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Why You Must Use Stop Losses (And How They Will Improve Your Trading Results)

A lot of traders wrestle with the question of what types of protective stops to place and how to place them. There are many different styles of stops that you can place. I think they are all beneficial. In fact the only one I do not agree with is the mental stop. I want to thank one of my students from the Philadelphia class I recently taught. Lindsey took a picture of a local stop sign and with a few minutes on the computer, I came up with a perfect reminder for traders.
I want to reiterate that there is no one perfect way to trade. That is what makes this so challenging and fun. We need to find a style that best suits us and create rules that we can follow and improve upon. For my own trading, I will start by placing a stop market order at the place where the markets would prove me wrong in my trade. For longs, that is an area below the distal line of the demand zone where I buy. In a short position, I place that stop above the distal line of the supply zone that allowed me to go short. By placing my stops in those places, I am only likely to be stopped out due to market conditions changing rather than normal fluctuations of the security.

In every trade, I know a minimum of three things before placing the trade. I know my entry, my target, and my stop. This knowledge removes emotions such as fear and greed from my trading and allows me to focus on price action. It also gives me direction for managing the trade. There is a saying in trading, “Once green, never red!”

This means that once you are profitable in a trade, you shouldn’t give back those profits and turn a winner into a loser. To me, this means I must adjust my stops to protect those profits. I don’t consider myself profitable in the trade as soon as the trade goes into the green. I wait until I have profit in the trade that is at least equal to the amount I was willing to risk initially in that trade, the amount between the entry and stop price. Once that occurs, I will move my stop to break even as not to go red after profiting.

Why You Must Use Stop Losses (And How They Will Improve Your Trading Results)

Once that happens, I will then use one of a few rule based strategies for protecting future profits and moving my stop with the trade. It could be a moving average a trend line, volatility stop, or swing lows or highs. There is no one perfect stop, the key is to be consistent and rule based.

I tend to use moving averages as a trailing stop for my trades. I can do this for intraday as well as longer term swing and position trades. I will use two averages, one short term and one medium term. I will exit with a close that is beyond the short term average. But to prevent losing lots of profits while waiting for a close, I could also close out my position when there is a break of the medium term average.

Why You Must Use Stop Losses (And How They Will Improve Your Trading Results)

To do this, I will place a stop market order below the medium term moving average and just change it when a new candle forms. When you use certain trading platforms, this can be automated as well. Should a close occur that violates the short term average, I will just manually exit the trade at the open of the new candle and cancel the stop market order.

There are times when I may get stopped out too soon in my trades. I do not mind this and can always adjust the moving averages to accommodate for market volatility but never while the trade is open. Also do not re-enter a trade when you feel you were stopped out too soon. Your risks are elevated when you chase price and it is not worth the small profit you may receive.

Be aware of all of the advantages and disadvantages of the tools available to you and create your trading rules based on what fits your style the best.

 

Written by Brandon Wendell, Online Trading Academy Instructor. As a former stockbroker, brokerage trader, and hedge fund trader, Brandon brings various market views and insight to his trading classes such as the Forex trading course and lectures on advanced futures trading, options strategies and more. He has held NASD securities series 7 and 63 licenses. An Online Trading Academy graduate himself in 1998, Brandon has been trading equities, options, forex, and futures in his own account ever since. Brandon taught for Online Trading Academy in 1999 to 2001 before becoming a Realtor and commercial mortgage broker and also managing a venture capital firm. Returning to the Online Trading Academy family late in 2005, he now balances trading, teaching and a real estate career. Brandon is also the San Diego Chapter Chair of the Market Technicians Association and holds the Chartered Market Technician Designation. Brandon has appeared as a guest on CNBC, Bloomberg TV, and Fox Business Channel. He has conducted special seminars for CNBC staff on technical analysis of the financial markets. Brandon has published articles in The Trader’s Journal, Forex Journal, Investor Magazine, and Investor’s Business Daily. Brandon has also appeared as an industry expert speaker at the Trader’s Expo, The Money Show, and Asia Traders and Investors Conference.

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