Dr. Keppler

Over the past few weeks I have received many questions and inquiries from students and traders about the placement of stops. All of the inquiries had one common thread; many of the traders were finding that their stops were being consistently hit. Once a stop is hit the loss is immediately incurred and locked in. When stops are frequently hit, the losses quickly add up and that should be a warning sign that something different needs to be done.

It is important to highlight that during the past several weeks the markets have experienced an extremely high level of volatility. Volatile markets demand adjustments to strategies and trading styles. Volatile markets will cause many stops to trigger that otherwise may not. There is always an increased level of risk whenever one trades in any volatile market.

While it is true that in general one of the most common reasons that cause many individual traders to lose money in the market is the way that they use their stop loss. This is especially true in volatile markets. The basic purpose of a stop loss is to help manage risk and protect a trader when a trade starts to move against them.

Unfortunately, all too often the stop loss becomes the primary source of losses for a trader. Even when they have correctly identified market direction, the market takes out their stop only to reverse and continue in the direction of the original trade. Some blame this frustrating experience on their broker; others blame the market makers or professional traders that are simply gunning for their stops. However, the true culprit is an efficient auction market.

The major problem with stop losses is that many traders place their stops in the same zone. These stops then appear as sitting orders on the exchange; naturally, an efficient market should fill as many orders as possible for both buyers and sellers. Once the market finds a large cluster of orders on the books, it needs to fill them. As a matter of fact the auction market would not be functioning efficiently if it abandons large clusters of orders and leaves them unfilled. The auction market must move in the direction of where the orders are to be found. A large cluster of stop orders is basically screaming at the market to be filled. Once the market fills this large cluster of stops and there are no more orders to fuel the market in the wrong direction, it now becomes time for the market to move back in the direction of where the other orders are sitting waiting to be filled. As a result, the dynamic auction quickly adjusts and starts to move back in the direction of where the volume and orders are found. The market is simply doing its job; it’s filling as many orders as it can for buyers and sellers.

Regrettably, once a stop is hit, the psychological impact of the loss keeps may traders on the sidelines and does not encourage them to participate in the directional move once it starts. There are a number of alternatives to tackle this problem. Each of the alternatives has its advantages and disadvantages. One possible solution is simply to overcome the psychological barriers and to develop the stamina required to enter the market again once the market starts to move directionally after taking out the stop.

Another, alternative is to use a wide stop. A stop that is away from the usual zone of where most stops are placed. This requires more experience on the part of the trader, first, it requires a trader to be able to identify the potential stop cluster zone and more importantly, it also demands that the trader be able to distinguish between a markets that is temporarily moving in the opposite direction vs. a market that has in fact changed direction. If the direction of the market has changed, the wide stop must be moved quickly to terminate the trade before the losses mount. Some choose to trade with what is called a “mental stop” along with an actual wide stop. The wide stop is immediately decreased to the mental stop level if the mental stop level is reached. This approach requires agility and a cooperative market. If the market is volatile, it is extremely difficult to properly implement this technique.

The issue can also be mitigated with an adjustment in position size, a trader may initially start the trade with a small position and a wide stop, this decreases the potential loss amount if the stop is triggered and allows the trade more room for fluctuations. Once the market starts to move in the desired direction the position size can then be increased with a greater level of confidence. The wide stop can also then be decreased and a trailing stop can be used to lock in profits.

Using and managing stops are both important skills that are cultivated with education and experience. The most dangerous and riskiest of all alternatives is to trade without any risk management in place. There is an art and science to the placement of stops, a stop should never be arbitrary, it should be determined based on the instrument, the individual’s trading style, trading goals and risk tolerance.