If there is one area guaranteed to confuse many traders and lead to multiple opinions on the most appropriate approach, it is the subject of stop losses. The science and the art of placing stops is featured extensively in many trading books and guides, but the bottom line is that there is no right or wrong answer, simply the fact that stop losses must be used to limit potential downside exposure when trading. Traders should also be careful not to confuse stop losses with buy stops, which trigger an opening position rather than closing the trade.
It is very important not to package together the placing of stops with money management, as the two represent different strands of trading. Simply put, stops are there to protect profits and limit the potential downside at any time once a trade has been opened, and are part of an exit strategy for trades that are already open. Money management covers position sizing or amounts to be risked within each trade of a portfolio.
Within this potentially complex subject, there are many different types of stops, and it should be added that stops are never guaranteed unless that facility is offered by the broker for an additional charge. Nevertheless, their use is an essential part of any trading strategy. For the examples below share prices are used, but stop losses should also be used when trading CFDs in commodities, forex or indices.
The uses and abuses of stops
Much has been written about the placing of stops and how to avoid them being triggered without too much risk. This of course is the $64m question for most CFD traders and very often causes more consternation than any other aspect of the trading process.
The basic idea behind where to place a stop is by reference to the overall trend or trading range within which the share is moving. As to the actual level of the stop, it depends on several factors including the trader’s overall money management rules, the amount of leverage, the time frame, and crucially the underlying volatility of the share chosen. The stop should aim to be placed at a level which if triggered would confirm the trade was incorrect.
There is no point in trading a highly leveraged CFD account with routine 5% stops as eight losses in a row, which statistically can be expected every few hundred trades, would lead to a minimum 40% drawdown on the account.
Having said that, there is equally no point in attempting to reduce the risk too far by setting 1.5% or 2% stops in highly volatile stocks or takeover situations as each trade needs room to breathe, and stops this tight are likely to be triggered within the normal daily ebb and flow of price movements.
A good rule of thumb is that if you cannot see at least double the potential profit in a trade compared to where you expect to place your stop loss, that trade should be passed over. Indeed some CFD traders look for three times profits achieved against losses as a starting ratio. Consequently an approach like this can be very successful by winning just three or four times out of ten, and is the hallmark of many of the world’s leading traders.
Many losing traders look for an entry point or strategy that wins six or seven times out of ten, but this is very hard to achieve consistently. Although the feeling of winning regularly is certainly warm, the win/loss ratio here very often tends to be very poor as too many winners are taken quickly, so the correct use of initial and running stops placement is crucial.
Types of stops:
The basic maximum loss stop
The maximum loss stop is the starting point for most traders and is triggered when the share price hits a level below or above the opening price of the trade, depending on whether it is a long or short position. It can be measured in percentage points or actual money terms, but for these examples percentages are used. So if a CFD trader buys shares in British Telecom at 330p with a 2% stop loss, then the allowed loss is 6.6p and the position is closed if the bid or selling price falls to 323.4p or lower.
Note that no mention is made of how many shares are purchased or how much is being risked, as this is part of the client’s overall money management.
If the shares gap down below the stop either intra-day or at the open of trading the next day, the closing trade is triggered at the first price available in the market for that size, which is why stops are not guaranteed.
As to the percentage size of the stop to be chosen, that depends on several factors including the trader’s overall money management rules, amount of leverage, time frame and crucially the underlying volatility of the share chosen, which is very important.
Volatility stops and the ATR
Clearly, a percentage based stop is likely to be triggered more quickly in a highly volatile share and one of the ways traders can adjust stop levels is by ratio to the underlying volatility. There are various measures of volatility available, but a simple way is to use a stop related to a multiple of the average true range indicator, which is featured in most software packages.
The ATR determines a share’s volatility over a set period that can be defaulted as desired. The daily ATR indicator is very simple to calculate and is the highest of:
The difference between the current high and the current low
The difference between the current high and the previous close
The difference between the current low and the previous close
Basically this is the maximum range in which the share has traded from the previous close to the current high and low. The average is then taken over a set number of days (ten is often used), and the stop is then calculated as a multiple of the ATR.
The reason this indicator is useful is that it becomes easier to place a stop outside the normal range of trading so that it is not hit by the short term random action of individual shares based on their average volatility.
As to the multiple of the ATR to be used, that is for the trader to decide, but longer term players and seasoned stockmarket investors tend to find a 2.7 to 3.3 multiple (which can equate to 5% to 15% stop losses) is applicable. Shorter term or highly leveraged players need to tighten the stop accordingly by adjusting this multiple.
The breakeven stop
This is a commonly used stop in which the trader closes the position if it reaches a minimum profit and then returns to even or back to a loss. So in the above example, if the price of BT rises say 2% to 336p, the stop is moved up to 330p, which was the opening price of the trade.
Please note that the breakeven stop here is not simply a new 2% stop loss – it’s very slightly different – but very often this approach is used as a rough and ready way to protect the downside. This leads on to the important subject of trailing stops.
Trailing stops
Trailing stops are widely used by professional traders as they provide an element of protection for winning positions without sacrificing too much of the profit.
The idea here is that once the position is opened, the trailing stop runs behind of the best profit achieved throughout the trade and the stop (whether percentage or price) is moved up accordingly.
There are three rules and suggestions (examples here are for long positions):
1. The stop can and must never be lowered
2. The percentage or price of the stop at each stage of the trade does not have to be the same. For example, the trader in the above example may begin with a 2% stop in BT, and then the share price might rise to 346.5p, which represents a 5% profit. At that point, the trader may wish to tighten the stop to 1%, so that a minimum 4% profit can be taken but with more potential upside. This approach is to the discretion of each player, but it is a very useful way of nailing down profits.
3. Another approach is to raise the stop loss with reference to recent action after a certain profit has been reached. Instead of a percentage stop, the trader might move the stop up behind daily lows, thus protecting against a potential trend change.
4. The stop might be triggered if there is a sudden rise in volatility with a reversal in the shares, and some traders use as a trigger if the day’s ATR is double the average ATR of the last ten days. This is very useful where a wider initial stop has been taken and there is the potential for a trend change before the trailing stop is hit, thus protecting the downside.
