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.