Stops that Make Sense: Part One

Stops are a very important component to trading. In my opinion, the most destructive mistake when trading is NOT placing a stop. In this article, we will review types of stops. In the next article, we will go over placement techniques, and at the conclusion, you will understand how to implement stops no matter your trading style. Not only will we cover the basics, but we may be able to troubleshoot existing trader’s issues with stops. If you are being stopped out too frequently, you might want to keep reading.

Stops are typically risk measures that allow the trader to exit a long or short position when the market reaches a certain price level. Stops are almost always “stop loss” orders – meaning that these orders are executed to cap losses. In ideal situations, they are used to lock in profits. It should be noted that some traders also use stop orders to enter the market. However, I have chosen to deal with the risk management aspect of stop usage for this article.

It is also important to note that the use of stop orders does not imply that some form of a guarantee is in place to limit losses. At all times, stop orders, like any order, are in place at the will of the markets. Under certain market conditions, you may not be able to exit the markets (and limit losses) therefore negating the effect of stop orders.

There are a few variations, such as:

Straight Stop – gets executed as a market order to ensure that the position is covered; the fill price might be different from the order price.

EXAMPLE:
• Eli is long one June Gold contract (GGCM2) at $1600. He is placing his sell stop below the market at $1575. Some positive economic news was released and gold traded to $1550; his stop was hit and filled at $1572. Eli experienced some slippage because his stop order was triggered and entered as selling one gold at the market. The difference between the order price and the fill price is called slippage.

Stop limit – ensures a fill at the price you specify, if you get filled. These orders stand the chance of not being filled if the market quickly trades past your limit price. If you are concerned about slippage, then you may benefit from using stop limits.

EXAMPLE:
• Lisa is short two June E-Mini S&P (ESM2) at 1400. She has placed a buy stop limit above the market at 1420. The market trades to 1450; Lisa’s stop was triggered and filled at 1420. The limit order prevented any slippage, but it was possible for the market to “jump” right over her stop, causing her to be in a more adverse situation.

Trailing stop – attempts to capture profits as a market moves in your favor. For example, should you enter a long position and the market begins to go higher (in your favor), in turn, you would then move your stop exit order higher as well. In this way, as the market moves in your favor, the stop moves for you.

EXAMPLE:
• Aaron bought two June Dollar index contracts (DX-MM2) at 81.000. His target of 81.500 has been reached and is now trading at 81.750; he thinks the rally could continue. So he changes his initial sell stop order to a trailing sell stop below the market with a .150 point trigger, otherwise known as a trailing delta. Every tick his position moves up, the stop follows it, and when the market trades against him, he has a .150 point cushion before his stop triggers a market order to sell two Dollar index contracts (DX-MM2).

Trailing stop limits – operate the same way as a trailing stop with the exception that the stop order gets placed at a limit price. Trailing stops are generally used to lock in profits and not for covering an initial speculative position. The trailing stop triggers should also be intentional and allow you to reevaluate why you have chosen a specific point value for your trailing delta.

EXAMPLE:
• Melissa is long June Crude Oil (GCLM2) for the day at $98 and is reaching her target price of $101. She is modifying her original stop below the market to a trailing sell stop limit at $99.75 with a trailing delta of .50 to protect as much of her profit as possible. If the market trades back to $99.75 she would be filled at that price or better, depending on how far the market rallies.