Dinosaur Trader wrote a post on his blog about respecting your stops. Basically he’s talking about not moving or ignoring stop levels. This is something that a great many new traders have a very hard time with.
Personally, I think part of the problem is the way people set their stops.
Stops generally come in two forms. One is the stop loss type. Those are ones where a trader places a stop at a point which prevents her/him from losing more than some predetermined amount on a trade. The other is the trade exit stop, which could also be called “if the market goes here the trade probably isn’t going to work out like I planned” stop.
I am not at all a proponent of the first type of stop. Firstly, it looks at things from the wrong perspective. It leads a lot of new traders to deciding first how many contracts or lots or shares to trade, then putting a stop at a point which fits their money management definitions. For example, a trader might buy 1000 shares of stock and put the stop $1 below the market because $1000 is where they want to cap their loss.
Contrary to what it might seem, this approach focuses first on profit and only secondarily on risk. As a result, stops which are too tight often are employed. That ends up leading to a higher chance of the stop getting hit, meaning on an aggregate basis the trader is actually increase their risk.
I also don’t like these money based stops because it takes the trader away from their strategy.
The second type of stop forces the trader to maintain a focus on their strategy. They are determining where they get out of the trade based on the rules of their trading, not some arbitrary point. This makes stops much more meaningful from a tactical and strategic point of view.
The second type of stop also gets the trader firstly focusing on risk, then adjusting trade size to fit. That’s the way to properly manage your risk.
Not respecting your stops comes at least in part from not having real faith in them. What kind of reliance can you have on the first type of stop? Those levels mean nothing. It’s quite easy to envision scenarios where a trader could very easily look at the price action and want to give the trade more room. When you follow the second stop path, though, your stop has a much firmer grounding so your rationale for not respecting them goes out the door.
Of course sometimes traders blow off their stops out of panic or some other emotional response. That won’t be completely avoided by better stop placement, but it could be meaningfully reduced.
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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
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