V.3:5 (157-158): Where to Put Your Stops by John Sweeney

Where to Put Your Stops by John Sweeney

Stops protecting an initial entry position are like forward passes in football: Three things can happen to you and only one of them is good!

1)You can be taken out of a strong adverse move early (That's good).

2)You can be taken out of a losing trade at the worst possible price (That's bad).

3)You can be taken out of a winning trade by an interim fluctuation (That's catastrophic!).

It's worth keeping in mind how these events come about, although the first is easy. Protection is what stops are supposed to provide. You have presumably set a stop where if reached, adverse price movement outside normal fluctuations is indicated. Your stop is hit and the price keeps on moving past it. You feel pain but you're not mortally wounded.

More often, though, as the price bounces against you, your stop is the first to feel the pain. You may notice that an exit on the close would routinely get you out at a better price—the only exception being when the close and the day's extreme are one and the same. In this second situation, you get nicked for more than you needed to lose in order to exit your position.

Thirdly, the stop is set too close in zeal to hold down losses. Routine price fluctuation touches it and for once your broker performs as advertised. By the end of the day or week the move you were trading is still on but you're off the bandwagon. This is doubly injurious to pride and profit: you've converted a winning trade into a losing trade. Your opportunity cost (foregone winnings) is astronomical and you're also hurting from a cash loss. Your equity is shrunken by the winnings you didn't get and the loss you did take. Avoid this situation like the plague if you want to stay in the game.