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Why You Should Use Stops When Trading

In talking to prospective students at the sales events that I conduct it is always intriguing to see how many of them don’t use stops. The reasons vary widely why the majority of retail traders/investors don’t implement stops. Some don’t even know what a stop is and therefore don’t know any better. Others refuse to use them because every time they place one in their trades they always seem to trigger right before the market takes off in the correct direction. Another motive for not using stops is refusing to accept that some of the time we’re going to be wrong. You would think that being wrong some of the time is a common reality for most traders; however, you would be surprised how many traders operate this way.

So why use stops when trading? Would you walk a tight rope without a net? Would you jump out of an airplane without a parachute? If you did, it would only happen once. Admittedly, most of you won’t be walking a tight rope, nor jumping out of an airplane anytime soon, however anytime we engage in risky behavior don’t we always have some type of safeguard to protect us from catastrophe. Why do you buy flood or fire insurance against your home? The same reasons we protect ourselves against a disastrous event in other areas of our life is the same reasons we need to have some type of stop loss on your trades.

Let’s now address the most common question about where a stop should be placed as to have a higher probability of not getting triggered. First, notice that it’s about odds not assurances. We have to accept that some of time we will be wrong and our stops will be triggered. This is just a cost of doing business.

A stop order serves two distinct functions: First, it allows us to clearly define our risk in every trade, and secondly, it delineates where the lowest risk entry point would occur. In other words, since the stop is going to be placed very close to the price on the chart where we will be proven wrong , the closer we enter to that price, the lower the risk on the trade.

Below is a recent example in the Mini Russell 2000 futures contract where we see it formed a supply zone ( highlighted in yellow ). This zone created a low risk entry point for a shorting opportunity. The entry is to be taken at the origin of the imbalance as we anticipate that the price of the Russell will fall once it reaches this level of imbalance.

The stop is place only a few ticks above the highs of the zone because that is point where all of the sell orders will be absorbed and thus the trade probably won’t work. As you can see the risk is very small, the probability is higher than average, and the profit margin is high, therefore it’s a good trade.

In the next chart we can see that the trade worked as planned, but if it hadn’t the risk was very small as we had a stop to protect us in the event it continued to climb to an all-time high. If you had shorted the Russell, and did not use a stop, then you would just be guessing as to how high it would go, and that in my assessment would just be gambling.

Most of you I’m sure have heard the adage “pulling all the Stops.” That meaning is good in most other endeavors, however in trading pulling all the stops can spell disaster. Stops are a must in executing a low risk strategy, if you are getting stopped out too often that is probably a function of the strategy that’s being implemented, and as such, it needs to be reexamined. At Online Trading Academy we might be able to help in that area, so please contact a center near you to explore some alternatives.

Written by Gabe Velazquez, Online Trading Academy Instructor. Gabe got his start in the markets as a broker trainee for Paine Webber, a mere 3 months before the market crash of 1987. He witnessed the gut wrenching fear of investors during that time period and the wild speculative euphoria of the late 90′s. That experience brought to light the importance risk management plays in trading and investing. In fact, it’s greatly influenced the way he trades today.

He spent 15 years as a stock and commodities broker, conducting technical analysis seminars through-out Southern California. After many years of managing other people’s money, Gabe now concentrates full time on trading his own portfolio and teaching. Students will benefit from his first hand experience of daily involvement in the market. He brings with him an acute awareness and understanding of how the markets really work. Articulating this knowledge clearly, succinctly, and with enthusiasm is something students can appreciate. This gift for communicating was honed through many years of public speaking. He currently holds a series 7, 63, 9 and 10 (securities and options principals license.)


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