time count. These methods will help you limit losses, prevent you from being prematurely knocked out of a trade, and reduce emotional stress, while capitalizing on letting your winning trades ride. 

THE BOTTOM LINE         

          The bottom line is this: Stops are not for sissies. You just need to know when changes in a market’s condition occur to help determine when to exit a trade. If you are in a trending condition for too long, chances are that you may be overextending your welcome; therefore, tightening stops is a good way to protect profits. After all, it really counts most when you get out of the trade. All traders struggle with stop placements. There is no one single best method. The concept is to develop a consistent method that helps you define cutting your losses and letting winners ride.