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.

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.

Trading Tips

Stop Getting Hung Up On Stops, Targets, and Risk/Reward

“Is 30 pips a good stop?”
“Should I use 50 pips as my target?”
“Your risk/reward ratio should be at least 3:1.”

These are some of the types of questions and statements I see in trading forum discussions on a pretty regular basis. New traders are always asking about the placement of stops, how much profit they should be taking  from a trade, what a good risk/reward ratio is and all of that. Usually they are doing it in isolation, without considering the big picture.

Let me make a few statements of my own.

A good stop allows a trade sufficient room to handle normal price volatility.
How far away that is from your entry point depends on things like your trading time frame and your trading methodology. No one can specifically tell you where that stop should be, unless they are trading the exact same way you are. New traders have a tendency to put stops too close because they think that means they are being less risky when in fact they are probably increasing their loss % and thus making their trading more risky.

There is no such thing as a stop that is “too wide”.
I see traders make statements like “I don’t want to risk 150 pips. That’s too much.” This completely misses the point. Your risk is defined by your trade size in conjunction with how far away you place your stop, not just your stop. If you need a “wide” stop, then trade smaller.

The Reward/Risk ratio is meaningless if you don’t know the Win%
Traders have a bias toward high R/R ratios. They think bigger is better. On the face of it, they’re right, but it’s only part of the equation. The R/R can only really be applied meaningfully in conjunction with the Win %. A system with a 4:1 R/R can be a loser (imagine a 20% win%) while a system with a 1:1 R/R can be a big winner (imagine a 70% win%). The two go hand in hand. If you have a low win % you need a high R/R. If you have a higher win%, then a lower R/R is fine, and in fact is probably all you’re going to get. If you’re winning at 75% and waiting only for 3:1 R/R trades then you are practically giving away profits.

Stops and Targets and Reward/Risk ratios are generally speaking not things you can just pick. They need to come from somewhere. That is, usually, your trading system. In particular, R/R is a metric like win % and average drawdown and all of that, not a variable for you to input. My advice to new traders is that they should spend a lot of time trying out different types of trading systems (ones which fit in with their overall trading plan, of course) to see what the metrics from them look like by way of comparison. The more of this you do, the better you will understand the way systems work and by extension how the market works.

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.

The Basics

Some Not-So-Great Tips for Using Stop Orders

Stock Trading to Go posted 10 Great Tips For Using Stop Loss Orders Successfully the other day. I’ll give the listing a middle grade. There are some good suggestions, but there’s also some stuff which range from perhaps too narrowly focused for general use all the way to just completely wrong.

First of all, I don’t agree with the idea put forth before the list of tips that stops are like insurance. Insurance makes you whole on losses suffered. Stops only provide a measure of assurance that they don’t get too large.

Here are the tips I’m good with:

2. Watch for hidden fees.
3. Never assume a stop loss order has been filled successfully.
6. New investors should use only stop market orders.
7. Use stop loss orders to setup a profit vs loss ratio.

In the case of #2, it’s a case where some brokers charge extra for non-market orders. And of course traders should always confirm all order entries and executions, which is #3.

In terms of #6, the comparison is against stop limit orders, which is where when a stop price is reached a limit order is activated rather than a regular market order. The difference is that a limit order will only be executed at the specified price or better. That means your order may not get filled, which you absolutely don’t want happening.

As for #7, I’ll go along with stops enforcing discipline and can help to better trade selection.

Now here are the ones I take issue with.

1. Never use stop loss orders for active trading.
4. For the original placement always give the stock at least 5% of space to avoid market maker abuse.
5. Don’t use stop loss orders for large positions.
8. Keep an eye out for after hours trading gaps.
9. Set the trigger price at common price increments.
10. Use with stocks that have high average daily volume.

Long-time readers of this blog know that I am not a fan of anyone using always or never in terms of trading rules, so you can guess my reaction to #1. That aside, the author is suggesting that because you’re in front of the screen watching the market you don’t need the stop. My contention is that stops help enforce discipline, and what happens if you are distracted by something while you’re trade is on?

Tip #4 is one that doesn’t fit many people’s trading. Short term traders, for example, may never expose themselves to a contrary move that large. I do, however, agree that stops should account for normal volatility.

Now for the really big problem for which I’m going to lump tips #5, #8, #9, and #10 together because they are all based on the same error in understanding. It’s one that appeared in the prior post that’s referenced at the outset of this one. The blogger is under the mistaken belief that a stop order will not get activated unless the market specifically trades at the order price. That is just flat out wrong, as this Investopedia definition indicates (italics mine):

What Does Stop Order Mean?
An order to buy or sell a security when its price surpasses a particular point, thus ensuring a greater probability of achieving a predetermined entry or exit price, limiting the investor’s loss or locking in his or her profit. Once the price surpasses the predefined entry/exit point, the stop order becomes a market order.

I tried to correct the blog author via comment when I saw the initial error, but it never went through (apparently). That site is one with a pretty large amount of traffic, suggesting the perception of authority, so I’m really surprised to see that kind of error being made.