Determining the “initial stop exit plan” is a very important part of your overall trading strategy. However, it is only that – another small piece in your method of trading. While there are countless ways to approach placing initial stops, we’ll discuss some basic ideas that may help you form your “initial stop exit plan”.
I am a firm believer in placing stops. Why?
- Unexpected events happen, and they are difficult to predict. We need to recognize the potential risk and build this belief into our overall strategy. In 2011, we couldn’t predict the earthquake in Japan or the Swiss National Bank intervention.
- Forecasting what is going to happen in the future is not easy. We need to accept that some of our positions will go against us and not in the direction we want it to go. This is where “battling our emotions” comes into play. Trading on emotion often leads to losses in the long run.
- Overall money management. It is crucial to avoid larger losses than necessary. Losing 20% or more in one trade is unacceptable and is considered poor trading – it’s called Siegel’s Paradox. Large, even infrequent, losses are difficult to overcome. If you lose 20% of the account, you need to make 25% to get it back. Thus, it is absolutely critical that we determine your maximum risk before the trade idea so you don’t allow small losses to become big losses.
- The only exception to placing stops is if you are disciplined enough to use mental stops – some do – but you better use it if the market crosses the specified level. Typically, only professional traders should employ this technique. Another exception is using a “stop-on-close” technique; however, notice that at the end of the day, it is a stop system. Click here to learn more about the “stop-on-close”technique.
Below are some important items to consider when placing stops:
- How much are we risking relative to our account size? Many traders use the 2% level. For example, if we have $100,000 in our account, a maximum risk amount of $2,000 could be used for the trade. If we’re risking more than 5% of our account, there is a high probability that our account will go bust as it is difficult to survive during extended and inevitable drawdowns.
- Volatility. What is it? One simple way to measure this is the ATR (Average True Range). We can use a 20-period ATR – the default is typically 14 periods. This gives us a sense of how much a market may move up and down over the course of time. If we’re viewing a daily for gold and the ATR is 50.38, it tells you that over the last 20 trading periods, gold has averaged $50.38 an ounce movement per day. Some traders will place a stop just outside 1ATR (1 x ATR). Other traders prefer more breathing room using 2ATR or 3ATR. Therefore, if we keep our gold stop 3ATR outside the current ATR, it would work $151.14 outside the price (3 x 50.38).
- Support and Resistance levels. This is more an art than a science. It depends on what we’re looking for and how much weight we place on certain indicators. For example, one trader may view local highs and lows while another is viewing Fibonacci retracement levels in search of turn arounds. Clients of Daniels Trading can also use the “Insider Market Advisory” to view support and resistance levels under the “Technicals” section.
Now that we have considered a few important data points, what do we do with the information to craft a stop strategy? Below are some of the most basic ways to determine stop levels:
- Percentage of account size: Simply choose a percentage of your account to risk per trade. Let’s say we have $50,000 in our account and are quite risk averse so we choose .50%. This means we’ll risk a maximum of $500 per trade idea.
- Volatility stop: Simply use the ATR to determine volatility, and pick a function of ATR – 1.5ATR, 2.2ATR, etc. Determine what seems to work and what doesn’t.
- Price stop: Usually determined from support and resistance levels. This makes the process more subjective so be aware of how our market bias affects our opinion. For example, what time frame are we trading on? Are you placing too much value on a certain technique or indicator?
- Dollar Amount: Pick a fixed dollar amount. We may only feel comfortable risking $250 per trade – this means that we’ll likely have to trade smaller contracts with less leverage, such as mini or micro contracts. Click here to learn more about using mini or micro contracts.
- Time stop: Uses time once the initial stop is determined. A pre-determined stop level is re-set as time passes. Let’s say we’re trading corn, and we believe the price is going up. We purchase at $6.50 and place a stop at the 1.1ATR using a daily chart. 1.1ATR = $0.20. Thus you place the stop at $6.30. Every day at the close, we will move the stop up $0.06 or six cents. Another way to determine a time stop may include a simple moving average or another technical tool(s). For example, place the stop below or above “x-period” moving average and drag the stop along with the moving average.
As traders gain more experience, they tend to tinker around with using some or all of the approaches above. As every trader knows, the market is constantly teaching and we are left to constantly learn and adapt.
There is no golden stop method – markets change all the time so you need to change accordingly. Recognize that when a market that is trading sideways and volatile versus a market that trades higher with low volatility will require two kinds of an initial stop exit plan.
Now we can pick an entry and determine where to place an initial stop. Now that the trade is in play, the next step will be to manage the trade. Will we ever move the stop? Why? Where? Do we have a profit target? This will be the next step in executing our overall trading plan.
I invite all questions and feedback in the “Comments Section” below, directly at 1.312.706.7649 or via email at firstname.lastname@example.org.
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