using stop orders

Should You Use Stops in Your Trading

The question of whether or not to use stops in your trading relates to the form of stop rather than to the concept of a stop. I don’t think there’s a trader out there who would not advocate having a stop level or price at which to close a losing position.

There are two main reasons to have a stop:

  • Capital Preservation
    The most important part of trading is capital preservation. You must protect your capital in order to be able to continue trading. You can’t win if you’re not in the game.
  • You’re Wrong
    You enter a trade because you think stock, option or future will move a certain way — up, down or sideways. Your trade thesis might be based on technicals, momentum, news or just a dumb luck guess. If that trade thesis proves to be wrong, and the trade starts working against you, you have a choice to make. You can either stick to your thesis and ignore what the market is telling you, or you can admit that your thesis did not unfold as planned and close your position. The first option can lead to enormous losses or a total account blowup. The second option lets you move on to the next trade with a healthy mind and account.

Therefore, every trade needs a stop, to protect your capital and to get out of a trade thesis that didn’t pan out.

Form of Stop

Most “Stops” are actually orders placed with brokers to execute when the financial instrument hits, or passes thru, a specified price. Every trading platform has the “stop” order option. These stop orders are usually placed below (for longs) or above (for shorts) established support or resistance levels or popular moving averages. Since all traders are looking at the same support and resistance levels and moving averages, it’s common for stops to be piled up around these levels.

As a result of these stop order clusters, large traders, institutions and market makers can “hunt” for them and trigger the stops in order to fill their own large buy or sell orders. These large players are seeking liquidity, and stop orders help provide that.

To avoid getting caught in this stop hunt, many traders will place their stop orders some distance away from where they think the stop clusters are located. Just a few ticks will probably not do the trick, so they need to go a bit further out. The problem with this is that placing a stop too far from your entry can result in an unfavorable risk reward ratio for your trade. So you need to balance getting “stopped out” with risking more than you planned to. Ideally, you should calculate the position of your stop before you get into a trade and size your position appropriately to only get into trades that have the risk/reward you are comfortable with.

The idea that the bog boys are hunting for your specific stop order is silly, because they are seeking large positions to provide their liquidity needs.  It’s the location of your stop orders that is what is making you a victim of the stop hunt.

The alternative to placing a stop loss order is simply having a mental stop. When the financial instrument hits your level, you will manually close your position. That way you won’t expose your order to the stop hunters and you’ll also be able to possibly stay in the trade longer by watching the price action and giving yourself a bit more leeway.

The problem with a mental stop is that you might end up not executing it because you either weren’t paying attention to your position or you let your emotions override your trading plan and risk management rules. Also, if your mental stop is in the same area as you would have placed your stop order, then you have nothing to gain for not actually placing the order and you might as well just let things play out without your emotions getting in your way.

Using Stop Hunting to Your Advantage

Instead of worrying about institutional traders hunting for your stops and not setting them, or placing them too far below or above your ideal level, you can try to use stop hunting to your advantage by following along with the hunters instead of fighting them.

If the hunters are going to take out a cluster of stops below a support area in order to provide the liquidity they need fill their buy orders, then it would seem like the ideal point to go along with them and BUY. If they surge to the upside to take out the shorts, then it could be the right time to go short on the surge — just like the big boys are doing.

Most retail traders tend to end up doing just the opposite of what the pros are doing. For example, on a huge spike through a resistance level, retail traders will tend to jump in long immediately on the break, not wanting to miss the breakout. Unfortunately, they often end up buying at the tippy top of the surge, which then comes right back down to the former resistance level and a bit lower. That’s usually the spot where most traders have placed their stops, since that spot would indicate that the breakout was a failure. So the stops get hit and the price jumps right back up and beyond.

Stop being like most retail traders and try to get on the same page as the pros.

Buy when they buy and sell when they sell.

Here’s a video that talks about this very point:

Bottom Line

Regardless of what you decide to do, always make sure you at least have a stop at the maximum amount you’re willing to lose, because you don’t want to get caught in a major move that causes severe damage to your account — or wipes you out completely.

 

 

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