Now that we covered the different types of stops in the previous article, let us focus on determining where to place them. Emotions run high when trading, especially in the faster moving futures markets like Crude Oil. Smart Stops are placed at areas that factor in market noise, thus recognizing the potential for whipsawing and preparing for significant trend changes. The examples below will demonstrate different methods for stop placement. The dt Pro platform comes with the tools and indicators I use in the following examples.
STOP ORDERS DO NOT NECESSARILY LIMIT YOUR LOSS TO THE STOP PRICE BECAUSE STOP ORDERS, IF THE PRICE IS HIT, BECOME MARKET ORDERS AND, DEPENDING ON MARKET CONDITIONS, THE ACTUAL FILL PRICE CAN BE DIFFERENT FROM THE STOP PRICE. IF A MARKET REACHED ITS DAILY PRICE FLUCTUATION LIMIT, A "LIMIT MOVE", IT MAY BE IMPOSSIBLE TO EXECUTE A STOP LOSS ORDER.
Support and Resistance Stops
While we keep in mind the potential limitations of stop orders to control losses, it is still relevant to use these orders to exit the market. In all phases of trading, money management plays a critical role; the increased visibility of monetary risk makes this form of stop assignment the benchmark for traders. This concept has two parts:
Part 1 – Determine support levels (or resistance in the case of short positions)
Support and resistance varies on the time period you view the charts. Support in 15 minute charts look significantly different from support on daily charts. Generally speaking, a stop is most effective a few ticks below a support level, possibly allowing the market to hit support or resistance and bounce off which might prevent premature stop execution.
Tight stops would be at initial support, or support 1, and a more relaxed risk tolerance would be around support 2. Think of your trade as your family dog – the more confident you are that the dog will not bite the passing postman, the looser you are with the leash. If you are stopped out, then you’re likely to gain confidence in a trade and develop greater tolerance for error. However, it’s possible that your analysis conveyed the wrong decision. As such, you would rather cover your losses, reevaluate, and have the capacity to try again. Now think about that dog again. If you are not sure if the dog will react negatively to the postman, you’ll probably grasp the leash tighter to protect not only the postman, but yourself as well!
Part 2 – Assign dollar values to our stop orders
Now let’s put this into action. Below is a chart of the E-Mini S&P 500. We have evaluated the chart and drawn in support and resistance areas. The next step is to determine what the potential dollar value impact would be if we were to get stopped out at those support or resistance levels. Once the trader is armed with this information, they can then determine if the trade is viable for them in light of their risk tolerance and account capitalization.
Stops at 10% or 20% are arbitrary and involve no significant thought process – everything the trader does should be intentional and deliberate. The point being that if you cannot stand the nominal risk based on support and resistance, you should not be in the trade. Percentage and nominal stops are used because they take less time to construct. However, if you find a method that works and practice it, the subsequent skills developed will be well worth the time invested. Put another way, before the trader enters the market, they should know what the risks are and be able to translate that value into a stop. Of course, there are no guarantees when it comes to exiting the market and stop orders, but at least you will have a plan prior to executing the trade.
Trends are important in determining the stop. Lower highs and higher lows generally indicate an upward moving trend, and inversely, lower lows and lower highs tell of a downward moving trend. The chart below has these levels marked with an indicator built into dt Pro for intermediate to long term trades. Placing stops at previous highs and lows is another way to allow your trade the space it needs to develop, provided you can weather the fluctuation risk. A break below previous lows could mean that the magnitude of the trend change could be significant. Therefore, you would rather be out and be able to play again than to let the dog continue to chew the postman’s pants off.
I think one of the most compelling reasons to use our dt Pro trading platform is its flexibility, especially for this type of stop. By electing to use this function of the platform, you can attach a stop order to a price based indicator and execute that indicators signal! I have included an example below which shows the Fibonacci Bollinger Bands a trader could use to attach stop orders at various levels. Depending on your preferences, an indicator stop may help in diligently following the progress of any market condition. The automatic feature eliminates the need to constantly change your orders and encourages traders to approach the markets systematically.
Moving average (MA) stops are a combination of moving average stops with support and resistance stops. Sometimes prices hover or bounce off of the MA; widely used time periods are 200, 50, and 9 days. Parabolic SAR and Pivot Points are also some indicators that act in this fashion, or any indicator that uses price as its value.
Options are intricate instruments, and the details involved with the option stop will go beyond the scope of what I can cover in this article. I will respond to any questions regarding option stops in the comment section below, or you may contact your Broker.
Essentially, options provide insurance. However, the trader has to pay a premium. The degree of protection varies – the better the protection (at-the-money option), the more expensive; the more relaxed the coverage (out-the-money the option), the less expensive it becomes. The function of the option is to offset the losing futures position, effectively becoming a hedge (theoretically, the delta of the option dictates how effective the hedge is). Also, it offers some peace of mind of having the choice of remaining in the futures position or exiting either leg. The option stop is not profitable until it pays for itself by gaining intrinsic value and offsets losses in the futures position. In comparison, traditional stops cost nothing except commission and fees once the trade is executed while there is a premium paid for the protection of an option plus fees.
A long futures position would require buying a put option on the same contract while a short futures position would mean buying a call option in the same contract. Should the position go against you, the value of the option could offset some losses in the future, allowing you to exit or stay in the trade.
We have covered the types of stops as well as different placement techniques. Utilization of these orders depends on your individual goals, and practice is a prerequisite to successful implementation. Make sure to take into account time periods, trade duration, and risk capital before translating our newly found knowledge to live trading. A solid approach to stop orders helps define the risk and employs a methodical approach to risk management. Your Daniels Trading Broker can review any of these concepts and develop them to further suit your goals.
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