| If there is one area guaranteed to confuse many | | | | trade is triggered at the first price available in the |
| traders and lead to multiple opinions on the most | | | | market for that size, which is why stops are not |
| appropriate approach, it is the subject of stop losses. | | | | guaranteed. |
| The science and the art of placing stops is featured | | | | As to the percentage size of the stop to be chosen, |
| extensively in many trading books and guides, but the | | | | that depends on several factors including the trader's |
| bottom line is that there is no right or wrong answer, | | | | overall money management rules, amount of leverage, |
| simply the fact that stop losses must be used to limit | | | | time frame and crucially the underlying volatility of the |
| potential downside exposure when trading. Traders | | | | share chosen, which is very important. |
| should also be careful not to confuse stop losses with | | | | Volatility stops and the ATR |
| buy stops, which trigger an opening position rather than | | | | Clearly, a percentage based stop is likely to be |
| closing the trade. | | | | triggered more quickly in a highly volatile share and one |
| It is very important not to package together the placing | | | | of the ways traders can adjust stop levels is by ratio |
| of stops with money management, as the two | | | | to the underlying volatility. There are various measures |
| represent different strands of trading. Simply put, stops | | | | of volatility available, but a simple way is to use a stop |
| are there to protect profits and limit the potential | | | | related to a multiple of the average true range |
| downside at any time once a trade has been opened, | | | | indicator, which is featured in most software packages. |
| and are part of an exit strategy for trades that are | | | | The ATR determines a share's volatility over a set |
| already open. Money management covers position | | | | period that can be defaulted as desired. The daily |
| sizing or amounts to be risked within each trade of a | | | | ATR indicator is very simple to calculate and is the |
| portfolio. | | | | highest of: |
| Within this potentially complex subject, there are many | | | | The difference between the current high and the |
| different types of stops, and it should be added that | | | | current low |
| stops are never guaranteed unless that facility is | | | | The difference between the current high and the |
| offered by the broker for an additional charge. | | | | previous close |
| Nevertheless, their use is an essential part of any | | | | The difference between the current low and the |
| trading strategy. For the examples below share prices | | | | previous close |
| are used, but stop losses should also be used when | | | | Basically this is the maximum range in which the share |
| trading CFDs in commodities, forex or indices. | | | | has traded from the previous close to the current high |
| The uses and abuses of stops | | | | and low. The average is then taken over a set number |
| Much has been written about the placing of stops and | | | | of days (ten is often used), and the stop is then |
| how to avoid them being triggered without too much | | | | calculated as a multiple of the ATR. |
| risk. This of course is the $64m question for most | | | | The reason this indicator is useful is that it becomes |
| CFD traders and very often causes more | | | | easier to place a stop outside the normal range of |
| consternation than any other aspect of the trading | | | | trading so that it is not hit by the short term random |
| process. | | | | action of individual shares based on their average |
| The basic idea behind where to place a stop is by | | | | volatility. |
| reference to the overall trend or trading range within | | | | As to the multiple of the ATR to be used, that is for |
| which the share is moving. As to the actual level of the | | | | the trader to decide, but longer term players and |
| stop, it depends on several factors including the | | | | seasoned stockmarket investors tend to find a 2.7 to |
| trader's overall money management rules, the amount | | | | 3.3 multiple (which can equate to 5% to 15% stop |
| of leverage, the time frame, and crucially the underlying | | | | losses) is applicable. Shorter term or highly leveraged |
| volatility of the share chosen. The stop should aim to | | | | players need to tighten the stop accordingly by |
| be placed at a level which if triggered would confirm | | | | adjusting this multiple. |
| the trade was incorrect. | | | | The breakeven stop |
| There is no point in trading a highly leveraged CFD | | | | This is a commonly used stop in which the trader |
| account with routine 5% stops as eight losses in a | | | | closes the position if it reaches a minimum profit and |
| row, which statistically can be expected every few | | | | then returns to even or back to a loss. So in the |
| hundred trades, would lead to a minimum 40% | | | | above example, if the price of BT rises say 2% to |
| drawdown on the account. | | | | 336p, the stop is moved up to 330p, which was the |
| Having said that, there is equally no point in attempting | | | | opening price of the trade. |
| to reduce the risk too far by setting 1.5% or 2% stops | | | | Please note that the breakeven stop here is not simply |
| in highly volatile stocks or takeover situations as each | | | | a new 2% stop loss - it's very slightly different - but |
| trade needs room to breathe, and stops this tight are | | | | very often this approach is used as a rough and ready |
| likely to be triggered within the normal daily ebb and | | | | way to protect the downside. This leads on to the |
| flow of price movements. | | | | important subject of trailing stops. |
| A good rule of thumb is that if you cannot see at least | | | | Trailing stops |
| double the potential profit in a trade compared to | | | | Trailing stops are widely used by professional traders |
| where you expect to place your stop loss, that trade | | | | as they provide an element of protection for winning |
| should be passed over. Indeed some CFD traders look | | | | positions without sacrificing too much of the profit. |
| for three times profits achieved against losses as a | | | | The idea here is that once the position is opened, the |
| starting ratio. Consequently an approach like this can | | | | trailing stop runs behind of the best profit achieved |
| be very successful by winning just three or four times | | | | throughout the trade and the stop (whether |
| out of ten, and is the hallmark of many of the world's | | | | percentage or price) is moved up accordingly. |
| leading traders. | | | | There are three rules and suggestions (examples here |
| Many losing traders look for an entry point or strategy | | | | are for long positions): |
| that wins six or seven times out of ten, but this is very | | | | 1 The stop can and must never be lowered |
| hard to achieve consistently. Although the feeling of | | | | 2 The percentage or price of the stop at each stage |
| winning regularly is certainly warm, the win/loss ratio | | | | of the trade does not have to be the same. For |
| here very often tends to be very poor as too many | | | | example, the trader in the above example may begin |
| winners are taken quickly, so the correct use of initial | | | | with a 2% stop in BT, and then the share price might |
| and running stops placement is crucial. | | | | rise to 346.5p, which represents a 5% profit. At that |
| Types of stops: | | | | point, the trader may wish to tighten the stop to 1%, so |
| The basic maximum loss stop | | | | that a minimum 4% profit can be taken but with more |
| The maximum loss stop is the starting point for most | | | | potential upside. This approach is to the discretion of |
| traders and is triggered when the share price hits a | | | | each player, but it is a very useful way of nailing down |
| level below or above the opening price of the trade, | | | | profits. |
| depending on whether it is a long or short position. It | | | | 3 Another approach is to raise the stop loss with |
| can be measured in percentage points or actual | | | | reference to recent action after a certain profit has |
| money terms, but for these examples percentages | | | | been reached. Instead of a percentage stop, the |
| are used. So if a CFD trader buys shares in British | | | | trader might move the stop up behind daily lows, thus |
| Telecom at 330p with a 2% stop loss, then the | | | | protecting against a potential trend change. |
| allowed loss is 6.6p and the position is closed if the bid | | | | 4 The stop might be triggered if there is a sudden rise |
| or selling price falls to 323.4p or lower. | | | | in volatility with a reversal in the shares, and some |
| Note that no mention is made of how many shares | | | | traders use as a trigger if the day's ATR is double the |
| are purchased or how much is being risked, as this is | | | | average ATR of the last ten days. This is very useful |
| part of the client's overall money management. | | | | where a wider initial stop has been taken and there is |
| If the shares gap down below the stop either intra-day | | | | the potential for a trend change before the trailing stop |
| or at the open of trading the next day, the closing | | | | is hit, thus protecting the downside. |