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Using Stops to Reduce Risk |
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In order to limit the maximum amount of loss acceptable on a particular trade, the trader will generally place a stop loss order every time a trade is entered. In most cases it will be a GTC (good till cancel) order. This stop loss order will also keep the trader from procrastinating about exiting a losing trade. |
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Stops are used as a protective measure to help decrease the risk that an account is exposed to. Stops can be used for an entry or exit strategy or for protective risk management. Stops that are used for risk management can be categorized in two ways: |
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A price stop will get the trader into or out of a trade if a predetermined price is hit. |
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A time stop will get the trader out of a trade whenever a certain amount of time has elapsed. |
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Perhaps the most important aspect of trading is the correct placement of protective stops. Before entering a trade, the trader must always predetermine where to exit the trade if the market fails to behave as expected. |
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It is important to remember that the longer a trade is held, the more risk a trader is exposed to. A protective stop placed too close to the market action will virtually guarantee the trader of being stopped out. If the stop is too far away, it loses its effectiveness. The amount of money that would be lost over time by using a protective stop is in large part determined by the percentage of winning to losing trades. By changing the profit and loss objectives, the trader will change the percentage of winning to losing trades. If the percentage of winning to losing trades is 50 percent, a trader must profit more than the amount placed at risk in order to be profitable. However, if the percentage of winning to losing trades is higher, a trader can earn less than the amount risked and still remain profitable. Likewise, if the percentage of winning to losing trades is less than 50 percent, a trader must make more than the amount risked to be net profitable. |
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A protective stop can be placed at a price level where the pattern that generated the entry signal has obviously been negated. For example, if the reason for going long was the formation of a double bottom, then placing the stop under the double bottom would be a logical place. The reason it is logical is that, should the price decline so that the stop was triggered, then obviously our perception of a double bottom was incorrect. By placing our stop at a price that indicates our entry reason was incorrect, we have been able to define our risk. If we are stopped out, we are able to preserve our equity and wait for another opportunity to present itself. |
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