The topic of stops and their placement is a regular theme of discussions among traders and investors. It is pounded into the heads of everyone coming into the markets that you must have a stop to protect against a large loss. This comes mainly from the idea that if you don't have a stop order in place you will be inclined to let losses run, which is something which happens far too often. This is a big enough problem with market participants that academics have given it a name – the Distribution Effect, which is the tendency to cut winners and let losers run.
Should you even use stops?
Before I address the strategy for stop placement, let me first tackle whether you should use them. Some will argue that you should have mental stops rather than standing orders to avoid any funny business from the markets (stop running, flash crash, etc.). I tend not to go for that, but what I'm really talking about here is whether you employ stops at all. Some strategies actually see degraded performance when stops are employed. As a result, it's always worth testing a system with and without them to see their impact.
Now, on to where to place your stops should you decide using them makes sense.
The case against fixed stops
First of all, realize that any strategy which employs fixed distance stops – either in terms of pips or % of current prices – runs the risk of not reflecting current market conditions and suffering for it. If, for example, you have a 50 pip stop but the "normal" volatility for the period in which you are operating is 100 pips, you're almost certain to be stopped out on what's a relatively insignificant move within the market's current context. This is something that burns traders quite frequently.
Some traders employ volatility based stops to account for this. Using a multiple of the Average True Range (ATR) is a common strategy. The one caution is that ATR, or any other reading of that sort, is going to necessarily be historical. It may not account for expected future volatility that could be anticipated during the span of you holding your position, such as from news or data releases. You'd want to factor that sort of thing into your stop.
Where do you no longer like the trade?
In my own trading I actually don't even think in terms of stops. I think in terms of negative exit strategy. By that I mean determining what market action would tell me that the trade I'm in is likely no longer going to perform the way I'd been expecting. This applies to both initial trade strategy and to on-going management (think trailing stops).
In other words, I don't think in terms of "I don't want to lose more than…" That comes later, in the position sizing decision. As a result, my stop is merely the order that takes me out of a position I no longer want to be in, just as a limit order takes me out of a winning position I no longer want to hold.
So where does that exit point come from?
It's based on my underlying reason for the trade. If I think the market is going to turn down when it approaches key resistance and I put on a short, if the market instead goes through that resistance then clearly the market isn't acting as expected, so I want out. If I get in on a long trade because I think a new uptrend is developing and the market starts trading negatively, then something isn't right and I want out.
It's also worth noting that a negative exit strategy isn't always about the market going against you. It can also be about closing a trade that just isn't going for you the way you thought it should when you got in. This is why I tend to steer clear of thinking just in terms of stops. They only reflect one side of the equation.
The right approach for you
The bottom line is that you need to take a look at the type of position entry strategy you are employing and develop a complimentary strategy for getting out of those positions. This goes not just for losing trades, but for winning ones as well. This will be different for trend following approaches than for ranging or mean reversion ones, and if you have a fundamental aspect to your trading or investing that will have to be incorporated as well.
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