How to Eliminate the Frustration of Using Stop-Losses

Posted 06/05/2009, 9:00 am EST by Jason Alan Jankovsky from tradingmarkets.com

Every trader has had the frustrating experience of placing a stop-loss order too close to the market. It really doesn't matter if the stop was to exit a losing trade or a winning trade, the frustration comes from having the stop get executed and then shortly thereafter the market continues to advance in the direction intended when the trade was initiated.

You either have taken a loss that could have been a gain; or cut a profit short. Of all the issues required to develop my trade approach, I probably have spent more actual time on the issue of improving stop placement than anything else. After giving the issue a lot of thought I decided the issue wasn't whether stops should be; after all trading without stops is an accident waiting to happen. It really is an issue of using stops effectively in order to maximize the probabilities inherent in your trading approach/system.

I took a look into the psychology of the stop-losses and I believe that any trader can improve their use of stops simply be being less aggressive with them. Here are the rules I recommend.

1. First of all, you must accept once and for all that stops are not optional. The surest way to suffer a debilitating drawdown in your equity is to trade without stop protection. This includes 'mental stops' in my opinion.

The purpose of a standing stop-loss order does not have to be solely to exit an existing trade; it needs to be considered as part of a well thought out trading approach that includes the understanding that no trader knows it all. If we are willing to admit to ourselves that we cannot know for certain if any one trade will be a winning trade, then your use of stops is simply an admission of that fact. You, as a serious trader must always have a protective stop working in the market you trade; regardless if you intend that to be an exit order for an open trade you currently have on for today. At the very least, a resting 'get me out' stop working against your open trade ensures that if, for whatever reason, you miss something before you exit the trade or enter an overnight stop; you are protected. As most traders know, it is the one time we act with enough over-confidence to assume we don't need a stop this one time (or will place that stop at the end of the day) that our market runs away against us dramatically. Always place a stop - you can always adjust it later as the trade progresses.

2. Next, you must think of stops as profit management tools rather than risk control tools. For the most part, if you have developed a sound enough approach to identifying the market's order flow, your trade will work when you are on the right side of the order flow. You could almost say that the initial risk control secured by the first protective stop was immaterial. That stop might as well have never been there. But since you are using solid discipline to protect yourself, once the stop is not needed as a risk control tool as the market goes your way; your stop now becomes a profit management tool. Regardless of your personal trading style or timeframe, you will have the market 'inhale' and 'exhale' while the price advances toward your initial profit objective. That ebb and flow in price action is normal and expected. The last thing you want to do is place your stop too close to the market to get 'tagged' during this normal ebb and flow. Rather than roll a protective stop under the market to lock a profit; consider rolling your stop to a breakeven point and wait for the objective to be reached. If you have truly seen the order flow, and you are positioned fairly well to begin with, the probabilities of the market trading your entry price after an advance in your favor drops over time.

After you have a reasonable lead on the market and you are holding a risk-free trade your only need is to watch for something to change. If nothing is changing continue to let the profit run until your objective is reached. If something changes you simply exit the trade with what you have in it at that point. If something changes, and you don't see that change fast enough to exit with what you have, your breakeven stop will take you out with no damage to your equity. If you had aggressively rolled the stop up behind the market, and been taken out on a normal ebb and flow of price action, you might be tempted to re-enter the trade at a less than optimal time/price relationship; which increases your risk.

3. Use the next highest time frame from your preferred trading time frame to decide where to place a stop. As my trading style evolved over time and through education, I found that my unique style would be considered a 'swing' trader or a 'position' trader (or a little of both). Since I was willing to enter a position and hold it for more than a week or so, the 'random noise', or ebb and flow of price action, could easily span several days, even though a day trader might see that as several individual opportunities.

In my case, my initial stop needed to be outside the range of this ebb and flow; which was often the weekly high or low. If the trade was working, and I was in it 3-4 weeks, I might roll my stop to protect the trade but I usually would always make it outside the range for the week. After critically examining the results I found that in most cases you should:

  • Use the next highest time frame or two from his trading time frame to decide where to place a stop, in most cases the stop will be outside of the normal ebb and flow.
  • In other words, if you are a day trader using the 60 minute chart for your entry signals, a stop outside the range for the last day or so would work fine. Of course, that needs to be in context with your actual tolerance for risk. If you are looking for 30-50 points on something but a risk-control stop outside the range is 100 points; that won't work so well. But in any case, if you are using the next higher time frame to assist you in stop placement you will find you are getting stopped out less often before your trade reaches your profit objective.

4. Benefit from the clear thinking that stop usage brings. I think the a great benefit to always having a stop order working and moving them less aggressively is the peace of mind you have from knowing you are trading in a disciplined manner. Your trade thinking improves when your initial risk is known and protected. Your profit potential improves when you allow the market to behave as it needs to on the way to your objective.

In conclusion, By simply adjusting your use of stops to a less aggressive and more disciplined manner your profit potential is the real main benefit because your losing trades are always going to be there. Using stops less aggressively on your winning trades allows you to hold winners a bit longer. Using stops consistently to begin with limits your equity loss to a more reasonable number until you are holding the winner.