Tuesday, February 16, 2010

Stop-Loss Points in Trading: Do We Need Stops When We Trade?

Henry Carstens has recently written about ways to manage risk other than through stop loss points. I've noticed with traders recently that stops not only tend to be price-based, but tend to be placed at price points that are relatively obvious. For example, someone who is short stocks will place a stop just above a recent high or vice versa. Stops just above or below recent price ranges are also common.

The problem with such stops is that they are natural targets for algorithmic programs that exploit asymmetries in buying and selling orders and tendencies. The trader with obvious stops falls victim to false breakout moves, exiting trades just before they reverse and go the intended way.

An important gauge of the value of your stops is to track markets *after* you have been stopped out. Do you stop loss points save you money on balance? Do they protect you from risk, or do they shake you out of opportunity? Most traders have never closely looked at the true value of their stops; they just take for granted that stops are needed and place them intuitively (and obviously).

Over the years, I've found that placing price-based stops further away from my entry at points where my underlying trade idea is clearly wrong helps keep me from getting shaken out of good trades. Those price-based stops act as "catastrophic" stops for me. More effective, as a rule, for my own trading have been indicator-based stops and time-based stops.

An example of an indicator-based stop would be a sudden surge in NYSE TICK to new highs or lows against my position or a surge in buying or selling volume against my position. As soon as I see the surge, I exit and reassess. More often than not, such a surge indicates that the short-term tide has moved against me and that it is not helpful to fight that.

Time-based stops are based on my observation that my best trades are executed well and tend to go my way relatively quickly, with little heat taken. If I have to sit and sit and sit in the trade, the odds that it will go my way eventually are diminished: the dynamics that placed me in the trade simply are not operative. Similarly, if the market moves against me very shortly after my entry, I generally find it's best to try to scratch the trade and reassess.

It *is* important to have stop-loss points for trades. As I've noted previously, everyone does have a stop-loss point: it is either explicit, based on market action, or it is unstated and based on pain. The latter can wipe out days' worth of good trading.

But while it's important to have stops, it's not necessarily the case that all stops need to be price-based. You should stop a trade when you see that the underlying idea is wrong, not simply when you've lost a certain amount of money.