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Stops. Every trader needs them, and if you don’t have one in
place, you are asking for trouble. The market will eventually reach out from
the computer screen and give you a less than friendly slap, and the stinging
wont only be in your face, but your trading account. A stop takes you out for
an acceptable loss when the trade moves against you and at a point where you
have decided that it is best to walk away and lick your proverbial wounds.
But what is in a stop? Every trader knows they should use
one, but very few actually consider the type that will suit them.
I am going to cover three in this blog –
- A small fixed number stop
- A stop that adjusts to recent market volatility
- A structure-based stop
Small Fixed Number Stop
This stop tends to be placed above or below the signal
candle by a certain number of pips. It will vary depending on the market you
are trading and also the timeframe, however for this example we will say you
use a 5 pip stop above or below your signal candle.
You use the same stop for every position you take, and the
overall stop size comes down to the size of your signal candle. This stop does
take into account the market volatility somewhat, since it is based around the
signal candle, however it does not give a lot of room for market movements once
in the trade.
- Your stop is easy to work out. You can do it quickly
before entering a trade. There is no uncertainty, since you know exactly what
size the stop will be.
- This type of stop tends to be better for risk reward
ratios. The smaller the stop, the less the market must move for you to get to a
good level or risk reward.
Drawbacks
- Because the stop is relatively tight to the candle, you
will suffer a higher portion of losses than say using a structure stop.
- It does not give the market a lot of room for normal price
movements before it hits your stop. You will find that on certain trades, you
are stopped out and then the market moves to your intended target.
Stop That Adjusts to Recent Market Volatility
This type of stop takes into account recent price movements.
It means your stop will expand as the market gains in volatility and reduce as
the market quietens down. There are a number of ways to set this stop, however
one of the easiest is to use the Average True Range. You simply add the Average
True Range to your chart and set it to what you consider a range that will
summarise the recent price action – I suggest 5 to 10 periods.
When using the ATR stop, it is also wise to ‘step-up’
timeframes to take the reading. If you are trading on the 1-hour timeframe, a
reading of 5 hours isn’t really giving you a good view of what the market has
been doing recently. But if you are on the 4-hour timeframe or daily, a 5-period
reading takes into account a much larger market sample.
You then decide on your stop level from the reading. It may
be 50% ATR, 30% ATR, 75% ATR or any percentage, depending on the type of
trading you are doing.
- As we mentioned, this takes into account the recent
volatility of the market. This means that your stop will get larger as the
market becomes more volatile, and smaller as it quietens down.
- You have a set stop size to use each day. It will also
suit each market since the reading is taken off of that market.
- Less losses than a small number stop since it uses the
market to determine size.
Drawbacks
- It is still an arbitrary number. Why a 30% stop instead of
a 50% stop? Why not a 25% stop?
- If the market quietens down and then moves into a sudden
period of high activity, your stop will not adjust quickly. Similarly, if the
market has been very volatile and then quietens, your stop will still be large
in relation to the market movements until the ATR catches up.
Structure Based Stop
I would say that this is the most common type of stop used
by beginner traders. It is promoted on most forums and blogs as the only type
of stop to use.
With this stop, you place the stop level above or below a
recent level of structure, or ‘swing’. The idea being that if you are trading
in a downtrend, you want to allow the market to chop around and it is only if
it starts breaking above the previous swing-high that you want to exit the
trade. If in an uptrend, you only want to be taken out if the market starts to
break previous lows (hinting at the end of the downtrend). For reversals, you
just pick a recent level of structure and place your stop above or below it.
Benefits
- You give the market much more room to move whilst in a
trade.
- Less losses.
- You are using market structure to determine the stop loss
level.
Drawbacks
- This stop tends to be a lot larger than the others.
Because of this, gaining a good risk reward is harder and requires much larger
price movements.
- It is very subjective. One ‘key’ piece of structure to one
trader may not be the same to the next trader. Because of this, it can become
difficult to determine where to put the stop.
So, there we have three different style of stop. You will notice
that they all have benefits and drawbacks. The truth is, with trading, it comes
down to the individual trader and their trading plan. I never advise that you
just pick a random stop and stick with it. You should test lots of different
style stops and also sizes of stops. Let’s say you use a structure stop and
need a 1:3 risk reward ratio to become profitable with your trading plan, but
your trading plan only produces on average 1:2 risk reward trades using the
structure stop. It won’t work and it doesn’t matter how ‘well’ you are trading.
Now let’s say you test your methods again and this time you use
a much tighter fixed number stop. You realise that using this stop you suffer
more losses, but now you can get lots of trades at 1:4 and 1:5 risk reward.
Suddenly your trading becomes profitable.
Most people do not like putting in the work, especially when
it comes to testing and refining their trading plan. They settle on something
they stumble across and then wonder why they are doing so badly. You MUST be
willing to try things that may not at first strike you as beneficial.
Do what others aren’t willing to do so you can achieve what
others will never achieve.
I hope you’ve all had a great trading week!
James Orr