Smart Stops by Tushar S. Chande
Setting stops is a fine art, whether you trade one contract or a thousand. The challenge in setting stops is to participate in long moves without getting shaken out of the trade by market volatility. A variable-index dynamic average (Vidya) may be used to place trailing stops that adapt to market volatility, which combines enough sensitivity to price changes with flexibility to fit your trading needs. Using this combination, in fact, may well provide an extremely profitable stop for the intermediate-term trader.
Once a trade has been initiated, most traders will use the risk management technique of placing a stop
order, which limits losses or captures profits. A stop order becomes a market order when trades occur at a
predefined price, while a buy stop is placed above the current market price and a sell stop is placed below
the current price. A trailing stop order will be adjusted by a trader as prices change, following the market
up or down, while a fixed-stop order will stay put. A stop order may be good for the day or be an open
order, which may be good until canceled. A trailing stop is simply a safety valve to protect your profits or
limit your losses.
In practice, a trailing stop is a leaky safety valve. There is no assurance that your trade or fill will occur at
or very close to the stop price. For example, the market may make a sharp move past your stop, thus
triggering it. The first trade after your stop (which may not be your intended fill) may be well past the
stop you ordered in rapidly changing markets. Though imperfect, the trailing stop should give your trade
some protection in most markets.