Stops, we know they’re essential and invaluable, but where should and where shouldn’t we place them?

Nov 27 • Between the lines • 1794 Views • Comments Off on Stops, we know they’re essential and invaluable, but where should and where shouldn’t we place them?

shutterstock_156477410Presumably the majority of our readers are now passed the belief, often mistakenly peddled on trading forums or through articles on trading websites that traders should trade without using stops. Of all the myths propagated in the industry the “trading without stops” myth is probably one of the most pernicious and dangerous, and using ‘mental’ stops is equally reckless.

The reasons certain traders offer up for not using stops includes brokers “stop hunting”. The insinuation that brokers, particularly those operating an ECN or STP trading model, deliberately reach up or down tens of pips or points from the real market, in order to take out individual trades is nonsense. But unfortunately, like many myths that absolve traders of their basic errors and failings, this myth has become ‘hard-wired’ into the thinking processes of many traders, when in fact it’s the market that stop hunts collectively and not individual brokers.

If a broker was moving their market feeds in order to take out individual stops then due to the power and speed of the internet, that broker would make itself an arbitrage target. Inside hours its practice would circulate through various forums. In short advanced traders would immediately zero in on the opportunities for easy money the broker’s bad practice would offer up.

Placing stops in the wrong place

It’s both amusing and concerning in equal measures to hear of traders bemoaning their “bad luck” or “bad broker practice” when they’ve placed their stops near to or at looming round numbers. For example, if you’re buying the Euro at 13550 and your stop is at 13500, then the chances that the market will revert to the looming round critical psyche number of 13500 is extremely high. You don’t have to employ much imagination to visualize the millions of buy, sell and take profit limit orders placed at 13500. Therefore it’s fairly obvious that the overall market could push the price of EUR/USD down to the area where millions of orders are clustered. Therefore placing our stop at 13500 would be reckless. But conversely placing our take profit limit order, if we shorted the security at 13500, would adversely make for extremely proficient trading.

Where to accurately place our stops is an essential discipline all traders must develop

In the next part of this article we’re going to discuss where to and where not to place our stops. We’ve already proved how placing our stops, without due diligence regarding looming and large round numbers, can result in the market reaching down or up to take out our trades. Therefore our trader should avoid placing stops close to these numbers. Similarly traders’ may wish to note where key simple moving averages are placed and avoid placing stops near moving averages such as the 200 SMA. But once again, similar to the example we have used earlier, key moving averages could be considered a highly effective area to place take profit limit orders.

Where to place stops as the trend changes

Naturally we’re focusing on the daily time frame and trend traders in our example, but the same theory could work in practice on many time frames. In simple terms our trader should be placing their stop at the low or high of the candle before the trend change becomes evident. If our trader has observed trend change in a classic manner then the decision is fairly simple.

As an example the DJIA stopped its bearish trend on October 9th. The candle on November 10th (using Heikin Ashi candles) was an inverted hammer indicating a strong reverse in sentiment. Our trader may have waited until November 11th to enter their long trade. Perhaps the reversal of the PSAR indicator at circa 15050 would be the trigger to enter the trade. The stop would therefore be placed at the previous recent low, approx. 14800, therefore our point risk on this trade would be circa 250 points.

However, should price suddenly stop its bullish trend and reverse sentiment to the downside it would be unlikely that the full 250 points would be lost, perhaps the realistic loss would be circa 150 before the PSAR signals a reverse in sentiment. Nevertheless we’re placing our stop at the extreme edge of our potential loss. In this instance we’re suggesting it as an example because should traders consult their charts they’ll find that this strong bullish move, that may be reaching its point of exhaustion now 16,000 has been reached, offers up a terrific example of why, where and when to place our stop.

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