To remove the subjectivity of exiting non-performing trades in the stock market or futures market, traders use mechanical stop-loss orders to place with the broker, usually online, using some trading software.
An introduction to setting trading stops has been previously described. A charting video is included here, illustrating charting software with an example of placing stop-loss in various strategic positions.
In this article, stops are discussed in terms of buying into a rising market. The same principles of stop setting apply when short selling a market, except the argument must be reversed. Stops must be placed at a level higher than the entry price to guard against the market moving in opposition to the trade.
Traders (e.g. Larry R. Williams) use a number of techniques for setting stops, depending on the situation, whether limiting risk of initial trade capital or protecting existing profits. Some of these are discussed below.
Fixed Dollar Stop
This method is used when considering whether a trade is worth taking. The maximum fixed amount to risk is decided in advance, and then the sell stop is determined by deducting this risk from the planned entry price.
Example:
- Figure 1 shows that stock XYZ provides a buy signal if the price breaks above $12.00. Once the price breaks, a possible stop-loss level needs to be set to control risk on the downside.
- Assuming $8,000 is available for this trade, deducting $70 for transaction costs leaves $7,930 net for the trade. For a buy entry price of $12.05, the number of shares bought will be $7,930/12.05 = 658 shares.
- The stop-loss level should be set at the maximum amount to risk, including costs; say $400 to risk, leaving $7,600 of the capital intact. This exit level is then this capital divided by the number of shares: $7,600/658 = $11.55
- Therefore, the calculated stop-loss restricts losses to $400, assuming slippage is negligible.
Trailing Stops
As a trade progresses, it becomes necessary to move stop levels upwards in case the market reverses. A certain amount of profit should be “locked in”. Traders employ several techniques to move the stop to a strategic level that will close out the trade. This will occur on penetration of certain technical indicators used for this purpose, such as:
- A 13-day moving average, or
- A trendline, or
- A support level
Note, the shorter the moving average, the higher the probability a stop will be hit prematurely. Conversely, the longer the moving average, the more that profits may be given back.
Percentage Retracement Stops
Percentage retracement stops are set at certain strategic retracement levels. The idea is based on the work of W.D. Gann who observed that it was not uncommon for a stock to retrace up to 50% of its gains before continuing its upward journey. Other values of retracements used by traders are based on Fibonacci ratios such as 38.2% and 61.8%.
Profit Stops
A profit stop automates exit of a trade when the target is reached. This may be based on Fibonacci ratios, percentage gains, or specific price levels. The higher the targets are set, the less likely they will be met. Profit targets should be considered with regard to:
- Frequency of buy signals received from the market
- Percentage of winning trades to losing trades
Time Stops
It is essential to set a time limit for staying in a trade that does not move as anticipated. If capital is left too long in a trade going nowhere, then there is an opportunity cost to consider.
References:
- “Trading with a Plan”, Tony Compton & Eric Kendall. Wrightbooks. Elsternwick, Australia. 2000.
Harry P. Schlanger - Hello, I started out as a physicist working for research organisations. Mostly in the area of heat transfer in solids and porous media. ...
