A Stop Loss guide. You don't have to agree with it but it works

Over the past week the post board has been dominated with topics about Stop losses. A lot of new traders are being told by proposed experienced traders that stops are not essential and in some cases must never be used. The justifications have been, broker malpractice like stop hunts and reversals taking you out of potential winning trades. Forgive me but most of these justifications are nothing but fallacies committed by people who are yet to meet their own crucifixion.

Anyway in light of all this advice I thought I’ll contribute to this topic from my and some of the most successful traders perspectives.

Why do we use stops? It is quite simple, it is to quantify financial risk which is much different from the risk on the trade. Let’s say you have $100 and you potentially wish to risk $2, this will determine lot size and ultimately stop loss distance. So if I was to then wish to have 50 pip SL I will then do 2/50 = $0.04, this becomes my lot size I must trade based on my financial risk being quantified as what I can afford to loose on that trade to accommodate a sensible drawdown on my capital.

This no doubt brings the next question…How do I determine my stop position? Answer-discretionary but Bruce Kovner, the most successful currency trader in history says, don’t put stops in obvious places put them in hard to reach places. It is common practice to put stops behind peaks and bottoms and also behind Moving averages and 50% Fib levels I am not saying that you should not put them there at all but these places are obvious and market makers call these stop clusters and they love to trigger these clusters to accumulate or distribute inventory. So place them in spots that are hard to reach like behind major support levels confirmed as support on multiple time frames, the logic here is that the market makers will not move price beyond those levels without causing themselves harm so it is good place to start.

I saw a stop cluster get triggered on GBP/USD just today at 9.30am during the CPI release for the UK. This was an accumulation move to release inventory for weak long positions. This was 1H 200 EMA however the real support was at 1.6658/60. So the market maker and specialist got in on the move most likely at 1.6667 without moving the price against themselves, instead used the cluster to convert the liquidated stops (sell orders) to buy orders (pretty clever eh!). So any stop should have been below 1.6660. This behavior alone gives you a trade signal that there is a bullish bias in GBP favour.

Most traders, even experienced traders confuse the risk on the trade with the financial risk hence the long debate on the issue.

Low risk trade - A trade that has been analyzed and confirmed using both fundamentals and technicals and also capital flows i.e. no point buying USD if Gold and Oil is rising these instruments have an inverse relationship, this will be high risk regardless of the technicals but if you did go ahead be sure to know that any move is short term and can be subject to reversals at any time. A low risk trade means you can afford a tighter stop essentially the risk of the trade has reduced financial risk. Again any Stop loss is really a protection against an unexpected move.

High risk trade - Usually the reward for these is greater but would usually be subject to extreme volatility. This is common when trading ahead of major news data. The pair will most likely will be in congestion with no direction, usually all capital markets tend to be still so there is no signal any movement will be fast so if you are intraday trading then a stop above or below the congestion area will offer a good financial risk reward ratio but in this scenario it is a high risk trade so a tight stop could mean you can double your position and still keep your financial risk low and your capital protected in the event the move is not in your favour.

Stops are very useful for the retail trader like yourself, of course an institutional trader with millions on the market has no need for stops as their positions tend to accommodate larger risk over longer periods and intraday movements are of no consequence plus any positions closed will be just opened up on the other side of the initial trade meaning the capital is always working. It is perhaps from here that the idea of not using stops came from but Bruce Kovner when asked in interview says, if I was a small trader I would use stops but by default as a large investor I cannot I just have to know when to get out.

I hope this piece convinces all those still debating the issue of stops to just use them and protect your capital however small. I assume one day most here would like to speculate with lots larger than 10k so this will be sound advice I think.

However if not good luck and I hope it all goes to plan.

This stuck out to me because I don’t agree with the statement fully.
Relationships between different investment vehicles are very tough to nail down because they are for the most part constantly changing. I don’t think it’s wise to simply avoid buying USD if XAU/Oil is rising based solely on the premise that they maintain “inverse relationships” because that’s not true.

Attached are two charts (XAU vs. USDollar & USOil vs. USDollar for the last year).
You can tell just by scanning the charts quickly that defining any exact correlation for the most part is scattered.

There are periods when both instruments move in lockstep whereas there are periods where they do indeed inverse.

Using your premise - Avoiding technicals/fundamentals which present a trade opportunity on one b/c of a position you’ve taken on another isn’t sound. If there’s a trade according to my trading plan to go long on Gold, Oil and a USD-based pair, I’ll take all three.

Now, they may not all fire off @ the same time, but regardless - if the trade is there, I’m taking it.


XAU V. USDOLLAR


USOIL V. USDOLLAR

The instruments we trade are always quoted in pairs.
How can you quantify USD strength objectively to compare it against Oil or Gold? I’d argue you can use something like the FXCM USDollar index which represents true USD strength/weakness against other majors.

If you only look @ a Gold chart, there’d be no argument that XAU and USD move inversely (and likewise for Crude), because in order for a bullish candle to print there needs to be buyers of XAU / sellers of USD and in order for a bearish candle to print there needs to be sellers of XAU / buyers of USD. That exchange of buyers of one / sellers of the other for a single instrument does not constitute capital flow across the broader market. It’s represents capital flow inward/outward for that single investment vehicle.

Correlations can’t be made using a single instrument in other words - just be careful with making that assumption.

XAU V. USDOLLAR
USOIL V. USDOLLAR

Jake

Quite right unlimited. The relationship between instruments don’t always hold on the longer time frames but my example was a simplified one to help the idea of understanding a risky trade in light of changing capital flows bear in mind as an investor looking at a longer time frame small intraday capital movements are just noise.

My point was one of capital flows which is the economics of all trading. E.g. Bonds, Gold and USD and Oil have a relationship in the wider market.

Oil - Is priced in US Dollars and WTI Crude is produced in Canada and the US is its largest consumer of Oil in that region, Brent is produced in the Mid East and tends to cover the Arab states that have most of their currencies are pegged to the USD. So Oil may rise as a result of a weak USD or just demand and Supply in both scenarios, rising oil prices will affect the USD. The relationship is distorted at present simply because of Ukraine and Russia. Oil prices are high but the USD has strengthened slightly but note this is a smaller correction for now in the face of an overall bearish sentiment.

Gold - Brettonwoods agreement pegged the world economy power houses to Gold but later collapsed now we have the USD as the currency of first reserve. Investors always run for cover when the USD is weak so Gold holds true to an inverse capital flow between the two. It is easy to forget that capital flows so to buy equities one must sell a currency to buy the asset and to buy Gold one must sell an a currency to do so. The USD being the currency of first reserve for the major capital nations any intraday rise in Gold will see a sell off in USD naturally investors are selling Dollars to buy Gold seeing Gold is priced in USD. Again on a longterm this may not hold true always simply because during risk on phases investors ditch both and move on to emerging markets for example.

Bonds - These again are safe have instruments and T-Bonds, T Notes and T-Bills have been major a benchmarks for risk sentiment. The latest crisis has some what messed up the bond market but it is slowly coming together again however you will often notice that any movement in Bond yields especially T-Bills, rising yields indicate a fall in Bond prices due to lack of demand meaning capital is likely either flowing into equities, in this case we see some USD strength as Bonds are sold and USD is bought and in most cases seeing bonds can be converted to equities we now see a close relationship with the stock markets and Bonds more so than currency but there is almost always some USD strength in the event bond yields keep rising.

This relationship extends to ETF’s as well for example the Greehaven Continuous commodity ETF mimics teh AUD as this ETF tracks commodities and with AUD being a commodity dollar any movement in commodities tends to have some effect on the AUD.

My point is that capital moves and for me it is a factor when deciding risk on a trade. Of course you may feel the risk is lower but you cannot possibly argue with the fact that no investor now invests in any instrument without looking at known correlations and inverses. Many times technicals say one thing and then the result of the trade is different however capital flows had long confirmed the potential change. So it is really seeing the broader market than a narrow picture.

I am sure when you drive you check your rear and side view mirrors for oncoming traffic.

Very, very insightful information. How many lots triggered that bearish drive in your opinion ? 50K , more ?

I couldn’t tell you accurately but there would have been probably millions of orders sitting at that level just waiting. The spot was just bait. I thought about putting my stop there, then my mind said, what the hell are you doing?? That’s a 200…A major release…massive bullish volume an hour before the release. It just screamed at me. It was a perfect example of a stop hunt.

Hello emerladorc,

you clearly have an insight into the market that most ‘junior members’ lack, so I would like to nominate you for
’honorary member’ status, informally at least!

Your insight into markets seems incredibly advanced to someone like me… I think that teaching myself all that you seem to know seems like a long way away, perhaps the sort of thing that you would only learn if you took lessons from a business school or doing an MBA or any other financial/economics sort of training - you get my meaning…

I am sure that it does not have to be that way, but for someone with thirty+ years of music/arts training and practice, this is a new world and even getting my head around basic fundamentals is quite a challenge for me… Does anyone else feel that way?

Yields, bonds, 10-year bill sales, swaps, ETFs, risk aversion, capital flow: all these terms hold a near-magical resonance to my ears, and although I munch them daily (reading articles etc.) I do not fully feel like I grasp the way in which economics work… Reading helps, but it is piecemeal and I almost wish that I could have one person sitting with me over a couple of weeks giving me homework and then checking that I understood things…

While I feel that I am making very good progress with my trading, I still feel that the fundamentals of economics escape me: if anything, I would like to understand them for myself first, and then, if suitable, adopt them for my trading strategies second.

Thank you for the informative post!

Cheers.

Wow. That’s a well-written guide. +1 from me. :slight_smile:

Good post Emerald.

Funny enough there is another way of looking at cable’s move yesterday, one offered by Sam Seiden and Chris Lori.

Lori talks about ‘inefficiencies’ always being corrected, Seiden talks about ‘missed’ or left behind orders and that price gets ‘engineered’ back to fill those orders.

It’s the old story about gaps.

Anyways, the story on cable goes back to Apr 8th, I’m too lazy to post the chart but at 08.30 gmt cable jumped on release of better than expected mfctr numbers.

This was big news.

Now I really should have said that price gapped up, around 30 pips, so as Seiden would say, what happened to any large buy orders that may have been on the table inside that gap?

The owners of those orders like a bargain and hate to chase at dearer prices.

So why yesterday? - well it’s the next news day (aside from rate decision which has long been a side show).

So why down to 6658 and stop? - well the aforementioned gap went right through 6660, 6670 and 6680 - so buy orders at those numbers were still there - the gap is now filled :slight_smile:

So where to put the stop on a news day? - below the gap, if price goes down there then that means the buy orders have been pulled or swamped with new sells, and there is only one reason for such a scenario - bad news.

Don’t mean to sidetrack this thread by going off on a tangent, (so apologies in advance to emeraldorc) so I’ll make this question very brief.

Do you follow Seiden or Lori on any website, or is it stuff you read from books peterma?

Only ask as I’d be interested in following them myself, keeps me away from ranting about today’s latest installment of total lies from the UK government.

Sorry again to to OP for side tracking.

Nah, watched Seiden’s videos some years ago, so also Lori’s - just was interested in how they were teaching something very similar but with entirely different language.

Lori, in teaching that market inefficiencies are always rectified made little sense because he doesn’t explain the reasoning, Seiden, on the other hand, from his floor experience, explains his reasoning very well.

To be fair I do have an Economics background with a finance specialty. The trouble is nothing you learn in Economics prepares you for real world economics. I used to be in consulting and briefly merchant banking. That said my trading development has been very independent even though I have spent a lot of time around traders from commodities to equities.

The science of market micro structure (market and price mechanics) is fairly a recent addition to the academic playing field and during my university years the subject matter wasn’t even well understood by institutions. The irony is if you are going to be an all round good trader, you need some knowledge in that area. So I spent a lot of time reading on market micro structure. I recommend Maureen O’ Hara.

My knowledge of fundamentals grew when I realized that most traders rarely talked about technicals like Fibonacci and so on in fact they paid keen attention to other markets especially the movement in commodities. So I spent a great deal of time following the actual money flows of institutional investors with so much real time data and so many ETF’s (Exchange traded funds basically these made it easier for investors to invest in a diversified portfolios of say commodities like they would invest in a stock reducing cost of transacting and exposure to one volatile commodity, so an ETF is like a tracker for physical assets), it could not be easier to do today unlike 15 - 20 years ago. It was this that led me to relational markets and was a game changer in my trading journey.

Now I digest any material on the subject matter I can get hold of. Thanks for the humbling comments, I am always glad to share my experiences and little knowledge in comparison to some people.

Yes Emerald, ETF’s are little used in analysis, another good source is John Murphy’s ‘Trading with Intermarket Analysis’.

An example he quotes, as you say using ETF’s, is EZU (EMU I Shares), an ETF tracking Eurozone stocks, see attached link.

Looking at the daily over 12 months and then daily 12months EURX and it’s easy to see the correlation in this ETF and the Euro.

Correlations, as Mr Murphy suggests, are only useful when there is positive divergence,

Quote “a positive divergence is created when one market starts to rise while another positively correlated market continues to fall.”

Some might say what’s so special about that? - well he gives one (then) recent example where in the start of 2012 the Euro was falling steeply, there was reluctance on the part of EMU to fall below support - suggesting that the sell off was overdone.

The divergence is very clear by July of that year - EURX is miles below it’s Jan price, not so the EMU, the Euro duly turned north.

I’ll give another little quote and then sign off before I bore everyone,
" the ability of EMU to stay above support (in summer 2010) raises hope that the Euro crisis might be contained."

iShares MSCI EMU ETF | EZU

Me again, another little ETF I should have mentioned is relating to our old friend Gold.

GDX, an ETF made up mostly of Gold Miners’ stocks, and bullion are correlated as one would expect.

Murphy suggests that it is a good idea for Gold traders to keep an eye on Gold mining shares, one easy way is via GDX.

He further asserts that an uptrend in bullion is stronger if miners are moving in the same direction.

https://uk.finance.yahoo.com/echarts?s=GDX#symbol=GDX;range=1d

Thank you emeraldorc, that was a very interesting post. I confess that a lot went clean over my head due to my lack of knowledge, but the stop placement really made sense.

The proof will be in my trading pudding.