Trading Tips

Help to avoid setting your stops too tight

I’ve written before on how tight stops make me nervous because too often those who employ tight stops are thinking about how many points or pips they are willing to risk on a given trade, having already decided how big a position they are going to trade (“I’m trading a standard lot of EUR/USD, and I only want to risk $200, so my stop is 20 pips”). Sound familiar?

This also ties into the whole fixation on risk/reward ratios I discussed in Stop Getting Hung Up On Stops, Targets, and Risk/Reward. Too many traders fail to realize that the closer they put their stop, the higher the probability that stop gets hit. The result is normal market moves taken them out of their trades, which leads some to claim stop-hunting to place blame elsewhere. It also means a lower win %, which can severely impact their overall profitability.

What these traders should be thinking about instead is how many pips of risk there is in the trade they are looking to make, and then backing out the position size (“I’m risking 50 pips, so in order to only risk $200 I can put on 4 mini lots of EUR/USD”). Many traders figure out their risk point using some form of technical analysis, identifying a point beyond which the market should not go if the trade is to retain a good prospect of working out as expected (see Where do I put my stops to avoid being taken out?).

There’s something else which can help in this regard, particularly for those who’s trading approach does not lend itself to easy identification of exit points – or for those working on trading system development. It’s the concept of value-at-risk (VaR). The basic idea of VaR is that you develop an idea of what kind of move the market may make against you based on historical information. There are limitations to VaR, which I will address below, but it can be a starting point for developing a strategy for stop placement.

The forex broker OANDA has a VaR tool which can be used to this purpose in terms of currency pairs (I don’t know off-hand of a similar one for other markets, but if you do please post a link in the comment section below). It looks at recent history to give you an idea of the size of moves have occurred as a certain significance level. For example, if I want to look at EUR/USD in the 30-minute time frame covering 10 bars (5 hours) I get the following:

Here we have a breakdown of how EUR/USD has traded over the last 300 periods. It tells us that 95% of the time the market moved 90 pips or less, averaging 39 pips, with a maximum move of 127 pips. The report also provides a graphical representation of the types of moves the market has made.

Reports like this can be very useful in understanding how far away you should put your stop to avoid it getting hit by normal market volatility. In the example above, if you were to have your stop only 20 pips away from the market the odds would strongly favor it being hit, but if your stop was at 50 pips the odds would favor it not being reached.

I’m not suggesting you just use VaR in this fashion by itself to set your stops, but you can certainly use it to get an idea of whether a stop you are contemplating is in a high-risk position or not.

A word of caution with this kind of backward-looking VaR. The future may not look like the past. Specifically, the market may be more or less volatile (more being the bigger risk for most traders). As a result, you would be well-served in joining some kind of forward-looking indication of volatility to a VaR analysis so you don’t get caught by a major shift.

Also, don’t let the 95% or 99% confidence level stuff lull you into not taking proper risk precautions. A number of financial institutions were basically sunk during the Financial Crisis by developments beyond those confidence levels. That’s where individual traders can get destroyed too. And you don’t need to trade all that much before you effectively assure that you’re going to have to survive a market move beyond those bounds.

Trading Tips

Ten of the leading trader mistakes

Jim Wyckoff has a good article out which looks at the causes of trader failure.

  1. Failure to have a trading plan in place before a trade is executed.
  2. Inadequate trading assets or improper money management.
  3. Expectations that are too high, too soon.
  4. Failure to use protective stops.
  5. Lack of “patience” and “discipline.”
  6. Trading against the trend–or trying to pick tops and bottoms in markets.
  7. Letting losing positions ride too long.
  8. “Over-trading.”
  9. Failure to accept complete responsibility for your own actions.
  10. Not getting a bigger-picture perspective on a market.

I think this is a very good list. I dedicated a considerable amount of my book (and by extension my course) to developing a good trading plan, and many aspects of Jim’s list tie in with the things I talked about there. I have written previously on the subject of “protective stops“, so I won’t go into that again here. You can also see my recent post about traders letting losers run too long.

For me, #9 may be the biggest one of them all – at least for some people. Too many traders want to blame poor performance on someone else.

I will contend with Jim on the trading with/against the trend in #6 as there are systems that do quite well operating in a counter-trend (often called mean reversion) fashion. That, though, is different from trying to pick tops and bottoms, which usually ends in disaster.

The Basics

It’s not your broker stop-hunting you

Stop-hunting is a very commonly discussed topic in the retail forex community – probably more so than it really deserves to be. It seems to come from a fundamental lack of understanding about how the markets operate. A prime example is a recent thread started on BabyPips where the poster asked if it was possible for ECN brokers to run stops.

Here’s the deal. Despite what some people would like you to believe – mostly because they refuse to accept blame for their own inability to perform in the markets – brokers do not make a habit of running customer stops. They really just pass prices through from the inter-bank market. ECN brokers don’t make markets at all (yes, there have been some cases of manipulation, but they are not nearly as prevalent as the blamers suggest). They just pass customer orders through into the market for execution in a way not dissimilar to the way stock or futures brokers operate. They have absolutely zero influence on the prices shown.

Stop-hunting, which really should be called order-hunting because they go after limit orders as well, happens in the inter-bank market. If the market price gets sufficiently close to a level where it is suspected that a high quantity of standing orders sit, certain types of traders from banks, hedge funds, etc. will attempt to get those orders triggered to benefit from the subsequent move.

Talk with anyone who’s been a professional trader in anything like a market maker or floor trader situation and they will have plenty of stories about stop-running. It happens in all markets, not just forex. The way to avoid it catching you out is to either not use standing orders or to place them at price levels away from chart points where a lot of other traders are likely to have their orders.

Trading Tips

Minimum Stop Loss

A question came up on Trade2Win that I thought probably was of interest to readers here as well.

Hi, has anyone done a ‘study’ on the minimum stop loss required for different times of the day, when trading eur/usd ? or is this even possible to determine ?

Minimum stop loss = least likelihood of being stopped out with the smallest monetary outlay.

Optimal stop levels are always on the mind of traders, especially those looking to develop systems. The problem is coming up with them is oftentimes a completely worthless exercise. I can tell you from experience that putting in some kind of fixed stop into many (most?) trading systems actually degrades the system’s performance, except in the case of very large stops meant to catch the largest of adverse movements.

All of this is why I constantly make the point that one should think not in strict “stop loss” terms, but rather in “trade exit” terms. By this I mean that the stop point should be placed in line with whatever the exit strategy of the system or method or whatever requires. If you’re trend trading then your stop should be at a point where indications would conclude the trend isn’t in play any longer. In a range trading system the stop would be at the point where it’s clear the range trade is no longer working.

A proper trading strategy has both a well thought out entry point and a well thought out exit point – be they systematically derived or discrectionary. The are each based on the intended focus of the strategy, not totally seperate approaches. If you attempt to mis-match entry and exit you end up with a system that is inefficient all the way around.

Trading News

No Evidence of Stop Hunting by Retail Forex Brokers

The subject of stop hunting continues to come up quite frequently, especially where forex trading is concerned. In response to a thread on the subject, Skalpist left the following comments on a BabyPips forum entry (the main question of the thread was whether Oanda runs customer stops). I certainly haven’t done the kind of testing mentioned here, but I agree with the general conclusion.

I’ve tested this theory on A LOT of brokers. I have yet to find a broker that really stop hunts. One way to test this for yourself is to run multiple copies of MetaTrader each with a different broker.

At 4Squared, at one time we were doing this for 18 different brokers at once and tested across all of them for 6 months. In all that time, there was not a single SHRED of evidence that any of the brokers did anything remotely like what they are repeatedly being accused of.

Oanda was one of the brokers we tested.

Thus far, in all of our testing, we have found a 100% correlation between traders simply making poor trading decisions and their claims of stop hunting.

In short, Oanda doesn’t stop hunt, neither does IBFX, neither does FxOpen, or FXCM, or …

In the case of Oanda, they have something north of 1 billion in deposits and several hundred million in active trades. Do you really think a company that is making that much money servicing trades is going to screw it up in such an easily verifiable method of stealing? Give me a break.

Reader Questions Answered

A Reader’s Story About a Stop Getting Hit

A reader named Susan left this comment recently on the Some Not-So-Great Tips for Using Stop Orders post I wrote a while back. I think it does a great job of highlighting a situation – or at least a type of situation – which new traders find themselves in where stops are concerned.

I have a question, as a newbie to trading, and using things like stops, etc. We had purchased a stock that started to go up… after it was in profit, we placed a stop order, for about .15 below the current trading price. Until our stop order, the stock was steadily (fairly quickly) headed upwards… but just in case we were not at the screen, we thought we would try a stop order.

I can’t figure out if we did something wrong, or what happened. But this is my perception of what happened -… within seconds of my placed stop order, the stock price steadily dropped to my exact stop price, my shares sold, and then headed right back up to the previous high, to go on higher. All within 5 mins or less.

I am aware stock prices fluctuate, but to my eyes, it seemed my lower “steal of a sale price” was noticed, somehow snatched up, and thing continued on upwards.

Prices can fluctuate, and I guess coincidences can happen. Or the more obvious answer may be that I didn’t place the order correctly, or understand what was to happen once I did.

My understanding was that this price was to execute only if the stock (naturally) dropped.. not to sell at this price immediately (which would otherwise seem kinda MARKET….).

I know this isn’t the case, but it seemed as if someone could read our price, got the stock prices to go down, grabbed ours at a “deal/steal” and then got the stocks to start moving up again. But I can’t grasp what did happen, likely because I have no experience, so likely a misunderstanding of stops altogether, or movement of stocks, in the least.

Any help in understanding this? Thanks so much for your time.

OK. We don’t know what stock Susan is talking about here, so we don’t have a proper frame of reference for the price movements likely to be seen. That said, when I read that she was using a stop 0.15 below the market I just about fell over. I think most experienced stock traders would agree that this is probably way too close. A move like that for most stocks is little more than statistical noise. You’re almost guaranteed that it will get hit just as a result of normal price volatility created by the interaction of buy and sell orders hitting the market – or by news induced price swings.

Tightness of the stop aside, anyone who’s been in the markets for any length of time has seen at least one instance of their stop getting hit and the market basically turning right back around. It’s very annoying, of course, but if you need to expect it. All you can do is review the analysis you did in placing your stop there and see if that was the right decision given what you knew at the time.

There are, of course, situations where stops and other standing orders do get “run” by the market, where large players attempt to create price movement to trigger the execution of those orders. That really only happens when there are large numbers of stops all in a very obvious location, though. Chances are if you’re stop is hit it probably wasn’t any conscious act.

Reader Questions Answered

Different types of stops

Stops are always a favorite topic for discussion in trading circles. Here’s a recent question that came up from my mailing list.

One question which I think is important in this volatile market is to develop a tool box of stops to accommodate different trading Scenarios. Example: A capital protection stop in the early part of the trade then a break even stop and finally a succession of stops to protect your profit. Please could you elaborate on this subject.

For me a stop is an exit order. Exits are defined by one’s trading methodology. Where your system tells you to put your stop is where you should put it. I am not one who thinks in terms of “stop loss”. Rather I look at it from the perspective of the price level which tells me the trade is probably not going to work out the way I’d expected – or in the case of trailing stops, the underlying basis of the position is no longer in place.

Now, having said that, there are trading systems (like moving average cross-overs, for example) which do not employ stops or pre-designated specific exit levels. In that case, I can understand the use of a “stop loss” to prevent an extreme market event from blowing out your account. Aside from that, though, the exit you use should be whatever is defined by the system.