Introducing Stop Orders (Into a Methodology)
What Is a Stop Order?
A stop order, also referred to as a stop-loss order is an order you can place with your broker to instruct the broker to automatically buy or sell a position at a less favourable price if your chosen price is traded. A stop order can be placed on a long or short position.
Buy Stop - You have a short position in BT. from 220 but want to exit if 235 is traded.
Sell Stop - You have a long position in JE. from 780 but want to exit if 710 is traded.
Hard Stops - The act of having an actionable stop order placed with a broker is generally called a "hard stop".
Soft Stop - This will generally be the term used for an end of day stop where the position is closed on the next trading day after it closes below a chosen level or a timed stop where a position might be closed if it has traded for a loss over a certain time period.
Whether the Stop "loss" order actually saves you from a bigger loss is a very debatable hot topic and so it should be. There is a very good reason for it being a hotly debated topic. Its called the outlier.
The Outlier Exit.
As soon as we introduce the stop order to a methodology we introduce the outlier. The outlier is psychologically destructive as its the gateway to a curve fitting grail hunt or worse still simply deciding "stops don't work" and ending up with some ugly losing positions.
What is an Outlier Exit.
The outlier exit is the occasional time that our position trades the exit level then reverses to trend strongly in the direction of the original trade idea and actually moves back to make a higher high in the trend. This is an important point. For example when I have a full position loaded and it moves higher I have a management method that I call trail mode. Very few trades will trade my exit price then reverse to make a new trending high. Those that do are called outliers.
The psychological problem around the stop loss exit area is heightened further because after an exit price is traded many stocks will bounce in the coming days or weeks and it will make us question the original stop order. If the exit point was a break in the primary trend structure price will usually be trading the exit area again in the near future. The outlier is the occasional whipsaw. It’s the culprit of many curve fitting grail hunts and in some cases it can cause people to turn their back on risk management altogether.
What Is a Stop Order?
A stop order, also referred to as a stop-loss order is an order you can place with your broker to instruct the broker to automatically buy or sell a position at a less favourable price if your chosen price is traded. A stop order can be placed on a long or short position.
Buy Stop - You have a short position in BT. from 220 but want to exit if 235 is traded.
Sell Stop - You have a long position in JE. from 780 but want to exit if 710 is traded.
Hard Stops - The act of having an actionable stop order placed with a broker is generally called a "hard stop".
Soft Stop - This will generally be the term used for an end of day stop where the position is closed on the next trading day after it closes below a chosen level or a timed stop where a position might be closed if it has traded for a loss over a certain time period.
Whether the Stop "loss" order actually saves you from a bigger loss is a very debatable hot topic and so it should be. There is a very good reason for it being a hotly debated topic. Its called the outlier.
The Outlier Exit.
As soon as we introduce the stop order to a methodology we introduce the outlier. The outlier is psychologically destructive as its the gateway to a curve fitting grail hunt or worse still simply deciding "stops don't work" and ending up with some ugly losing positions.
What is an Outlier Exit.
The outlier exit is the occasional time that our position trades the exit level then reverses to trend strongly in the direction of the original trade idea and actually moves back to make a higher high in the trend. This is an important point. For example when I have a full position loaded and it moves higher I have a management method that I call trail mode. Very few trades will trade my exit price then reverse to make a new trending high. Those that do are called outliers.
The psychological problem around the stop loss exit area is heightened further because after an exit price is traded many stocks will bounce in the coming days or weeks and it will make us question the original stop order. If the exit point was a break in the primary trend structure price will usually be trading the exit area again in the near future. The outlier is the occasional whipsaw. It’s the culprit of many curve fitting grail hunts and in some cases it can cause people to turn their back on risk management altogether.
Question! Is the outlier more important than the methodology?
The methodology should make returns with the occasional outlier thrown into the mix. The risk of not executing a stop order exit for a small loss is far more damaging to a portfolio if that position turns into a trend in the opposite direction. The Big Loss.
The Fundamentals Versus the Technical's.
Price is trading 52 week lows but the fundamental story or forecast reads bullish. There could be articles promoting the great opportunity and institutional upgrades supporting the bull case. The story is screaming this stock is going higher so why is it trading 52 week lows? In over 30 years with money in the markets Its extremely rare that I've encountered a stock trading 52 week lows that is priced wrong. This simple hack will help you avoid a high percentage of profit warning. Never underestimate price.
Stop-Loss Orders from a Victims Viewpoint.
Its generally considered by novice traders that the market makers are out to get them and the whole game is rigged in their favour so why should you use a stop loss? Many articles on stop orders are targeted towards curve fitting a stop loss method in an effort to rescue losers so a predetermined stop loss exit area doesn't have to be a loss if you do this or that and sprinkle some magic fairy dust on it. I'm going to try and turn your thinking upside down so the stop loss or simple trade exit is very low on your trade psychology heat scale.
Its worth repeating here what a stop order is again. A stop order is an order you can place with your broker to instruct the broker to automatically exit a position when the chosen price is traded. When the price is traded the order becomes a market order and you get filled where the market can fill you. Sometimes its at a better price and sometimes its worse. Plus or minus slippage. The fact that price is trading near the order should indicate the trade is probably wrong but until it trades that price you still have a reward to risk scenario playing out. If exiting a trade is an emotional decision we need to ask why. Did we risk too much? Did we fail to position size correctly? It shouldn't be that difficult a decision to exit a trade and the method used should be simple to apply be it price trades a level or closes below a level or maybe times out in the case of a timed stop. Whatever suits your method should be a really easy simple process where there is no second guessing shenanigans. An If - Then Scenario. If = if it trades or closes here. Then = Hard stop executes or end of day signals I close on tomorrows open. Simple, repeatable but also meaningful. Simply pinning a stop order on a position doesn’t in itself really mean anything. Random stops as with random position sizing will give random results.
Reward to Risk Flip and Overriding Stops.
Overriding predetermined stop loss orders by exiting a position early could be a double edged sword. As with outliers where prices can execute your stop loss before moving back to high's they can also trade close to your stop loss without executing and move back to high's. Sometimes you can be exiting a position to save pennies at the cost of pounds. If you loaded a trade with a reward to risk of 2-1 meaning your target will return 2 times your risk then the reward to risk will dynamically increase if price fades from the entry. If the entry was 100, the stop order was 90 and the target was 120 this would give a reward to risk of 2-1. What if price pulled back to 95? The reward to risk is now dynamically reading risk=5 - reward=20. You are risking 1 to make 4. What if price pulled back to within 1 point of your stop order. The trade is dynamically reading risk=1 - reward=20. You are now risking 1 to make 20. Reward to risk is actually at its greatest near the stop order and until that order executes you are still in the game. Exiting trades early for whatever reason as price fades in the direction of the stop is going to be better where reward to risk flip is at a minimum and that is going to be near the entry price.
Why Use a Stop Order?
This might sound like a very simplistic question but it actually goes much deeper than that. I've chosen to leave "loss" out of the stop order title as its very misleading as to what the use of stop orders can introduce to trade and money management.
Having a well thought out wrong area for the exit of a trade gives a bracket to position size for. The exit area could be within the noise being close to price or outside the noise meaning the volatility would need to increase to an extent that it trades outside its usual range to execute an exit signal. If you know where you want to exit then you have the first piece of a trade plan. With this information you can now move forward to add some bomb proof risk management to prevent you from exposing your account to the potential destruction of a black swan event or prolonged bear market that could put you in a hole that is so deep many don’t have the psychology needed to trade out of. Simply understanding that whipsaws will happen and sticking with the exit plan is the key to being relaxed knowing that if the worst case scenario happens tomorrow I've already got it covered. It all starts with a simple stop order. I think my friend Murray said it best. Its better to be whipsawed than to be chainsawed.
The Fundamentals Versus the Technical's.
Price is trading 52 week lows but the fundamental story or forecast reads bullish. There could be articles promoting the great opportunity and institutional upgrades supporting the bull case. The story is screaming this stock is going higher so why is it trading 52 week lows? In over 30 years with money in the markets Its extremely rare that I've encountered a stock trading 52 week lows that is priced wrong. This simple hack will help you avoid a high percentage of profit warning. Never underestimate price.
Stop-Loss Orders from a Victims Viewpoint.
Its generally considered by novice traders that the market makers are out to get them and the whole game is rigged in their favour so why should you use a stop loss? Many articles on stop orders are targeted towards curve fitting a stop loss method in an effort to rescue losers so a predetermined stop loss exit area doesn't have to be a loss if you do this or that and sprinkle some magic fairy dust on it. I'm going to try and turn your thinking upside down so the stop loss or simple trade exit is very low on your trade psychology heat scale.
Its worth repeating here what a stop order is again. A stop order is an order you can place with your broker to instruct the broker to automatically exit a position when the chosen price is traded. When the price is traded the order becomes a market order and you get filled where the market can fill you. Sometimes its at a better price and sometimes its worse. Plus or minus slippage. The fact that price is trading near the order should indicate the trade is probably wrong but until it trades that price you still have a reward to risk scenario playing out. If exiting a trade is an emotional decision we need to ask why. Did we risk too much? Did we fail to position size correctly? It shouldn't be that difficult a decision to exit a trade and the method used should be simple to apply be it price trades a level or closes below a level or maybe times out in the case of a timed stop. Whatever suits your method should be a really easy simple process where there is no second guessing shenanigans. An If - Then Scenario. If = if it trades or closes here. Then = Hard stop executes or end of day signals I close on tomorrows open. Simple, repeatable but also meaningful. Simply pinning a stop order on a position doesn’t in itself really mean anything. Random stops as with random position sizing will give random results.
Reward to Risk Flip and Overriding Stops.
Overriding predetermined stop loss orders by exiting a position early could be a double edged sword. As with outliers where prices can execute your stop loss before moving back to high's they can also trade close to your stop loss without executing and move back to high's. Sometimes you can be exiting a position to save pennies at the cost of pounds. If you loaded a trade with a reward to risk of 2-1 meaning your target will return 2 times your risk then the reward to risk will dynamically increase if price fades from the entry. If the entry was 100, the stop order was 90 and the target was 120 this would give a reward to risk of 2-1. What if price pulled back to 95? The reward to risk is now dynamically reading risk=5 - reward=20. You are risking 1 to make 4. What if price pulled back to within 1 point of your stop order. The trade is dynamically reading risk=1 - reward=20. You are now risking 1 to make 20. Reward to risk is actually at its greatest near the stop order and until that order executes you are still in the game. Exiting trades early for whatever reason as price fades in the direction of the stop is going to be better where reward to risk flip is at a minimum and that is going to be near the entry price.
Why Use a Stop Order?
This might sound like a very simplistic question but it actually goes much deeper than that. I've chosen to leave "loss" out of the stop order title as its very misleading as to what the use of stop orders can introduce to trade and money management.
Having a well thought out wrong area for the exit of a trade gives a bracket to position size for. The exit area could be within the noise being close to price or outside the noise meaning the volatility would need to increase to an extent that it trades outside its usual range to execute an exit signal. If you know where you want to exit then you have the first piece of a trade plan. With this information you can now move forward to add some bomb proof risk management to prevent you from exposing your account to the potential destruction of a black swan event or prolonged bear market that could put you in a hole that is so deep many don’t have the psychology needed to trade out of. Simply understanding that whipsaws will happen and sticking with the exit plan is the key to being relaxed knowing that if the worst case scenario happens tomorrow I've already got it covered. It all starts with a simple stop order. I think my friend Murray said it best. Its better to be whipsawed than to be chainsawed.