V. 14:1 (45-49): On Using Stops by Joe Luisi
Stop orders are used to manage risk and to enter and exit positions. But what are some of the methods you can use to do so? For a look at the basics plus some of
the finer points, read on.
Say your favorite indicator flashes a buy signal. You proceed to call your broker and enter the market. Then what do you do? Do you just sit back and wait for the profits to roll in? What happens if the market falls apart and it turns out you're facing a big loss? Getting into a trade is the easy part; learning how to protect and manage the trade is the hard part. That's where the stop order comes in.
Stop orders, which are often referred to as just stops, are placed at price points where you want to enter or exit a trade. Technically, a stop order is one that you give your broker stating if the market trades at a certain price, then the order is triggered and becomes an order to be executed at the current market price. Buy stop orders are placed above the current market price. If the market price rises to the price on the stop order, then the order becomes a "buy at the market" order. Sell stop orders, on the other hand, are placed below the current market price. If the market falls to the stop-order price, then the order becomes a sell at the market order.
All traders should use stops, whether they are mental or actually placed with a broker. There are a variety of stops that can be used depending on your situation, the market you are trading and what you are trying to accomplish. Here, we will focus only on using a stop once you are in a trade (that is, protective stops). We will explore the various types of available stops and the various techniques that can be used with them to help you manage your position and reduce your overall risk.
THE VALUE OF STOPS
Once you enter a trade or even before, you should have a stop in mind. I would not recommend mental stops unless you have the discipline to follow through with placing the order if that level is hit. People who prefer mental stops do so because they feel the floor traders will try to push the market to price levels that will trigger the execution of stop orders, and if you have your stop order in the floor broker's hand, you will suffer an unnecessary loss.
Stop running occurs when a large number of stops accumulate above resistance levels or below support levels. Stops often collect at price levels that are whole numbers (for example, 452.00). When the market seems to lack a sense of direction, floor traders will try to push the market into these stop levels to create a temporary influx of price activity. Because these moves are the result of noise, not market fundamentals, the market tends to fall back into the normal zone of trading. Fortunately, this does not happen frequently enough to be a problem. If you place your stops
wisely, you can prevent yourself from getting caught in this activity. It is frustrating when you enter a trade, only to be stopped out; it seems as if the market moved exactly to your stop, only to reverse and move in your anticipated direction.